The transmission of import prices to domestic prices: an application to Indonesia

Abstract

The manner in which the landed price of imports affects domestic prices is central to trade policy analysis. This study clarifies the relationship between two methods of modelling this relationship. These are the pass-through elasticity and the ‘Armington’ elasticity of substitution in demand between imported and domestically produced goods. The latter treatment is commonly used within applied general equilibrium models. The properties of the models are sensitive to the assumed values of these elasticities, but empirical estimates of Armington elasticities are rare. The theoretical relationship between the pass-through elasticity and the Armington elasticity is derived from a simple supply and demand model which incorporates Armingtion assumptions. The relationship is then illustrated empirically in the context of rice imports into Indonesia. Even though imported and domestically produced rice are considered relatively close substitutes in demand within Indonesia, time series econometric estimates of the pass-through elasticity imply Armington elasticities no greater than about 5. The Armington elasticities implied by the estimates of the pass-through elasticity presented here are well within the range of parameter estimates normally assumed within applied general equilibrium models.