Demand shifts and willingness to pay in applied trade models

Emerging issues facing open economies, including global value chains and non-tariff measures, have important implications for demand that are often not well suited for analysis with the supply-side mechanisms commonly found in economic models – namely taxes and productivity. The aim of this paper is to provide a methodological approach for implementing demand-side changes. Specifically, the approach adapts the Armington equation to model a change in consumers' willingness to pay for imports. To illustrate, we estimate the impacts of the World Trade Organization's Trade Facilitation Agreement (TFA). Estimated ad valorem equivalents of the TFA are applied as demand-side shocks to consumers' willingness to pay in a global applied general equilibrium model and the results compared to those obtained using Samuelson's iceberg approach. We find that the iceberg approach results in a technical change which increases the productivity of imports, raising real GDP, while the willingness-to-pay approach causes a smaller rise in real GDP, although trade increases further. The impact on the terms of trade differs significantly between the two mechanisms, with prices falling as costs fall, under the iceberg method, and rising with increased willingness to pay. Our results clearly show that the choice of mechanism matters.