An Empirical Demand and Supply Model of Multilateral Trade

Abstract

T HIS study develops an empirical model for the joint determination of the demand and supply for bilateral trade, in which both bilateral quantities and bilateral prices are endogenous. In theory each bilateral demand (supply) equation would contain income (output) variables together with all relevant bilateral prices. Given differences in the commodity composition of trade and given price discrimination, export prices of any country will differ over destination countries. In addition, transport costs and tariffs will drive a wedge between bilateral export and import prices. Thus, a bilateral demand and supply system for aggregate trade among n countries would require consideration of 2n2 price variables, an overwhelming task for empirical research. As a compromise between pure theory and practice, we use a two-tier construction in which total import demand and export supply are determined by aggregate real income (output) and relative aggregate prices, and then bilateral trade flows are determined by theory-based allocations featuring relative bilateral prices. This approach is more general than either specifying only bilateral demand behavior (assuming infinitely elastic supply at given prices) or including the supply side through stringent assumptions such as constant market shares.' For empirical application the model is extended to include proxies for nonprice competition and structural factors, a flowadjustment specification of dynamics, and a trend/cycle decomposition of income (output). The model is estimated from a panel of bilateral trade flows covering the United States, Japan, France, Germany, and United Kingdom for the years 1958-1974. The theoretical model is developed in section II, the empirical specification is presented in section III, and the empirical results are discussed in section IV.