D2.3 Armington-type trade models without CES


D2.3 Armington-type trade models without CES

Executive Summary

The standard way of modelling bilateral trade flows in the models in BATModel uses the Constant Elasticity of Substitution (CES) function in combination with the so-called Armington assumption (Armington 1969). Although a proven approach in numerous applications, it has some drawbacks when it comes to modelling homogeneous products and trade flows that either emerge or disappear. 

Three approaches have been pursued with the BATModel project to resolve these issues. The first approach works with the implementation of more flexible functional forms in place of the CES function. The second replaces the reduced-form CES approach with a spatial price equilibrium coupled with explicit and increasing trade costs. The
third considers the larger possilibity that some markets appear or disappear. So the emergence or removal of economic flows also concern the production and demand of new/old products, in addition to the trade flow. 

As regard the first approach, we maintain the Armington insights of many frictions captured in a reduced-form manner but implement it with a LES-CES expenditure system. One critical contribution is the implementation in the large-scale PE and CGE models, used in the BATModel. 

As regard the second approach, a new modelling module has been defined which relies on the law of one price, i.e. with a Spatial Price Equilibrium (SPE) module. For each trade link, import price is at most as high as export price plus trade costs, and if there is a trade flow then the previously stated condition holds with equality. Moreover, trade costs are assumed to increase in trade volume of each flow, providing an easy way of calibrating the trade flows to almost any observed pattern of trade and price differences.

As regard the third approach, a new modelling of production and demand of commodities have been developed, as well as a new trade model to link excess demands by all countries. This New Commodity Market (hereafter NCM) modelling approach also replaces the usual equations of production and demand, that are usually close to the
CES function used in the trade modelling, by more flexible ones (relying on normalised quadratic expenditure function and logit specification). One crucial issue when implementing this new approach is to gather economic data on latent production and demand flows. 

These three approaches have been tested on well know models: CAPRI, CGEBox and GTAP, starting with their GAMS version. The illustrative experiments show that the modelling innovations work as expected.