RDP 9312: A Re-examination of the Determinants of Australia's Imports 3. The Conceptual Framework

The equilibrium quantity of imports is the product of interaction between demand and supply in the market for importables. Demand can be satisfied from two sources: the foreign supply of imports or the domestic supply of substitutes. However, the determinants of supply are more complex than those of demand (Leamer and Stern 1970). Difficulties with respect to the identification of supply functions for importables have tended to be overcome by assuming that there is an infinite elasticity of supply, so that the equilibrium quantity of imports can be related solely to changes in demand (Murray and Ginman 1976, p.75). Certainly, there is likely to be infinite elasticity of the foreign supply of imports. This will not be the case for the domestic supply of substitutes. Thus, to the extent that the domestic supply of importables is relevant, import demand functions are, in effect, excess demand functions. Hereafter, import demand functions will be considered in that sense.

In the traditional model of import demand, import volumes are a function of real income and the price of importables relative to that of domestically produced goods:

where: M is the volume of imports; P_m is the price of imports; P_y is the price of domestically produced goods; and y is domestic money income.

This traditional import demand function is, however, the most restricted model presented in the literature. It distinguishes only between the prices of imports and those of all domestically produced goods. Purchasers, in fact, allocate their budgets between imports and various classes of domestically produced goods. Domestically produced goods comprise those which are exportable, importable and non-traded. The prices of each type of good can, therefore, be incorporated into an import demand model of Hall, Jankovic and Pitchford (1989).^[10] Furthermore, the import decision is also influenced by supply side conditions. Thus the traditional import demand function has been adapted to include additional prices and a supply side term. Typically, a term for capacity utilisation is included, although other supply side factors can be considered.^[11] Central to this paper is a measure of openness. Assuming that the import function is homogeneous of degree zero with respect to income and prices, it can be normalised by any one of these prices. Normalising by the price of non-traded goods yields:

where: there is a single price of importables; P_x is the domestic price of exportables; P_n is the price of non-traded goods; and z is a supply side condition.^[12]

This approach follows the analysis (Hall et al. 1989). Applications of it by Horton and Wilkinson (1989) and Wilkinson (1992) have made a valuable contribution to the Australian empirical literature by establishing a role for relative domestic prices in the determination of import demand.

The choice between equation (2) and any restricted version of it is ultimately an empirical question. The approach adopted in this paper is as follows. First, the traditional import demand function will be estimated. Then, additional terms will be included as arguments in the function. In particular, inclusion of a term for protection is expected to help explain import behaviour. The following sections describe the data required for estimation and the estimation technique to be adopted.

Footnotes

This approach assumes that there is no separability in consumption. Separability in consumption occurs when consumers allocate their expenditure first between traded and non-traded goods and then between imports and domestically produced import substitutes so that import demand is independent of the price of non-traded goods. For a detailed discussion of this issue see Goldstein et al. (1980). [10]

Reduced spare capacity may encourage consumers to switch from domestic to foreign sources of supply, thereby increasing the demand for imports. See Leamer and Stern (1970) and Gregory (1971) for an early discussion and, more recently, Wilkinson (1992). [11]

Use of a single price of importables does, however, carry with it the assumption that imports and import replacements are perfect substitutes with perfect price flexibility (Arndt 1979). If the assumption of the law of one price for importables were relaxed, functions for import demand could also include the domestic price of import substitutes. [12]