Armington Elasticities and Terms of Trade Effects in Global CGE Models

Multi-country computable general equilibrium (CGE) models are important tools for analysing tariff and trade policy changes and most such models incorporate the ‘Armington assumption’.

The Armington assumption differentiates commodities by their country of origin. It takes the products of an industry which come from different countries to be imperfect substitutes for each other. This model structure enables the construction of complex models based on existing world trade statistics.

The choice of the Armington assumption is an important one as it impacts on the outcomes of policy shocks introduced to CGE models. This is due to both the Armington structure itself and the size of the substitution elasticities, which can have a large effect on the terms of trade (the ratio of export to import prices).

This paper illustrates the complex relationship between the Armington assumption and the terms of trade. In particular, it demonstrates that:

• the terms of trade effect of a tariff is positively related to the home country’s elasticity of substitution between domestic and imported goods;
• the terms of trade effect of a tariff is negatively related to the elasticity of substitution between domestic and imported goods in foreign countries and to all foreign countries’ elasticities of substitution between import sources;
• increasing proportionally all elasticities of substitution, starting in the range of typical Global Trade Analysis Project (GTAP) default values, does not reduce terms of trade effects much, because these opposing effects approximately offset each other;
• • however, reducing proportionally all elasticities of substitution below unity increases the terms of trade effect sharply.

The results on the relationship between Armington elasticities and terms of trade are robust. They are not affected by the size of the tariff-imposing country relative to the rest of the world, nor by the dimension and structure of the model. The results hold for large sophisticated models of global trade, as well as for scaled-down versions.

• The results highlight the importance of understanding how the Armington assumption affects simulation results and the importance of having reliable, model-consistent and empirically sound estimates for Armington elasticities in any model that is used to simulate the effects of changes in trade policies.