Demand side: the Armington Assumption

SMART relies on the Armington assumption to model the behavior of the consumer. In particular, the adopted modeling approach is based on the assumption of imperfect substitutions between different import sources (different varieties). That is, goods (defined at the HS 6 digit level) imported from different countries, although similar, are imperfect substitutes—e.g., bananas from Ecuador are an imperfect substitute to bananas from Saint Lucia. Thanks to the Armington assumption, a preferential trade agreement does not produce a big bang solution, where all imports demand would shift to the beneficiary of the preferential tariff.

Within the Armington assumption, the representative agent maximizes its welfare through a two-stage optimization process:

• First, given a general price index, she chooses the level of total spending/consumption on a “composite good?, (say aggregate consumption of bananas). The relationship between changes in the price index and the impact on total spending is determined by a given import demand elasticity.
• Then, within this composite good, she allocates the chosen level of spending among the different �“varieties? of the good, depending on the relative price of each variety (say, choose more bananas from Ecuador, and less from Saint Lucia). The extent of the between-variety allocative response to change in the relative price is determined by the Armington substitution elasticity.

Next: Trade Effects

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