Page 118 - Azerbaijan State University of Economics

Yadulla Hasanli, Gunay Rahimli, Fuad Quliyev, Mattia Ferrari: Evaluation of Sectoral
Foreign Trade Elasticities of Azerbaijan

INTRODUCTION
Imports and exports are key indicators of an economy, and their volumes vary
depending on prices and demand. The responsiveness of import and export volumes
to relative price changes is measured by trade elasticity, which provides important
insights into a country’s foreign trade performance. Export elasticity describes how
exporters respond to changes in various factors. When demand changes, the resulting
dynamics in domestic and imported product volumes are captured by the price
elasticity of imports (Imbs, J.; Mejean, I. (2017)). These elasticities are crucial for
understanding the role of international prices in balancing trade, the optimal level of
international portfolio diversification, the effects of regional trade agreements, and the
welfare gains from expanding world trade (Feenstra, R.; Luck, P; Obstfeld, M; Russ,
K. (2018)). General equilibrium models frequently employ Armington and Constant
Elasticity of Transformation (CET) functions to represent international trade
(Lofgren, H.; Cicowiez, M. (2018)).

The CET function models the producer’s decision of whether to sell in the domestic
or foreign market, while the Armington function captures consumers’ choices
between domestic and imported products. The Armington function is a CES-type
function, named after Paul Armington, who introduced it for this purpose (Armington,
P. (1969)). In a 1968 article, two Australian economists Powell, A. and Gruen, F.
(1968) proposed the concept of constant elasticity of transformation.

Paul Armington claims that domestic and imported goods are not perfect substitutes.
Consumers differentiate between them. According to Armington, total demand for
good is split between domestic and imported varieties. To estimate this split he
employs a constant elasticity of substitution (CES) utility function depicted in
Equation (1) (Annabi, N.; Cockburn, J.; Decaluwé, B. (2006); Armington, P. (1969)).

1
= ( + ) (1)

whereby is a parameter representing the effectiveness of substituting imported and

domestic products for the i-th commodity or service group, and are CES

distribution parameters, and is used to calculate the elasticity of substitution

between imported and domestic products. The elasticity of substitution between
1
imported and domestic goods is then computed as = .

1+

According to profit-maximization behavior, for each group of goods and services,
profit is maximized when the difference between total revenue and the combined cost
of domestic and imported goods reaches its maximum (Hosoe, N.; Gasawa, K.;
Hashimoto, H. (2021)).
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