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Welfare costs and rent premia when quotas are not transferable
.
European
Trade
Economic
Review 38 (1994) 577-585
and Politics
EUROPEAN ECONOMIC REVIEW
of Trade
Welfare costs and rent premia when quotas transferable
are not
Jaime de Melo a *, Alex Pfaff b, David Tarr ’ * University of Geneva, CH-1205 Geneva, Switzerland b Massachusetts Institute of Technology, Cambridge, MA 02139, USA ’ World Bank, Washington, DC 20433, USA
Abstract Rationing is pervasive in transition economies and in many developing countries. This paper contrasts the welfare costs of two forms of rationing: with and without license transferability among license holders. In the latter case, for a given level of rationing, welfare costs will be higher if users of rationed products have different elasticities of demand. Illustrative general-equilibrium-based numerical calculations are carried out to derive orders of magnitude of the costs of rationing for an economy that trades 40 percent of its GDP with half of its imports concentrated in manufactures. In this setting, rationing of manufactures to 70 percent of their freetrade desired level reduces free-trade income by 6 percent when licenses are transferable. Nontransferability of licenses adds approximately 20 percent to the costs of rationing.
Key words: Quotas; Premia; Non-transferability; JEL
classification:
Fll;
General equilibrium
F13
1. Introduction Either through the rationing of foreign exchange or the licensing of imports, rationing of imports is still frequent in many developing countries. Although foreign exchange rationing often comes in response to a balance-of*Corresponding
author. This paper has been partially funded by RPO
Bank. The views are those of the authors, not those of their Alexander Meeraus and Wendy Takacs for helpful suggestions
respective
OO14-2921/94/$07.00 0 1994 Elsevier Science B.V. All rights reserved SSDl 0014-2921(93)E0082-V
677-91 at the World alliliations. We thank
578
J. de Me10 EI ul. 1 European Economic
Review 38 (1994) 577-585
payments crisis, once in place it is often maintained.’ Interest in the effects of rationing has also regained momentum with the analysis of reforms in transition economies where licensing has been widespread. Two broad types of rationing schemes have been used. One, the least pernicious, allocates foreign exchange licenses to the favored activities with license holders allowed to transfer licenses freely. The other, more frequently used, scheme does not allow license transfers of foreign exchange or the license to import. This paper compares these two forms of rationing. As shown below, in the latter case, rationing is no longer equivalent to a suitably defined equivalent across-the-board tariff, if users of the rationed imports do not use them in the same proportions. What are the likely welfare costs of these two rationing schemes? We estimate the effects of across-the-board import rationing under each type of scheme using a static general equilibrium model for an archetype economy disaggregated into seven sectors, with rationing taking place in the three manufacturing sectors. Section 2 describes how we model the two rationing schemes. Section 3 describes the calibrated economy subjected to rationing and Section 4 gives the results. Concluding remarks follow in Section 5. To anticipate our main results, we find that seemingly plausible (in terms of magnitude) rationing rates result in high distortionary costs estimates.
2. Modelling
rationing
We model rationing in a static general equilibrium model, whose structure is briefly described here (for details, see de Melo and Tarr (1992)). Commodities supplied (or purchased) abroad and domestic commodities sold on the domestic market are imperfect substitutes. This assumption of national product differentiation is commonly used in applied general equilibrium analysis. On the export side, the assumption of product differentiation is reflected in the constant elasticity of transformation (CET) function between domestic and foreign output. On the import side, the assumption of product differentiation is reflected in a CES function between imports and the corresponding domestic substitutes. A symmetric functional form is specified for intermediate demand by sector. Import supply (export demand) is
1 For example, Bhagwati (1977, pp. 36-37) notes that India imposes extremely specific QRs and bans transfers among license-holders. Until January 1989, Hungary licensed all imports, with the right to import limited to the original license holder; see Lanyi (1989). Rationing in the former Soviet Union (FSU), Poland and Algeria, was by means of foreign exchange allocation at the firm level without the right to transfer; see Michalopoulos and Tarr (1992) for the FSU, and Olechowski and Oles (1991) for Poland. For a description of licensing schemes in China, see Byrd (1987).
J. de Melo et al. 1 European Economic Review 38 (1994) 577-585
519
infinitely elastic, so there are no terms of trade effects induced by policy changes. Consumption demand is derived from a Stone-Geary utility indicator which allows for non-unitary income elasticities of demand and non-zero cross-price elasticities of demand between domestically produced and foreign produced consumer goods.’ Technology is parametrized by assuming CES functions for value-added and Leontief functions between intermediates (as a whole) and value-added, as well as across intermediates. However, within each sector, intermediate demand is a CES function between the domestically produced intermediate and the competing foreign intermediate. To given an example, no substitution is allowed between purchases of steel and glass when their relative prices change as a result of rationing, but there is substitution between domestic and imported steel when imported steel is rationed. Denoting by cij the elasticity of substitution between domestically and foreign-produced intermediates of sector of origin i by end-user j, the cost-minimizing input choice will be given by
where I/M,, and I/Dij are imported and domestic intermediate purchases of steel by sector j respectively, Sdij is the share parameter in the CES trade aggregation function, and 17, is the exogenous import price (where we ignore trade barriers for the moment), and PDi is the price of the domestic steel substitute product in sector i. In Eq. (1) aij is an elasticity of substitution, i.e., the percentage change in the ratio of domestic to import purchases with respect to their relative price. Rationing of consumer goods presents no allocative choice for license distributions since the model only has one representative consumer. However, for goods that are purchased by several end-users, that is intermediaries, there are two alternatives: either the aggregate volume of intermediate imports is restricted by say X percent, or else each user of imports is restricted by X percent. In both cases, the same reduction in import volume is achieved but in the former case, import license holders are allowed to trade them until the same premium value is received by all users, whereas in ‘The measure of the welfare change variation (EV) measure EV=CCwP’,Y’),
due to a policy change
PO)l -CCWPO,
is given by the Hicksian
equivalent
YO). POI,
where C is the cost function corresponding to the Stone-Geary utility indicator, superscripts 0 and 1 refer to the equilibrium before and after the counterfactual trade policy experiment, p is the vector of final goods prices, and IU is indirect utility which depends on prices and income. If EYis positive, the representative consumer is better off as a result of the policy shift.
580
J. de Melo et al. 1 European Economic
Review 38 (1994) 577-585
Fig. 1. The welfare costs of rationing
the second case, no license trading is allowed and premia values will differ across end users. Letting an asterisk denote an unrationed value and a superscript c denote a rationed variable, and defining VTMi=xj 1/M,,, the sum of intermediate imports of i used by all purchasing sectors, then rationing with license trading amounts to determining the premium rate pi such that the constrained quantities would have been demanded in an unconstrained equilibrium, i.e. VTMC < VTM;*ITi(
1 + C$Q),
(2)
where lli is the exogenous import supply price. Alternatively, when rationing takes place by end-user, there is an endogenously determined premium rate by end-user, k, i.e. I/TM;
< I/TM~,~17i(
1 + ~ik)
(3)
so that each user would be expected to pay a different price for the rationed commodity. The additional welfare cost of not allowing license trading is shown in Fig. 1 where My and MT are the import demand curves for two users, and S’S’ is the supply curve of imports. Without loss of generality, we assume that OM’ is the desired (and actual) import level by each user in the absence of rationing. Suppose now that each user is rationed to the import level OM’,.
J. de Melo et al. / European Economic
Review 38 (1994) 577-585
581
At this allocation, the value of a marginal unit to user 2 exceeds that to user 1. If licenses are transferable, trading will occur until the marginal value of restricted imports is equal for both users. This is shown in Fig. 1 by the rationed import allocations of OM; and OMC, (MiMi = M’,M’,). User 1 will transfer licenses to import M;M’, units to user 2, and a uniform premium, 4, results. If import licenses cannot be traded, i.e. if the rationed goods are directly allocated to end-users with no resale allowed, then at the constrained equilibrium marginal import values will not be equalized and the user with the most elastic demand will have the largest premium (d2 > #i). Under the usual partial equilibrium assumptions, Fig. 1 can be used to calculate the additional welfare loss from not allowing trade in licenses. Netting out the common areas, the additional welfare cost of not allowing trade licensing is (B+D+E)-(A)=B+C, which is the shaded area in Fig. 1.3 This additional welfare cost is an increasing function of the differences in import demand elasticities across end-users. In the formulation in Eq. (1) if the price of the domestically produced good and its quantity remains unchanged, Oij is the (expenditure compensated) price elasticity of import demand for i by end-users. Clearly if import demand elasticities are the same by end-user, the welfare cost of rationing will not be sensitive to differences in license allocation mechanisms. Whether or not users have different demand elasticities for intermediates is difficult to ascertain since econometric estimates typically do not provide price elasticities of demand by user. At the same time, even if demand elasticities were the same, in practice, rationing rates are rarely uniform across users. To illustrate the costs of alternative rationing schemes, we find it presentationally easier to impose the same set rationing rates across-theboard, but to allow for different elasticities across users. How we proceed is described below.
3. Base structure, calibration and elasticities The simulations to estimate the costs of rationing are intended to be representative of a semi-industrial developing economy or a transition economy. Typically, formerly planned economies inherited highly specialized industrial structures and traded extensively with other planned economies through bilateral trade agreements provided by the CMEA (see Tarr (1992) for a description of the bilateral rules that amounted to pervasive rationing). Not having at our disposition a reliable data set, we constructed a free-trade economy from Korean data for 1982 for an economy aggregated into seven 3 When license transfers are allowed, the welfare costs are areas (A+E+G)+(G+F) license transfers are not allowed (E + G) + (B + D + E + G + F).
and when
J. de Melo et al. / European Economic Review 38 (1994) 577-585
582
Table 1 Structure
of the calibrated
Sectors
(Oij)
economy”
Intm/DS
Finm/DS
Total importsb
Value added’
Primary 0.972 0.033 (38.9) 9,045 (13.2) (1.5) FoodProc 0.058 0.025 4,012 (1.2) (4.0) (5.9) ConsGood’ 0.122 0.055 5,701 (0.8) (9.4) (8.3) 0.026 ProdGood’ 0.214 (22.1) 7,901 (11.6) (0.6) 0.334 HeavyInd’ 0.437 (21.2) 4,013 (0.6) (5.9) 0.018 15,267 TrdServ 0.066 (22.3) (1.2) (4.4) 22,448 NonTrdServ (1.2) (32.8) _~ a Intm = Intermediate imports; Finm = Final goods imports;DS = Domestic supply; * = indicates sector subject to rationing. b Percentage of total imports. Imports are 42.3 percent of GDP and final goods imports are 17.9 percent of total imports. ’ Percentage of total value added in parentheses.
sectors. The advantage of using Korean data is threefold: Korea trades a large share of her GDP, has a well-developed industrial sector, and imports are concentrated in intermediate goods. To a large extent, these features approximate the foreign trade structures of many formerly planned economies (and of many developing countries). Table 1 displays the structure of the economy in the constructed solution along with the assumed values for the price elasticities of demand for imported intermediates.4 These estimates are based on Stern et al. (1976). Rationing is for manufacturing sectors. Both final goods and intermediate goods imports are rationed. This amounts to rationing sectors which account for 25.8 percent of GDP and rationing 52.6 percent of imports. In the base solution, prior to rationing, imports are equal to 42.3 percent of value-added. Thus rationing occurs for only about half of the total value of imports, probably an underestimate of the amount of rationing that often prevails. On the other hand, since the share of imports in GDP is high, rationing distorts resource allocation for a relatively large portion of the economy.
4. Results Table 2 gives the welfare cost estimates from progressive rationing (10 percent, 20 percent, 30 percent) of final and intermediate imports of: (i) consumer goods; (ii) producer goods; (iii) heavy industry. Starting from the same calibrated solution values, Table 2 gives estimates for two sets of
4The model was initially calibrated to the prevailing tariff structure solution was obtained by removing protection and solving the model.
in Korea.
The free trade
J. de Melo et al. / European Economic Review 38 (1994) 577-585
Table 2 Welfare costs of rationing trade income)
in manufacturing
(expressed
as a percent
583
of free
Equal elasticities of substitutionb
Unequal elasticities of substitutionc
Rationing rate
transferable (1)
not transferable (2)
transferable (3)
not transferable (4)
10%
-1.0 -2.6 -5.1
-1.0 -2.7 -5.9
-1.2 -3.4 -1.1
-1.4 -3.8 -8.6
20% 30%
a Welfare measured by the equivalent variation measure. For definition of EV measure, see footnote 3. Results in columns 1 and 3 (2 and 4) are for rationing with trading in licenses permitted (not permitted). bElasticities of substitution (03 are the same across users of intermediates and given by the elasticities in Table 1. ‘Same as b but the elasticities of substitution for the primary sector use of intermediates from the three manufacturing sectors are increased by 50 percent, and those for the manufacturing sectors are reduced by 50 percent, thereby maintaining the same import-weighted average elasticity of substitution for intermediate imports as in column 2.
substitution elasticities for intermediate imports (aij) to contrast the effect of allowing license transferability. One set of elasticities imposes the same value for all users of intermediate imports (aij= gik for all i, j, k), the other allowing for differences across users but maintaining the same average elasticity (see Table 2). Consider first the estimated welfare costs of rationing when licenses are transferable and elasticities are the same across users (column 1). The distortionary costs of rationing rise more than proportionately with rationing. With a 10 percent rationing rate, the welfare cost is only 1 percent of initial income, but with a 30 percent rationing rate, the cost is 5.7 percent of initial income. This is due in part to the nonlinearity in demand and supply curves that cause the distortionary costs to rise more than proportionately with the premium. It is also due to the fact that when the premium increases, with no change in elasticity, the quantity change also increases which acts multiplicatively on the distortion wedge in calculating the welfare wedge. These results illustrate the biases that are likely to result from partial equilibrium estimates obtained from linearizing demand and supply elasticities around the base solution (as would be done with calculations based on Fig. 1).5 Contrast now the results in column (2) with those above. End-users still ’ An example is the classic calculation by Harberger (1959) for Chile. Based on linear approximation calculations, he concludes (1959, p. 140) that an upper bound estimate for the welfare costs of trade distortions in Chile at 5 percent of GDP.
584
J. de Melo et al. / European Economic Review 38 (1994) 577-585
face the same set of elasticities but licenses are no longer transferable. As suggested by the discussion in Fig. 1, when users face the same substitution elasticities, not allowing license transfer causes little increase in the estimates of the costs of rationing, at least for moderate rationing rates. However, for rationing rates of 30 percent (and certainly beyond), the divergence accentuates because the demand elasticity also depends on the initial shares dij which differ across sectors. With equal substitution elasticities of demand across users, the costs of rationing manufacturing sector imports are already close to 6 percent of GDP. When users face different substitution elasticities of demand (columns 3 and 4) welfare costs are higher, increasing by two percentage points of GDP when licenses are transferable. Not allowing for license transferability raises the estimated welfare cost by another percentage point of GDP. With only half the value of imports under rationing, the estimated cost of rationing is 8.6 percent of GDP. When licenses are transferable, premia are equalized across users so the variance across intermediate goods users is zero. For example, in the case of 30 percent rationing with unequal elasticities mean premia are (figures in consumer parentheses): consumer goods (149 percent); producer goods (343 percent); and heavy industry (613 percent). When licenses are not transferable, premia rates differ across users and the corresponding mean and coefficient of variation values (for the same rationing rate and elasticities) are: consumer goods (145 percent, 15); producer goods (463 percent, 58); and heavy industry (563 percent, 116). In this latter case, the welfare cost of rationing manufacturing sector imports by 30 percent amounts to 36.2 percent of initial value-added in manufacturing.
5. Conclusions The traditional calculations of the costs of protection are usually based on tariff data alone because of the difficulty of collecting reliable data on the tariff equivalents of QRs. These calculations are also typically carried out in partial equilibrium using linear approximations and taking income in the distorted situation as the point of reference. The result are relatively small estimates of the welfare costs of protection, a typical upper bound estimate being Harberger’s (1959) estimate of 5 percent of GDP for Chile. The approach in this paper was to carry out general equilibrium calculations taking the free trade income level as the basis for evaluation and to consider the costs of protection by introducing rationing of imports rather than tariff protection. It was shown that for plausible elasticity estimates of an economy trading about 40 percent of its GDP, and in which only half of the value of imports are rationed, the welfare costs of reducing rationed imports by 30 percent of their desired value could yield a cost ranging
J. de Melo et al. 1 European Economic Review 38 (1994) 577-585
between 8 and 9 undoubtedly rough tically explored by trade regimes such highly inefficient.
585
percent of GDP. While these higher estimates are approximations, they confirm the intuition, first systemaBhagwati (1978) and Krueger (1978), that QR-ridden as those found in many formerly planned economies, are
References Bhagwati, J., 1978, Foreign trade regimes and economic development: Anatomy and consequences of exchange control regimes (Ballinger, Cambridge, MA). Brada, J., 1993, Regional integration in Eastern Europe: Prospects for integration within the region and with the European Community, in: J. de Melo and A. Panagariya, eds., New dimensions in regional integration (Cambridge University Press, Cambridge) 319-346. Byrd, W.A., 1987, The impact of the two-tier plan/market system in Chinese industry, Journal of Comparative Economics 11, 295-308. de Melo, J. and D. Tarr, 1992, A general equilibrium analysis of US foreign trade policy (MIT Press, Cambridge, MA). Harberger, A., 1959, Using the resources that hand more effectively, American Economic Review 69, 134146. Havrylyshyn, 0. and D. Tarr, 1991, Trade liberalization, in: P. Marer and S. Zecchini, eds., The transition to a market economy (OECD, Paris). Krueger, A., 1978, Foreign trade regimes and economic development: Liberalization attempts and consequences (NBER, Distributed by Ballinger, Cambridge, MA). Lanyi, K., 1989, Invisible regulations and deregulation in Hungarian foreign trade, UNDP World Bank conference paper, Budapest. Michalopoulos, C. and D. Tarr, 1992, Trade and payments arrangements for states of the former USSR (The World Bank, Washington, DC). Olechowski, A. and M. Oles, 1991, Poland, in: J. Williamson, ed., Currency convertibility in Eastern Europe (Institute for International Economics, Washington, DC). Stern, R., J. Francis and B. Schumacher, 1976, Price elasticities in international trade: An annotated bibliography (Trade Policy Research Centre, Distributed by Macmillan, London). Tarr, D., 1992, Problems in the transition from the CMEA: Implications for Eastern Europe, Communist Economies and Economic Transformation 4, no. 1, 2343.
European
Trade
Economic
Review 38 (1994) 577-585
and Politics
EUROPEAN ECONOMIC REVIEW
of Trade
Welfare costs and rent premia when quotas transferable
are not
Jaime de Melo a *, Alex Pfaff b, David Tarr ’ * University of Geneva, CH-1205 Geneva, Switzerland b Massachusetts Institute of Technology, Cambridge, MA 02139, USA ’ World Bank, Washington, DC 20433, USA
Abstract Rationing is pervasive in transition economies and in many developing countries. This paper contrasts the welfare costs of two forms of rationing: with and without license transferability among license holders. In the latter case, for a given level of rationing, welfare costs will be higher if users of rationed products have different elasticities of demand. Illustrative general-equilibrium-based numerical calculations are carried out to derive orders of magnitude of the costs of rationing for an economy that trades 40 percent of its GDP with half of its imports concentrated in manufactures. In this setting, rationing of manufactures to 70 percent of their freetrade desired level reduces free-trade income by 6 percent when licenses are transferable. Nontransferability of licenses adds approximately 20 percent to the costs of rationing.
Key words: Quotas; Premia; Non-transferability; JEL
classification:
Fll;
General equilibrium
F13
1. Introduction Either through the rationing of foreign exchange or the licensing of imports, rationing of imports is still frequent in many developing countries. Although foreign exchange rationing often comes in response to a balance-of*Corresponding
author. This paper has been partially funded by RPO
Bank. The views are those of the authors, not those of their Alexander Meeraus and Wendy Takacs for helpful suggestions
respective
OO14-2921/94/$07.00 0 1994 Elsevier Science B.V. All rights reserved SSDl 0014-2921(93)E0082-V
677-91 at the World alliliations. We thank
578
J. de Me10 EI ul. 1 European Economic
Review 38 (1994) 577-585
payments crisis, once in place it is often maintained.’ Interest in the effects of rationing has also regained momentum with the analysis of reforms in transition economies where licensing has been widespread. Two broad types of rationing schemes have been used. One, the least pernicious, allocates foreign exchange licenses to the favored activities with license holders allowed to transfer licenses freely. The other, more frequently used, scheme does not allow license transfers of foreign exchange or the license to import. This paper compares these two forms of rationing. As shown below, in the latter case, rationing is no longer equivalent to a suitably defined equivalent across-the-board tariff, if users of the rationed imports do not use them in the same proportions. What are the likely welfare costs of these two rationing schemes? We estimate the effects of across-the-board import rationing under each type of scheme using a static general equilibrium model for an archetype economy disaggregated into seven sectors, with rationing taking place in the three manufacturing sectors. Section 2 describes how we model the two rationing schemes. Section 3 describes the calibrated economy subjected to rationing and Section 4 gives the results. Concluding remarks follow in Section 5. To anticipate our main results, we find that seemingly plausible (in terms of magnitude) rationing rates result in high distortionary costs estimates.
2. Modelling
rationing
We model rationing in a static general equilibrium model, whose structure is briefly described here (for details, see de Melo and Tarr (1992)). Commodities supplied (or purchased) abroad and domestic commodities sold on the domestic market are imperfect substitutes. This assumption of national product differentiation is commonly used in applied general equilibrium analysis. On the export side, the assumption of product differentiation is reflected in the constant elasticity of transformation (CET) function between domestic and foreign output. On the import side, the assumption of product differentiation is reflected in a CES function between imports and the corresponding domestic substitutes. A symmetric functional form is specified for intermediate demand by sector. Import supply (export demand) is
1 For example, Bhagwati (1977, pp. 36-37) notes that India imposes extremely specific QRs and bans transfers among license-holders. Until January 1989, Hungary licensed all imports, with the right to import limited to the original license holder; see Lanyi (1989). Rationing in the former Soviet Union (FSU), Poland and Algeria, was by means of foreign exchange allocation at the firm level without the right to transfer; see Michalopoulos and Tarr (1992) for the FSU, and Olechowski and Oles (1991) for Poland. For a description of licensing schemes in China, see Byrd (1987).
J. de Melo et al. 1 European Economic Review 38 (1994) 577-585
519
infinitely elastic, so there are no terms of trade effects induced by policy changes. Consumption demand is derived from a Stone-Geary utility indicator which allows for non-unitary income elasticities of demand and non-zero cross-price elasticities of demand between domestically produced and foreign produced consumer goods.’ Technology is parametrized by assuming CES functions for value-added and Leontief functions between intermediates (as a whole) and value-added, as well as across intermediates. However, within each sector, intermediate demand is a CES function between the domestically produced intermediate and the competing foreign intermediate. To given an example, no substitution is allowed between purchases of steel and glass when their relative prices change as a result of rationing, but there is substitution between domestic and imported steel when imported steel is rationed. Denoting by cij the elasticity of substitution between domestically and foreign-produced intermediates of sector of origin i by end-user j, the cost-minimizing input choice will be given by
where I/M,, and I/Dij are imported and domestic intermediate purchases of steel by sector j respectively, Sdij is the share parameter in the CES trade aggregation function, and 17, is the exogenous import price (where we ignore trade barriers for the moment), and PDi is the price of the domestic steel substitute product in sector i. In Eq. (1) aij is an elasticity of substitution, i.e., the percentage change in the ratio of domestic to import purchases with respect to their relative price. Rationing of consumer goods presents no allocative choice for license distributions since the model only has one representative consumer. However, for goods that are purchased by several end-users, that is intermediaries, there are two alternatives: either the aggregate volume of intermediate imports is restricted by say X percent, or else each user of imports is restricted by X percent. In both cases, the same reduction in import volume is achieved but in the former case, import license holders are allowed to trade them until the same premium value is received by all users, whereas in ‘The measure of the welfare change variation (EV) measure EV=CCwP’,Y’),
due to a policy change
PO)l -CCWPO,
is given by the Hicksian
equivalent
YO). POI,
where C is the cost function corresponding to the Stone-Geary utility indicator, superscripts 0 and 1 refer to the equilibrium before and after the counterfactual trade policy experiment, p is the vector of final goods prices, and IU is indirect utility which depends on prices and income. If EYis positive, the representative consumer is better off as a result of the policy shift.
580
J. de Melo et al. 1 European Economic
Review 38 (1994) 577-585
Fig. 1. The welfare costs of rationing
the second case, no license trading is allowed and premia values will differ across end users. Letting an asterisk denote an unrationed value and a superscript c denote a rationed variable, and defining VTMi=xj 1/M,,, the sum of intermediate imports of i used by all purchasing sectors, then rationing with license trading amounts to determining the premium rate pi such that the constrained quantities would have been demanded in an unconstrained equilibrium, i.e. VTMC < VTM;*ITi(
1 + C$Q),
(2)
where lli is the exogenous import supply price. Alternatively, when rationing takes place by end-user, there is an endogenously determined premium rate by end-user, k, i.e. I/TM;
< I/TM~,~17i(
1 + ~ik)
(3)
so that each user would be expected to pay a different price for the rationed commodity. The additional welfare cost of not allowing license trading is shown in Fig. 1 where My and MT are the import demand curves for two users, and S’S’ is the supply curve of imports. Without loss of generality, we assume that OM’ is the desired (and actual) import level by each user in the absence of rationing. Suppose now that each user is rationed to the import level OM’,.
J. de Melo et al. / European Economic
Review 38 (1994) 577-585
581
At this allocation, the value of a marginal unit to user 2 exceeds that to user 1. If licenses are transferable, trading will occur until the marginal value of restricted imports is equal for both users. This is shown in Fig. 1 by the rationed import allocations of OM; and OMC, (MiMi = M’,M’,). User 1 will transfer licenses to import M;M’, units to user 2, and a uniform premium, 4, results. If import licenses cannot be traded, i.e. if the rationed goods are directly allocated to end-users with no resale allowed, then at the constrained equilibrium marginal import values will not be equalized and the user with the most elastic demand will have the largest premium (d2 > #i). Under the usual partial equilibrium assumptions, Fig. 1 can be used to calculate the additional welfare loss from not allowing trade in licenses. Netting out the common areas, the additional welfare cost of not allowing trade licensing is (B+D+E)-(A)=B+C, which is the shaded area in Fig. 1.3 This additional welfare cost is an increasing function of the differences in import demand elasticities across end-users. In the formulation in Eq. (1) if the price of the domestically produced good and its quantity remains unchanged, Oij is the (expenditure compensated) price elasticity of import demand for i by end-users. Clearly if import demand elasticities are the same by end-user, the welfare cost of rationing will not be sensitive to differences in license allocation mechanisms. Whether or not users have different demand elasticities for intermediates is difficult to ascertain since econometric estimates typically do not provide price elasticities of demand by user. At the same time, even if demand elasticities were the same, in practice, rationing rates are rarely uniform across users. To illustrate the costs of alternative rationing schemes, we find it presentationally easier to impose the same set rationing rates across-theboard, but to allow for different elasticities across users. How we proceed is described below.
3. Base structure, calibration and elasticities The simulations to estimate the costs of rationing are intended to be representative of a semi-industrial developing economy or a transition economy. Typically, formerly planned economies inherited highly specialized industrial structures and traded extensively with other planned economies through bilateral trade agreements provided by the CMEA (see Tarr (1992) for a description of the bilateral rules that amounted to pervasive rationing). Not having at our disposition a reliable data set, we constructed a free-trade economy from Korean data for 1982 for an economy aggregated into seven 3 When license transfers are allowed, the welfare costs are areas (A+E+G)+(G+F) license transfers are not allowed (E + G) + (B + D + E + G + F).
and when
J. de Melo et al. / European Economic Review 38 (1994) 577-585
582
Table 1 Structure
of the calibrated
Sectors
(Oij)
economy”
Intm/DS
Finm/DS
Total importsb
Value added’
Primary 0.972 0.033 (38.9) 9,045 (13.2) (1.5) FoodProc 0.058 0.025 4,012 (1.2) (4.0) (5.9) ConsGood’ 0.122 0.055 5,701 (0.8) (9.4) (8.3) 0.026 ProdGood’ 0.214 (22.1) 7,901 (11.6) (0.6) 0.334 HeavyInd’ 0.437 (21.2) 4,013 (0.6) (5.9) 0.018 15,267 TrdServ 0.066 (22.3) (1.2) (4.4) 22,448 NonTrdServ (1.2) (32.8) _~ a Intm = Intermediate imports; Finm = Final goods imports;DS = Domestic supply; * = indicates sector subject to rationing. b Percentage of total imports. Imports are 42.3 percent of GDP and final goods imports are 17.9 percent of total imports. ’ Percentage of total value added in parentheses.
sectors. The advantage of using Korean data is threefold: Korea trades a large share of her GDP, has a well-developed industrial sector, and imports are concentrated in intermediate goods. To a large extent, these features approximate the foreign trade structures of many formerly planned economies (and of many developing countries). Table 1 displays the structure of the economy in the constructed solution along with the assumed values for the price elasticities of demand for imported intermediates.4 These estimates are based on Stern et al. (1976). Rationing is for manufacturing sectors. Both final goods and intermediate goods imports are rationed. This amounts to rationing sectors which account for 25.8 percent of GDP and rationing 52.6 percent of imports. In the base solution, prior to rationing, imports are equal to 42.3 percent of value-added. Thus rationing occurs for only about half of the total value of imports, probably an underestimate of the amount of rationing that often prevails. On the other hand, since the share of imports in GDP is high, rationing distorts resource allocation for a relatively large portion of the economy.
4. Results Table 2 gives the welfare cost estimates from progressive rationing (10 percent, 20 percent, 30 percent) of final and intermediate imports of: (i) consumer goods; (ii) producer goods; (iii) heavy industry. Starting from the same calibrated solution values, Table 2 gives estimates for two sets of
4The model was initially calibrated to the prevailing tariff structure solution was obtained by removing protection and solving the model.
in Korea.
The free trade
J. de Melo et al. / European Economic Review 38 (1994) 577-585
Table 2 Welfare costs of rationing trade income)
in manufacturing
(expressed
as a percent
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of free
Equal elasticities of substitutionb
Unequal elasticities of substitutionc
Rationing rate
transferable (1)
not transferable (2)
transferable (3)
not transferable (4)
10%
-1.0 -2.6 -5.1
-1.0 -2.7 -5.9
-1.2 -3.4 -1.1
-1.4 -3.8 -8.6
20% 30%
a Welfare measured by the equivalent variation measure. For definition of EV measure, see footnote 3. Results in columns 1 and 3 (2 and 4) are for rationing with trading in licenses permitted (not permitted). bElasticities of substitution (03 are the same across users of intermediates and given by the elasticities in Table 1. ‘Same as b but the elasticities of substitution for the primary sector use of intermediates from the three manufacturing sectors are increased by 50 percent, and those for the manufacturing sectors are reduced by 50 percent, thereby maintaining the same import-weighted average elasticity of substitution for intermediate imports as in column 2.
substitution elasticities for intermediate imports (aij) to contrast the effect of allowing license transferability. One set of elasticities imposes the same value for all users of intermediate imports (aij= gik for all i, j, k), the other allowing for differences across users but maintaining the same average elasticity (see Table 2). Consider first the estimated welfare costs of rationing when licenses are transferable and elasticities are the same across users (column 1). The distortionary costs of rationing rise more than proportionately with rationing. With a 10 percent rationing rate, the welfare cost is only 1 percent of initial income, but with a 30 percent rationing rate, the cost is 5.7 percent of initial income. This is due in part to the nonlinearity in demand and supply curves that cause the distortionary costs to rise more than proportionately with the premium. It is also due to the fact that when the premium increases, with no change in elasticity, the quantity change also increases which acts multiplicatively on the distortion wedge in calculating the welfare wedge. These results illustrate the biases that are likely to result from partial equilibrium estimates obtained from linearizing demand and supply elasticities around the base solution (as would be done with calculations based on Fig. 1).5 Contrast now the results in column (2) with those above. End-users still ’ An example is the classic calculation by Harberger (1959) for Chile. Based on linear approximation calculations, he concludes (1959, p. 140) that an upper bound estimate for the welfare costs of trade distortions in Chile at 5 percent of GDP.
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J. de Melo et al. / European Economic Review 38 (1994) 577-585
face the same set of elasticities but licenses are no longer transferable. As suggested by the discussion in Fig. 1, when users face the same substitution elasticities, not allowing license transfer causes little increase in the estimates of the costs of rationing, at least for moderate rationing rates. However, for rationing rates of 30 percent (and certainly beyond), the divergence accentuates because the demand elasticity also depends on the initial shares dij which differ across sectors. With equal substitution elasticities of demand across users, the costs of rationing manufacturing sector imports are already close to 6 percent of GDP. When users face different substitution elasticities of demand (columns 3 and 4) welfare costs are higher, increasing by two percentage points of GDP when licenses are transferable. Not allowing for license transferability raises the estimated welfare cost by another percentage point of GDP. With only half the value of imports under rationing, the estimated cost of rationing is 8.6 percent of GDP. When licenses are transferable, premia are equalized across users so the variance across intermediate goods users is zero. For example, in the case of 30 percent rationing with unequal elasticities mean premia are (figures in consumer parentheses): consumer goods (149 percent); producer goods (343 percent); and heavy industry (613 percent). When licenses are not transferable, premia rates differ across users and the corresponding mean and coefficient of variation values (for the same rationing rate and elasticities) are: consumer goods (145 percent, 15); producer goods (463 percent, 58); and heavy industry (563 percent, 116). In this latter case, the welfare cost of rationing manufacturing sector imports by 30 percent amounts to 36.2 percent of initial value-added in manufacturing.
5. Conclusions The traditional calculations of the costs of protection are usually based on tariff data alone because of the difficulty of collecting reliable data on the tariff equivalents of QRs. These calculations are also typically carried out in partial equilibrium using linear approximations and taking income in the distorted situation as the point of reference. The result are relatively small estimates of the welfare costs of protection, a typical upper bound estimate being Harberger’s (1959) estimate of 5 percent of GDP for Chile. The approach in this paper was to carry out general equilibrium calculations taking the free trade income level as the basis for evaluation and to consider the costs of protection by introducing rationing of imports rather than tariff protection. It was shown that for plausible elasticity estimates of an economy trading about 40 percent of its GDP, and in which only half of the value of imports are rationed, the welfare costs of reducing rationed imports by 30 percent of their desired value could yield a cost ranging
J. de Melo et al. 1 European Economic Review 38 (1994) 577-585
between 8 and 9 undoubtedly rough tically explored by trade regimes such highly inefficient.
585
percent of GDP. While these higher estimates are approximations, they confirm the intuition, first systemaBhagwati (1978) and Krueger (1978), that QR-ridden as those found in many formerly planned economies, are
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