Using gravity to move Armington An empirical approach to the small initial trade share problem in general equilibrium models Marijke Kuiper Agricultural Economics Research Institute (LEI) - Wageningen UR marijke.kuiper@wur.nl Frank van Tongeren OECD, Directorate for Food, Agriculture and Fisheries frank.vantongeren@oecd.org Paper prepared for the Ninth Annual Conference on Global Economic Analysis, June 15-17, 2006 in Addis Ababa, Ethiopia (Version 0.3, 3 May 2006) This paper is a result of work carried out on behalf of the OECD secretariat, Directorate for Food, Agriculture and Fisheries under contract nr. 28182. The views expressed are those of the authors and do not necessarily reflect the official views of the OECD or of the governments of its member countries. 1. The small shares problem This paper addresses a well-known problem in applied trade policy models using an Armington-style specification of import demand. The ‘small shares stay small’ problem implies that even after significant reductions of import barriers these models do not predict sizeable changes in trade flows from importers whose initial import shares are small before liberalisation, but who might be competitive suppliers after liberalisation. To solve this problem, this paper proposes a marriage between an estimated gravity equation and an Armington import demand specification, which both come together in a CGE model. The public and scientific debate on the expected impacts of trade liberalization, as for example aimed for in the current Doha round, is often based on ex-ante analyses of trade liberalization with general equilibrium models. The majority of these general equilibrium models is based on GTAP data and uses a similar theoretical structure. A key feature of this model structure is to model bilateral trade flows with an Armington specification. This specification is a convenient way to make the model correspond with important stylized facts such as imperfect transmission of world price changes to domestic prices, incomplete specialization and two-way trade. Most current applied general equilibrium models use a two-level structure to model import demand. Import demand is derived from decisions regarding the sourcing of goods for intermediate use or for final consumption. In step one goods are either from domestic or foreign origin. In the second step the foreign goods are sourced from different countries. Figure 1 reproduces the approach taken in GTAPEM. 1