Economic Reform, Allocative Efficiency, and Terms of Trade

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NOT FOR QUOTATION WITHOUT PERMISSION OF THE AUTHOR

ECONOMIC REFDRM,

ALLOCATlVE

EFFICIENCY, AND TERMS OF TRADE

Ern6 Zalai

November 1983 WP-83-112

Working Papers a r e interim reports on work of t h e International Institute for Applied Systems Analysis and have received only limited review. Views or opinions expressed herein do not necessarily represent those of t h e Institute or of its National Member Organizations.

INTERNATIONAL INSTITUTE FOR APPLIED SYSTEMS ANALYSIS 2361 Laxenburg, Austria

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This Working Paper is one of a series embodying t h e outcome of a workshop a n d conference on E c o n o m i c S t m c t u ~ d Change: A n a l y t i c a l Issues, held a t IIASA in July and August of 1983. The conference a n d workshop formed part of t h e continuing IIASA program on Patterns of Economic S t r u c t u r a l Change and Industrial Adjustment.

S t r u c t u r a l change was interpreted very broadly: t h e topics covered included t h e n a t u r e and causes of changes in different s e c t o r s of t h e world economy, t h e relationship between international m a r k e t s a n d national economies, a n d issues of organization a n d incentives in large economic systems.

There is a general consensus t h a t important economic s t r u c t u r a l changes a r e occurring in the world economy. There are, however, several alternative approaches t o measuring these changes, to modeling t h e process, and t o devis- ing appropriate responses in t e r m s of policy m e a s u r e s a n d institutional redesign. Other interesting questions concern t h e role of t h e international economic system i n transmitting such changes, a n d t h e m e r i t s of alternative modes of economic organization in responding t o s t r u c t u r a l change. All of t h e s e issues were addressed by participants in t h e workshop a n d conference, and will be t h e focus of t h e continuation of t h e r e s e a r c h program's work.

Geoffrey Heal Anatoli Smyshlyaev Erno Zalai

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ECONOMIC

_REFT)RM,

ALLOCATIVE

EFFICIENCY,

AND TERMS

OF TRADE

ErnZi Zalai*

1.

TNTRODUCTION

This paper addresses various issues related to, and in t h e framework of, a computable general equilibrium model of an open economy. The particular economy represented by t h e numerical model is t h a t of Hungary and t h e model is used, among o t h e r things, t o highlight some issues connected with economic reform. Foreign trade will be a focal point in our analysis of changing resource allocation p a t t e r n s under various assumptions.

Ideas for economic reform in Eastern Europe have in r e c e n t years developed through several stages; nevertheless, some basic elements have remained practically unchanged. Among these l a t t e r is t h e establishment of economically more sound price systems, t h e increased role of prices in economic decisions both a t the c e n t r a l (macro) a n d t h e enterprise (micro) level, and t h e simultaneous decentralization of decision making. The various suggestions for economic reform have rarely been based on a rigorously developed economic t h e oretical framework. However, i t is probably fair to say t h a t in most cases they have relied on some intuitive model of perfect competi- tion stimulated by individual or group financial/material interest. Hence, we believe t h a t t h e adoption of a competitive general equilibrium model framework for t h e analysis of expected outcomes of economic reform measures is justified.

In our analysis attention will be focused on r a t h e r specific problems.

Within t h e usual competitive static framework we will evaluate t h e expected impact of a price reform on t h e allocation of resources and t h e consequent gains in economic efficiency. Comparative static analysis involves t h e basic assumption t h a t the underlying s t r u c t u r e of the economy, for example,

*International h s t i t u t e for Applied Systems Analysis, Laxenburg, Austria. On leave from t h e Karl Marx University of Economics, Budapest, Hungary.

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technological conditions and consumer preferences, remains unchanged. This critical feature of the analysis will assume a special meaning in our case and add a n important qualification t o t h e interpretation of t h e results.

One plausible interpretation of t h e above assumptions is suggested by some ideas especially typical of earlier stages in t h e formulation of reform concepts. These were concerned mostly with t h e question of how t o improve central planning by means of establishing economically more sound price systems, which would aid planners in allocating resources according to optimal resource use.

Another, somewhat related interpretation can be distilled from t h e actual reform experience in Hungary. Many observers inside and outside Hungary assert t h a t , because of surviving institutional rigidities and worsening external trade conditions, t h e economic reform did not produce satisfactory results a t the micro (enterprise) level. The enterprises failed to modernize t h e i r product s t r u c t u r e to a sufficient extent, and consequently the increase in productivity and competitiveness on foreign and domestic markets was smaller than had been expected. Our simulation results suggest t h a t , under s u c h conditions, one can really expect only modest results (if any improvements a t all) from t h e introduction of an equilibrium price system and t h e corresponding reallocation of resources, i.e., following t h e rules of a laissez-faire m a r k e t equilibrium.

As mentioned above, we employ here a model of t h e computable general equilibrium type* to assess t h e repercussions of the assumed changes in a con- sistent manner. The basic assumption is t h a t changes in relative prices and costs will be followed by appropriate shifts in t h e composition of inputs, outputs, consumption, and trade. While t h e model is intended t o capture some ele- m e n t s of t h e working of an economic or planning system i n which prices a n d m a r k e t considerations play some role, albeit limited, it should not a n d cannot be regarded a s a fully adequate, descriptive model of t h e Hungarian or any other real economy. Our basic aim is to t e s t various reform concepts under t h e conditions outlined above.

Since we a r e dealing with an open economy, special attention is also paid t o foreign t r a d e and t h e possible effects of trade-liberalization policies. We repeat our comparative s t a t i c exercise under alternative assumptions concern- ing export conditions. In some runs we assume- (we believe, quite realistically) that, due t o o u r inability t o a l t e r the export s t r u c t u r e or t o unfavorable external conditions, changes in t h e volume of exports a r e accompanied by endogenously-induced terms-of-trade changes. We will show t h a t , contrary t o some common beliefs, moving closer to a market equilibrium (in s u c h a situation) does not necessarily improve Pareto efficiency. The increase i.n allocative efficiency will be reduced and may even be completely offset by endogenously- induced terms-of-trade deterioration. The optimum tariff a r g u m e n t suggests t h a t in such cases i t might be advantageous t o keep some central control over export decision.^. since individual exporters may not perceive (or i t may n o t be in their interest t o account for) this scale effect.

Finally, t h e paper also addresses a more general, methodological issue con- cerning computable general equilibrium modeling. This is t h e question of t h e t r e a t m e n t of foreign trade in general, and t h e so-called Armington assumption in particular. The numerical examples presented will illustrate t h e effect of alternative assumptions regarding export functions and t h e size of export

*Models of this type have been developed during the past decade in various places for economic policy analyses. Some representative examples are the work of Johansen (1959), D e . ~ s et al. (1982), Dixon e t al. (1982), Kelley e t al. (1983), m d Scarf and Shoven (1983).

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elasticities. I t will be argued t h a t t h e export demand furlctions and values of elasticities frequently adopted introduce unwanted and unreasonable terms-of- trade effects into t h e analysis, and t h a t these effects should and can be avoided.

2. THE MODEL:

AN

OUTLINE

Before presenting a complete mathematical s t a t e m e n t of t h e model, we will give an informal, brief outline for the sake of readers less interested in mathematical formulas. The model in most of its elements follows quite closely what may already be called a "traditional" computable general equilibrium approach. In this outline we will, however, also c o m m e n t on some less traditional features of our model, which distinguish i t from related models developed elsewhere.

Commodities in t h e model represent sectoral outputs and, according t o one fairly common statistical classification in Hungary, 19 s e c t o r s a r e distinguished. Commodities are further classified into t h r e e categories: domesti- cally produced, and competitive and noncompetitive imports. Both imports and exports are also classified in t e r m s of dollar and rouble trading areas, which results in a fairly detailed foreign trade structure. Rouble t r a d e in this version of t h e model is exogenously given, reflecting t h e fact t h a t rouble t r a d e flows as a rule are fixed by five-year bilateral agreements and t h u s a r e relatively inflexible over t h e short term. Exports and competitive imports a r e t r e a t e d as perfect substitutes for domestic products. This t r e a t m e n t , especially in t h e case of imports, is a departure from t h e traditional, neoclassical general equilibrium models, in which imports a r e usually t r e a t e d as imperfect substitutes.

Nevertheless, we employ formally similar, relative price dependent import share functions, as in t h e more traditional models, which can be derived on t h e basis of cost-minimization assumptions and a CES-type substitution function.

Our rationale for using t h e s e import s h a r e functions is, however, different from t h e neoclassical one (which assumes imperfect substitutability and perfect adjustment). They a r e intended to simply reflect limited (probably imperfect) adjustments t o relative price changes, which may be caused by a variety of factors. (It should be mentioned, though, t h a t t h e numerical results a r e not much affected by t h i s change in t r e a t m e n t . ) As a result, we have two s e t s of balance equations for t h e sectoral commodities: one combined balance for domesti- cally produced goods plus competitive imports, and one for t h e noncompetitive imports (eqns. 1 and 3, below).

Total use of commodities is split up between production, investment, consumption, and export (if applicable). Use in production and investment is determined through fixed input-output coefficients (Leontief technology). Con- sumption is treated in a special way, which c a n be viewed as a generalization of t h e frequently used Linear Expenditure System (LES). Total consumption (see eqns. 15-17) is made up of a fixed part (identified here with t h e base consumption) and a variable part (excess consumption). The s t r u c t u r e of t h e l a t t e r is fixed ( a Leontief or Kantorovich type of preference function), t h u s leaving only t h e level of excess consumption t o vary. This makes t h e implicit objective (welfare) function similar t o those employed in sorne linear planning models.

Another special advantage of this formulation is t h a t it allows us t o measure

*The model employed here was developed by t h e author, and more elaborate discussion of i t ctm be found in Zalai (1980, 1982). The author wishes t o achowledge the valuable assistance i n preparing the numerical version of the model given by his colleagues h t.he Hungarian Planning Office.

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welfare changes in a conceptually very simple way.

Gross investment is defined by eqn. (2) a s t h e s u m of replacement and new investment. The former is determined by t h e variable sectoral capital stocks and fixed replacement coefficients, which a r e different from t h e amortization rates. The amount of new ( n e t ) investment i s exogenously given in this version of t h e model.

Labor and capital a r e undifferentiated with respect to their sectoral use:

the;. a r e assumed to be freely mobile across sectors. The uses of labor and capital in production a r e specified by Cobb-Douglas production capacity functions (which results in a Johansen-type production technology). Sectors a r e assumed to minimize the joint cost of labor and capilal used. Total available labor and capital a r e held constant and assumed to be fully utilized (see balance equations 4 and 5).

The rest of t h e foreign trade relations a r e modeled as follows. Dollar exports a r e assumed to adjust t o relative (domestic/foreign) price changes and the size of shifts is determined by fixed elasticity coefficients.* This is a nor- mal, but critical t r e a t m e n t . Such a formulation is traditionally supported by Armington's (1969) assumption about regional product differentiation and leads to a downward-sloping export demand function. Conversely i t m e a n s t h a t t h e export price is assumed t o change with t h e volume of export. This is a tenable assumption even in t h e case of a "small" country, b u t leads t o some problems seldom addressed in applied models. We will come back t o this point during t h e discussion of t h e results. Since rouble t r a d e flows a r e fixed, we have only one balance-of-payment ( c u r r e n t account) constraint in t h e model for dollar trade.

The t a r g e t deficit level is fixed in t h e model.

Now we t u r n t o t h e description of the equilibrium pricing rules. As a basic principle we have tried to follow a s closely as possible t h e so-called two- channel, normative price formation rule, discussed extensively in the litera- t u r e related t o price reform ideas (see, for example, Csik6s-Nagy 1975). Equili- brium (domestic producers') prices are, t h u s , defined a s t h e s u m of unit material costs, amortization, wages, and uniformly determined (normative) r e t u r n s on labor and capital. The normative r a t e s of r e t u r n on labor and n e t capital a r e determined endogenously a s equilibrium r a t e s (factor clearing prices). The domestic price of dollar imports i s determined through their world m a r k e t price and t h e equilibrium exchange rate. The domestic price of rouble imports (since they a r e fixed) needs special treatment. In t h e noncompetitive sphere i t is assumed t o move in proportion to t h e price of dollar noncompetitive imports, whereas in t h e competitive sphere it varies proportionally to t h e average price level of t h e substitutes. And, finally, since we do not record how large t h e share of inputs from various sources is in different uses, the s a m e average sectoral prices a r e used to evaluate t h e composite input in each a r e a of use.

A complete formal description of t h e model, including t h e list of variables and parameters, now follows in Section 3.

*In two sectors (foreign trade and waterworks) we held export constant. In t h e first case because of accounting problems (some part of export earning is counted in t h e foreign trade sector, and as a result i t shows up as if it were an independent and very profitable exporting activity), and in the second case because of i t s negligible role and inelastic nature.

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3.

FORMAL

STLT%:!TEXT

OF

_TI* FdODEL

Endogenous Va~iables

Xj gross output in sector j = 1 , 2 , .

. .

, n

Mid competitive dollar import of commodity i ₌1 , 2 , . .

.

, n Z dollar export of c o m m o d i t , ~ i

=

1 , 2 , . .

.

, n

xi!.-+

¹ total gross investment

M i , ~ i d

total and dollar noncompetitive import of commodity

i

=

1 , 2 ,

. . . ,

n

Ci total private and public consumption of domestic-competitive - import commodity i

=

1 , 2 , ,

. .

, n

Ci total private and public consumption of noncompetitive import commodity i = 1 , 2 ,

. .

^,, n

Kj

capital used in sector j

=

1 , 2 ,

. . .

, n k j capital coefficient in sector j

=

1 , 2 , .

.

^., n Lj labor employed in sector j

=

1 , 2 , .

. .

, n

Z j labor coefficient in sector j

=

1 , 2 , . ^,

.

, n

Sj u s e r cost of labor and capital per unit of output in s e c t o r j

=

1 , 2 , . . . , n

Wj u s e r cost of labor in sector j

=

1 , 2 ,

. . .

, n

W

n e t r a t e of r e t u r n requirement on labor

Q

u s e r cost of capital in sector j

=

1 , 2 , .

. .

^,ⁿ

R n e t r a t e of r e t u r n requirement on capital

-

mi s h a r e of rouble import in total noncompetitive import of commodity i = 1 , 2 . .

. .

, n

rnir,mid proportions of competitive rouble a n d dollar imports of commodity i

=

1.2..

.

^,, n

P

domestic producer's price of commodity j

=

1 , 2 ,

. . .

^,ⁿ

Pjd

d

dollar export price of commodity j

=

1 , 2 ,

. . .

, n dollar exchange r a t e

average price of domestic-import composite commodity i

=

1 , 2 , , . . , n

E total consumption expenditure EE excess expenditure level

Ezogenous Variables and Parameters

sj capital replacement r a t e in sector j = 1 , 2 ,

. . .

, n

P

new investment (at base prices)

6 j depreciation r a t e in sector j

=

1 . 2 , .

. .

, n

K

total capital stock L total labor

q d , z i d

p a r a m e t e r s i n the dollar export functions

to,#.

parameters in t h e production functions

P ~ P dollar world market export and import prices of commodity i , (compe titive-noncompetitive import)

Dd

t a r g e t surplus or deficit on dollar foreign trade balance

%

input coefficient of domestic-import composite commodity i

=

1 , 2 , .

. .

^,ⁿ^{in sector}j

=

1 , 2 , .

. .

, n , n +1

M rouble competitive and noncompetitive imports of corn.modity i

=

1 , 2 ,

. . . ,

n

Zp,

rouble export of commodity i

=

1 , 2 ,

. . .

, n

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mg,rn$ p a r a m e t e r s in t h e import functions, i = 1 , 2 , .

.

. , n CLiT'k&i _bi,bi

1

fixed (base) a m o u n t of total consumption of commodity i

=

l , 2 . . . . , n

c i , c i - fixed s t r u c t u r e of excess consumption of commodity i = 1 , 2 , . . . , n

w j wage coefficient in s e c t o r j = 1 , 2 ,

. . .

, n -

vj r a t e of n e t t o gross capital in sector j = 1 , 2 , .

. .

, n

Balancing Equations Intermediate Commodities

Noncompetitive Imports

P r i m a r y Factors

Trade Balance

n -

W I -

2 ^P,E, ^qd ^-

^pi:%iid

^- z

^pid

^M~~ ⁼

^D~

T e c h m l o g i c a l Choice

ax.

"j

$= ".

I

where

s;' =

W j l j

+

Q j k j

(This l a t t e r equation is o m i t t e d from t h e model, since, by Euler's t h e o r e m , it is a direct consequence of eqns. 7-9.)

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Import and Jkport f i n c t i o n s Noncompetitive Imports

-

- Mtr mi

=

min -; 1

[ M i

:

Competitive Dollar Imports

Exports

Final Demand Equations

h i c e s and Costs

w, =

(1

+

w ) W j

Qj

=

(6,

+ ", ^{R )}

^P,+,

n n

- WI-

pn+l

= x

^{,n+l +}

C

^{vd pid} ^mi^,n+l

i =l t = l

pF _rd

= ,

I if t.here is n o endogenous export

pzE

price change assumed

' 1 1 %d i

=

1,2, . , . , n

]

^otherwise

Zpd

, &

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Price N o r m a l i z a t i o n Rule

4.

THE

SIMULATION F'RAMEWORK

AND

DATA

The data* for t h e model presented in t h e previous sections were mostly obtained from t h e 1976 official statistical input-output table of t h e Hungarian economy (see Csepinszky 1982). Where direct observations were not available we had t o rely on expert estimates or various r a t h e r ad hoc methods. Thus, for example, t h e r e is no published information available on t h e a r e a composition of exports a n d imports. The corresponding data in t h e model a r e therefore only rough estimates. Similarly, t h e initial dollar export prices (expressed in domestic c u r r e n c y units) were also estimated using indirect methods. The divi- sion of imports i n t o competitive and noncompetitive p a r t s was derived from more detailed (product group) investigation based on expert estimates.

The assignment of values t o t h e p a r a m e t e r s occurring in t h e technological and behavioral relationships constitutes a very frequently e n c o u n t e r e d problem. Available econometric estimates a r e scarce and very unreliable. We have followed t h e r a t h e r comrnon calibration procedure (see, for example, Mansur and Whalley 1983) in which most of these p a r a m e t e r s a r e "guesstimated" on t h e basis of t h e available l i t e r a t u r e and qualitative judgments, combined with sin- gle d a t a point estimates. These l a t t e r a r e derived by assuming t h e initial (base) s t a t e of t h e economy t o be, a t least partially, .one of equilibrium. In t h i s way, t h e model specification is capable of reproducing t h e initial position of t h e economy a n d comparative s t a t i c exercises can be performed. Table 1 contains some of t h e major indicators of the Hungarian economy i n 1976 and also a few crucial model parameters.

The specification of a n d elasticities i n t h e export relationships deserve special a t t e n t i o n here, because t h e sensitivity of t h e r e s u l t s with respect t o t h e s e factors i s one of t h e major concerns of t h i s paper. The main role of t h e export function is t o allow some limited shift i n t h e volume of exports i n various sectors if relative (foreign/domestic) prices change. In linear programming models of resource allocation t h e same goal (i.e., allowing for some, b u t not complete specialization) is achieved by t h e use of individual bounds on export activities. Here, in t h e case of relative price dependent export functions, t h e larger t h e elasticities of these functions, t h e larger t h e scope for taking advantage of international specialization. If, however, t h e y a r e i n t e r p r e t e d as export demand functions, which is often t h e case. t h e n t h e foreign price of t h e exported goods is dependent on t h e i r volume. The smaller t h e elasticities, t h e larger t h e size effect of t h e export volume on prices. The usual size of t h e s e elasticities is relatively small (-3; -1.5) both in t h e available l i t e r a t u r e on econometric e s t i m a t e s (see, for example, Houthakker a n d Magee 1969, Sato 1977, o r Browne 1982) a n d i n t h e CGE models using s u c h specifications. These small elasticities, however, imply t h a t endogenously-induced terms-OF-trade effects will be r a t h e r large, which may be h a r d t o justify on empirical grounds.

I t will, therefore, be interesting to s e e how t h e size of t h e export elasticities influence t h e solution of t h e model. To this e n d we have r e p e a t e d each

*The author wishes to acknowledge the invaluable assistance of Gy. Boda arid F. Hennelne in furnish- ing appropriate data for t h e model.

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TABLE 1 Sectoral characteristics of production. export and import (percentage shares), and trade elasticity parameters.

$ Competi- tive import/

domestic Import source

*

elasticity*

Import/

Share in Export/ $ Export/ Export domestic production production production* elasticity* source

2.27 3.63 0.84 -2.00 74.63

1.76 1.63 1.01 -3.00 10.34

4.9 1 33.01 23.00 -2.50 47.91

13.44 43.55 13.24 -2.50 80.14

1.63 12.29 7.91 -2.50 25.02

Net income shares

0.250 0.068 0.141 0.282 0.203 Sector

1. Mining 2. Electricity 3. Metallurgy 4. Machinery 5. Construction

materials 6. Chemicals 7. Light industries 8. Other manu-

facturing

9. Food processing 10. Construction 11. Agriculture 12. Forestry

and logging 13. Transport and

communication 14. Domestic trade 15. Foreign trade 16. Waterworks 17. Personal and

economic s e n i c e s 18. Health and

cultural s e n i c e s 19. Public ad-

ministration

Total 100.00 16.90 8.60 20.70 3.45

*Hypothetical data.

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simulation after doubling t h e size of t h e initial export elasticities.

Also, besides the pure export demand specification, we have r u n the model with two alternative variants. The first of these can be tentatively interpreted a s an export supply specification. In this r u n we assume t h a t t h e volume of export has no e f f e c t on t h e export price, i.e., t h a t t h e price is dictated by t h e world market; other than this, we use t h e same export functions. In t h e second case, we have tried to calculate a solution corresponding to t h e logic of a programming model or, using a t e r m familiar in international trade theory, to an optimal tariff situation. In this r u n we assume t h a t t h e terms-of-trade effects a r e real, but t h a t they a r e not perceived by t h e atomistic exporters. We wanted t o see how t h e planners optimum (in which t h e country takes advantage of t h i s m a r k e t "power" in international trade) would differ from the laissez-faire equilibrium (the first case). To obtain the exact results would in general require t h e solution of a relatively large nonlinear programming problem.

Since, however, our model is r a t h e r close to a neoclassical formulation, we can approximate this solution by introducing appropriate optimum tariffs into t h e determination of export revenues (for the analytical and theoretical underpin- nings of this approach, see Zalai 1982).

Thus, in effect, we will present in total six runs, which differ partly in t e r m s of export specification (pure demand, supply, and optimum tariff) and partly in terms of t h e size of t h e export elasticities.

As indicated earlier, t h e major t h r u s t of our simulation effort is t o esti- mate t h e impact of a price reform on t h e economy, if t h e relative price changes were followed by appropriate reallocation of resour-ces, including dollar foreign trade. In order t o do this we assume t h a t t h e initial state of t h e economy is

"almost" a general equilibrium one, in which t h e only major distortion mani- fests itself in t h e price system. That is, individual decisions a r e viewed a s roughly economically rational, except t h a t they a r e based on incorrect price information. (As can be seen in Table 1, sectoral prices include r a t h e r different n e t incomes (profits) in different sectors.) The above assumption is admittedly very bold, though not inconsistent with some (especially earlier) Hungarian reform ideas. More realistic assumptions would require qualitatively different model specifications, for which, for t h e time being, both theoretical and empirical bases a r e lacking.

Thus our model, with a slight change in its specification, reproduces t h e 1976 situation of t h e Hungarian economy. The change is in t h e price formation rule (see eqn. 21). Prices in t h e base case equal costs, which also include normative n e t incomes (close to 30 percent on wages and 5 percent on net capital value in 1976). "marked-up" by fixed, but sectorally different profit rates. In t h e vatious r u n s we calculate t h e effect of t h e abolition of these profit mark-ups, i.e., t h e effect of a price reform, where prices a r e formed according to t h e principle of uniform (normative) r e t u r n requirements. The optimum tariff calcula- tion includes, in addition, taxes on exports, which distinguishes i t from t h e o t h e r two specifications.

5. THE SIMULATION RESULIS

Table 2 contains t h e sectoral producers' price indexes calculated in t h e various runs. These may be of special interest because t h e r e a r e a number of published studies t h a t have calculated normative prices on t h e basis of input-output tables both in Hungary and elsewhere (see, for example, Ganczer 1962, BBrAny and Szakolczai 1975, and Banhidi 1978, for Hungary). These

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studies have u s e d a somewhat different methodology; for example, in m o s t cases t h e y rely on exogenously-defined normative r e t u r n r a t e s on labor a n d capital. Even where t h e y a r e endogenous ( a s in t h e c a s e of BBnhidi 1978), t h e m e t h o d followed i s different ( a closed Leontief model). What m a k e s our model clearly distinguishable from t h e previous ones i s t h a t s o m e of t h e input coefficients themselves (like those of labor a n d capital) c h a n g e i n response t o price changes a n d t h a t t h e (domestic/import) composition of i n p u t s changes.

TABLE 2 Producers' price indices in various r u n s .

Sector

Low elasticities High elasticities

Dem SUP 0 pt Dem s u P Opt

m a t e r i a l s 6. Chemicals 7. Light

h d u s t r i e s 8. Other m a n u -

facturing 9. Food pro-

cessing 10. Construction 11. Agriculture 12. Forestry

a n d logging 13. Transport a n d

communication 14. Domestic t r a d e 15. Foreign t r a d e 16. Waterworks 17. Personal

a n d economic services 18. Health a n d

c u l t u r a l services 19. Public ad-

ministration

In spite of t h e s e a n d o t h e r differences in methodology, data, o r t i m e period studied, o u r r e s u l t s show remarkable similarity with those of previous calculations. There a r e striking similarities, n o t only in g e n e r a l tendencies, s u c h a s disproportionality between global industrial, agricultural, a n d service price lev- els, b u t also in t h e r a n k order of sectors according t o t h e i r n o r m a t i v e price level. Comparing t h e different r u n s one can s e e tha.t t h e price indices i n four r u n s ( d e m a n d a n d supply a t both s e t s of elasticities) a r e practically t h e s a m e ; only t h e o p t i m u m tariff solution r e s u l t s in somewhat different prices, especially

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in the case of low elasticities. This difference can be clearly traced back t o t h e imported input components and t o variations in t h e dollar exchange rate. The latter decreases from its base level by about 20-25 percent in t h e four runs mentioned above, whereas in t h e optimum tariff r u n s i t stays basically t h e same a t high elasticities and increases by nearly 35 percent a t low elasticities (see Table 3).

TABLE 3 Main indicators (aggregate indices a t base prices): First model.

Low elasticities

Dem SUP Opt

102.04 101.58 100.58 102.11 101.77 100.91 99.91 101.52 102.68

High elasticities Indicator

GNP GDP Final

consumption Excess consumption Dollar t e r m s of trade Total trade/

GDP ratio Total export Total import Total competitive import Total noncompetitive import Total dollar import Total dollar export Dollar exchange r a t e Return r a t e on wages Return r a t e on capital

Base Dem SUP Opt

103.06 102.42 102.37 103.27 102.75 102.66 100.37 102.28 101.03

One may wonder why t h e model suggests revaluation r a t h e r than devaluation of t h e Hungarian currency, a t least in t h e pure equilibrium solutions: t h i s seems a t first sight in marked c o n t r a s t with what conventional wisdom would suggest in t h e case of Hungary. The explanation is in fact r a t h e r simple: it is due t o t h e decrease of price level in the major exporting sectors. If t h e exchange r a t e remained unchanged or increased, it would in general result in growing exports and decreasing imports, and i t would thus violate t h e trade balance condition. Therefore, the exchange r a t e has t o drop accord.ingly. Even in this situation, total trade turnover increases and, as expected, relatively more so in t h e case of higher export elasticities. I t is also interesting to see t h a t t h e increase of exports is larger in t h e demand t h a n in t h e supply runs, because in the former, increased exports have to make u p for t h e terms-of-trade

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deterioration (total imports increase a t more or less the same r a t e in t h e two types of run).

The optimum tariff cases produce results t h a t a r e qualitatively different frorri t h e other four variants and also from each other in the cases of higher and lower elasticities. Lower elasticities imply stronger international market power, the exploitation of which results in reduced trade volume and improved t e r m s of trade (see Table 3). Thus, quite apart from t h e increased allocative efficiency, additional welfare gains result from the improving t e r m s of trade.

The increased dollar exchange r a t e (close to a 35 percent devaluation) makes imports decrease. If t h e r e were no tariffs on exports, they would increase significantly because of the high exchange rate. The tariffs offset this impetus.

The large difference between the exchange rates in the case of pure demand and t h e optimum tariff r u n clearly indicates that the tariffs a r e quite large.

Indeed, t h e i r size varies between 60 and 100 percent, depending on t h e size of t h e export demand elasticity.

When the elasticities are higher, t h e scope for increasing allocative efficiency becomes larger, whereas t h e terms-of-trade effects become significantly smaller. In fact, it proves to be advantageous to utilize t h e reallocation possibilities even to the extent where the general level of the t e r m s of trade actually deteriorates. The size of t h e tariffs becomes, of course, much smaller in this case (20-35 percent) and a s a result of these interacting forces, t h e exchange rate remains practically unchanged.

Readers interested in more detailed results of t.he simulation r u n s can find additional tables in the Appendix. These include percentage changes in dollar exports a n d competitive imports in different sectors, and the price t e r m s t h a t explain t h e direction of change in dollar exports and competitive import shares, as well as detailed statistics on changes in production and employment of the two primary resources, labor and capital. The analysis of these data is left to the reader. In the remaining part of the paper we will r e s t r i c t ourselves to an analysis of various general features of our results and draw some broad conclusions on t h e basis of t h e summary Table 3.

The main aggregates measuring the output level of the national economy, gross (total) national production as well a s GDP, show only a modest increase resulting from the reallocation of resources. This is a common phenomenon frequently- encountered in similar resource allocation exercises. More significant changes can naturally be seen in the export and import activities.

Except for one case, our calculations interestingly reproduce t h e historical observation that imports grow faster t h a n output. This is a direct consequence of increased international specialization. As one can see, the measure of t h e openness of the economy, total trade/GDP, increases in all cases but one. The exception is the optimum tariff solution a t low elasticities, which suggests t h a t more specialization and increased foreign trade need not necessarily be beneflcial for an economy. As we know, this is the case where export prices r e a c t r a t h e r sensitively to changes in export volumes.

One surprising result of our numerical simulations may be t h a t in one of the r u n s t h e move toward a perfect equilibrium situation frorn a distorted one results in welfare loss. However, this may only be surprising because we tend to associate competitive equilibrium with Pareto optimality. This is, however, not the case when the economy is open and faces imperfect.1~ elastic export demand. In such a situation the optimal policy is a kind of monopolistic r a t h e r than pure competitive equilibrium, as is known from the theory of optinium tariff. This solution is approximated, as indicated earlier, by the optimum tariff run. As we can see, the difference in terms of welfare between t h e pure

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competitive (laissez-faire) and the optimum tariff ( p L a ~ n e ? - s ' optimum) solutions is close to t h r e e percent of total consumption.

We can further characterize t h e trade-off possibility between allocative efficiency and terms-of-trade efficiency by means of t h e supply run. This l a t t e r approximates t h e potential allocative efficiency gain, i.e., t h e gain t h a t would be achieved in t h e absence of terms-of-trade changes. As we can see, this potential allocative efficiency gain, a t low elasticities, is approximately 1.6 percent of total consumption. This potential efficiency gain is offset by t h e simultaneous terms-of-trade deterioration in t h e demand run. In t h e optimum tariff run i t is not fully utilized, but in t h a t case t h e additional gain from t h e terms- of-trade improvement is significantly larger t h a n t h e possible loss from not utilizing fully t h e allocative efficiency potential.

Most of our analysis so far has been concerned with t h e usual low elasticity case. As we have seen, t h e terms-of-trade effects brought into t h e numerical simulation through t h e downward-sloping export demand functions a r e quite significant, and seem to be quite unrealistic. The same r u n s repeated with t h e sizes of these elasticities doubled clearly exemplify t h e dilemma t h a t t h e build- e r s of computable general equilibrium models face. Larger elasticities will significantly increase t h e resource reallocation possibilities a n d reduce t h e effect of t h e terms-of-trade changes. Thus, for example, even in t h e optimum tariff run, i t proves to be advantageous t o utilize t h e resource reallocation potential, even t o t h e e x t e n t of incurring a deterioration in t h e t e r m s of trade.

As can be seen, t h e laissez-faire and p l a n n e r s ' optimum solutions do not differ so m u c h a s in t h e previous case. These solutions c a n , however, be criticized because they all.ow for unrealistically large shifts in t h e allocation of resources, primarily in exports.

One may believe t h a t our results, especially t h e welfare loss occurring after a shift toward equilibrium, have to do with our departure from neoclassical assumptions. The consumption s t r u c t u r e is fixed, a n d t h u s adjustment on t h e consumers' p a r t is excluded. Also, as mentioned, import s h a r e changes a r e t r e a t e d in a nonneoclassical fashion. It is, therefore, interesting t o check how sensitive t h e simulation results a r e t o these changes. To this end we repeated our exercise with a model strictly in line with neoclassical assumptions. In these r u n s imports were t r e a t e d as imperfect s u b s t i t u t e s and t h e usual cost minimization assumption was invoked. In t h e case of consumption we assumed t h a t five percent of total consumption c a n be readjusted to changing prices in accordance with a Cobb-Douglas-type utility function. Thus we employed a n LEStype demand s t r u c t u r e . The main indicators of these r u n s a r e summarized in Table 4. They clearly indicate t h a t t h e results a r e qualitatively t h e same, and even t h e quantitative differences a r e negligible.

6. CONCLUDING REMARKS

Although t h e r e are admittedly rnany speculative elements in our simulations, we can still draw some conclusions t h a t may be interesting from t h e economic-policy point of view. First, t h e phenomenon discussed above seems t o capture some elements of what actually happened in Hungary in t h e 1970s. I t is very likely t h a t a large p a r t of t h e terms-of-trade deterioration t h a t Hungary suffered over t h e past t e n years was endogenously induced. To offset t h e effects of external terms-of-trade changes and t o compensate for increasing imports, Hungary had to export m o r e and more. The inability t o build up new, more efficient export capacities added an endogenously-induced terms-of-trade

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TABLE 4 Main indicators (aggregate indices a t base prices): Second model.

Indicator GNP GDP Final

consumption Variable consumption Implicit welfare function Dollar t e r m s of trade Total trade/

GDP ratio Total export Total import Total competitive import Total noncompetitive import Total dollar import Total dollar export.

Dollar exchange r a t e Return rate on wages Return rate on capital

Base Dem SUP Opt Dem SUP Opt

100.00 102.35 101.95 100.98 103.41 102.86 102.70 100.00 102.33 102.05 100.93 103.51 103.09 102.87 100.00 100.00 101.87 102.56 100.56 102.68 101.23

deterioration t o t h e external one.

Second, a general lesson t h a t can be learned is t h a t economic reforms t h a t do not r e a c h and genuinely affect the micro decision level can produce only modest, if any improvement i n overall economic efficiency. Unless t h e r e are major changes in t h e micro s t r u c t u r e of production, leading to more efficient use of resources a t t h e enterprise level and more profitable a n d exportable products, a price reform followed by a rational reallocation of resources will not produce satisfactory results.

Third, t h e simulation results also suggest that a complete decentralization of foreign trade, especially t h e export activity, may not be advantageous if export demand i s imperfectly elastic. Domestic firms may n o t perceive t h e opportunities arising and may therefore behave as atomistic price takers.

Therefore t h e r e i s some room for t h e central planning authorities t o guide individual decisions in more generally beneficial economic directions.

Fourth, a n d partly related t o t h e above issue, i t is interesting to note t h a t general price distortions may result in welfare improvement, similar, but not equal to t h e effect of optimal tariffs. Thus, if some international agreements,

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such a s t h o s e of GATT, exclude t h e possibility of applying tariffs on exports, it is, a t l e a s t in theory, possible t o use general taxes on production a s a second- b e d solution.

And finally, as a niethodological observation, we m a y conclude f r o m o u r analysis t h a t in computable general equilibrium models it s e e m s crucial t o distinguish a n d s e p a r a t e t h e ' e n v i s a g e d changes in t h e export p r i c e s ( t e r m s of trade) from t h o s e in t h e speed of export a d j u s t m e n t . One c r u d e a n d p r a g m a t i c solution m i g h t be t o use one s e t of relatively small elasticities in t h e export functions, a n d a n o t h e r s e t of relatively l a r g e r elasticities in t h e d e t e r m i n a t i o n of export prices ( s e e Zalai 1982 for details of this solution). Needless t o say, t h e degree of freedom in reallocating r e s o u r c e s in a n open economy depends greatly on t h e potential for foreign trade. Thus, it is crucial in s u c h exercises t o r e p r e s e n t this potential properly. At p r e s e n t it appears t h a t n e i t h e r t h e t e h n i q u e s used i n linear programming n o r those in computable g e n e r a l equilibrium models a r e fully adequate for handling t h i s problem.

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REFERENCES

~ r m i n ~ t o n , P. (-1969) A Theory of Demand for Products Distinguished by Place of Production. IMF S t a f f P a p e r s , 16: 159-1'78.

BAnhidi, F. (19'79) Armodell, BrszAmitAsok (Price Model, Price Calculations). In M. Augusztinovics (Ed.) Nbpgazdas&gi m o d e l l e k a t 4 b l a t i t e r v e z b s b e n

(Models of L o n g - T e r m P l a n n i n g ) . Budapest: KozgazdasAgi Cs Jogi Kiado.

BBrAny, B. and Gy. Szakolczai (19'75) A t e r m e l b s r e 4 l i s k i i l t s b g e i 6 s a z

&rszintproblBm&k (Real Costs of P r o d u c t i o n a n d h-ic e Level P r o b l e m s ) . Kijzgazdasagi Szemle, No. 11-12.

Browne, F.X. (1982) Modelling Export Prices and Quantities in a Small Open Economy. R e v i e w o f E c o n o m i c s a n d S t a t i s t i c s , IXIU(2).

Csepinszky, A., ed. (1982) IIgazaCi k a p c s o l a t o k m b r l e g e 1970-1979 ( h t e r i n d u s -

try

B a l a n c e s 1970-1 979). Budapest: Hungarian Statistical Office.

Csik6s-Nagy. B. (19'75) Socialist h i c e i'heory a n d Price P o l i c y . Budapest:

AkadCmia Kiad6.

Dervis, K., J. De Melo and S. Robinson (1982) General E g u l i b r i u m Models f o r D e v e l o p m e n t Folicy. Cambridge: Cambridge University Press.

Dixon, P.B., B.R Parmenter, I.M. Sutton and D.P. Vincent (1982) ORANI: A &I- t i s e c t o r a l Model of t h e A u s t r a l i u n E c o n o m y . Amsterdam: North-Holland.

Ganczer, S. (1962) a 7 . s z 4 m i t k o k m o d e r n m a t e m a t i k a i m b d s z e r e k k e l ( h i c e Cal- c u l a t i o n s b y M e a n s of M o d e r n M a t h e m a t i c a l Methods). Budapest: academic dissertation (mimeo).

Ginsburgh, V., a n d J. Waelbroeck (1981) A c t i v i t y A n a l y s i s a n d General Egui- l i b r i u m Modelling. Amsterdam: North-Holland.

Houthakker. H.S., a n d S.P. Magee (1969) Income and Price Elasticities in World Trade. R e v i e w of E c o n o m i c s a n d S a t i s t i c s , L1(2).

Johansen, L. (1959) A A i d t i s e c t o r a l S t u d y of E c o n o m i c Growth. Amsterdam:

North-Holland.

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Kelley, A.C.. W.C. Sanderson a n d J.G. Williamson (Eds.) (1983) Made lling Growing Economies in Equilibrium and Disequilibrium. Durham, North Carolina:

Duke University Press.

Mansur, A H . a n d J. Whalley (1983) Numerical Specification of Applied General Equilibrium Models: Estimation, Calibration, and Data. In

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Scarf and J.

Shoven ( ~ d s . ) , Applied General Equilibrium Analysis. London: Cambridge University Press.

Sato. K. (1977) The Demand Function for Industrial Exports: A Cross-Country Analysis. Review of Economics and Statistics, LIX(4).

Scarf,

H.

and J. Shoven (Eds.) (1983) Applied G n e r a l Equilibrium Analysis. Lon- don: Cambridge University Press.

Zalai, E. (1980) A Nonlinear MuLtisectoral Model f o r h k n g a r y : General Equi- l i b r i u m Versus Optimal Planning Approach. WP-80-148. Laxenburg, Aus- tria: International Institute for Applied Systems Analysis. Revised version in A.C. Kelley, W.C. Sanderson, and J.G. Williamson (Eds.), Modeling Orowing Economies in E q u i l i b r i u m and f i e q u i l i b r i u m . Durham, North Carolina:

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TABLE A1 P e r c e n t a g e changes in doll~ar exports.

Low elasticities

-

High elasticities

Dem SUP Opt

79.99 73.93 71.42 47.33 42.11 71.37 125.62 116.59 106.01 190.64 175.14 187.90 85.41 77.75 95.04

Sector Dem

industries 8. Other m a n u -

and logging 13. Transport a n d

communication 14. Domestic t r a d e 15. Foreign trade*

16. Waterworks*

17. Personal a n d economic services 18. Health a n d

ministration Total

*Exogenously fixed.

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TABLE A2 Percentage changes in competitive dollar imports.

Dem Dem SUP Opt

112.74 112.48 98.10 Sector

materials 6. Chemicals 7. Light

industries 8. Other manu-

fac turing 9. Food pro-

a n d logging 13. Transport a n d

communication 14. Domestic trade 15. Foreign t r a d e 16. Waterworks 17. Personal

a n d economic services 18. Health and

ministration Total

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TABLE A3 Relative price terms in t h e export and import functions.

Opt* Opt*

Sector Dem Sup

100.36 103.50 107.58 110.87 91.86 94.00 84.04 86.30 98.19 101.11

Exp Imp 117.48 58.74

96.35 64.23 105.58 63.35 90.03 54.02 99.32 59.59

Dem Sup Exp Imp

and logging 13. Transport and

communication 14. Domestic trade 15. Foreign trade 16. Waterworks 17. Personal

and economic services 18. Health and

cultural services 19. Public ad-

ministration

*The difference between t h e export and import price terms is due to t h e export tariffs.

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TABLE A4 Percentage changes in production.

Low elasticities High elasticities Dem s u P 109.12 107.80 104.77 104.17 114.48 110.60 115.19 112.73 98.76 98.08 Dem s u P

105.69 104.73 103.23 102.84 111.48 108.60 109.21 107.65 100.51 99.84 Sector

industries 8. Other m a n u -

cessing 10. Construction 11. Agriculture 12. Forestry

a n d logging 13. Transport a n d

communication 14. Domestic trade 15. Foreign trade 16. Waterworks 17. Personal

a n d economic services 18. Health a n d

ministration Total

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TABLE A5 Percentage changes in employment.

Dem SUP

Dem SUP Opt

101.36 100.39 104.29 100.86 100.57 101.45 109.41 106.63 99.41 108.04 106.51 105.14 99.49 98.90 100.22 Sector

cessing 10. Construction 11. Agriculture 12. Forestry

and logging 13. Transport a n d

communication 14. Domestic trade 15. Foreign trade 16. Waterworks 17. Personal

and economic services 18. Health and

cultural services 19. Public ad-

ministration Total

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TABLE A6 Percentage changes in capital used.

Dern SUP Opt

118.06 116.64 114.70 105.54 104.88 104.41 117.31 113.25 110.93 119.93 117.25 118.39 99.91 99.12 100.53

Sector Dern

and logging 13. Transport a n d

communication 14. Domestic t r a d e 15. Foreign t r a d e 16. Waterworks 17. Personal

and economic services 18. Health and

cultural services 19. Public ad-

ministration

Total 100.00 100.00 100.00 100.00 100.00 100.00

Economic Reform, Allocative Efficiency, and Terms of Trade

ECONOMIC REFDRM,

EFFICIENCY, AND TERMS OF TRADE

ECONOMIC

ALLOCATIVE

AND TERMS

TNTRODUCTION

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