Estimating The Impacts of Prices, Taris, and

Exchange Rates on Import Demand:

A Discrete Choice Model
Aravind Moorthy
July 25, 2008
Abstract:
In this paper, I propose a simple discrete choice model of demand, where
consumers choose a single good from a set of dierentiated products with multiple
characteristics, and show how this model can be used to estimate own- and cross-
price elasticities of import demand with widely available aggregated data. I then
extend the model to allow the estimation of equilibrium prices and market shares
by adding a supply side, and show how the impacts of price, tari and exchange
rate changes can be assessed in equilibrium. I estimate the model using 5 years
of data on US wine imports.
1
1 Introduction
The trade literature contains several papers which estimate price elasticities of import de-
mand (eg, Houthakker and Magee (1969), Leamer and Stern (1970), Burgess (1974), Eaton
and Kortum (2002), and Erkel-Rousse and Mirza (2002)). However, to my knowledge, most
of the existing literature either considers prices and import volumes in aggregate categories,
assumes a constant elasticity of substitution between goods, or otherwise assumes that goods
are indistinguishable from each other in utility. In these settings, cross-price elasticities be-
tween particular import goods either cannot be calculated, or are assumed to be identical
across dierent goods, eliminating the potential for rich substitution patterns that are based
on the varying characteristics of goods within an industry. The value of obtaining such
elasticities is clear: cross-price elasticities can be used to assess the eects of a price change
for an import good not only in terms of the change in demand for that good, but in terms of
the expected changes in import demand quantities of competing goods. These estimates con-
tribute to a more rened picture of how aggregate import volumes might change, and which
nations and manufacturers might be responsible for the changes. Moreover, estimates of
market share elasticities for any good will be biased unless the eects of competing products
are considered.
The empirical industrial organization literature also addresses the problem of estimat-
ing price elasticities (eg, Bresnahan (1981), Berry (1994), and Berry, Levinsohn and Pakes
(1995)
1
), and considers substitution patterns that vary across dierentiated goods, but does
not address other variables specic to international trade, such as exchange rates, distance
costs, or taris that vary across goods.
In this paper, I propose a simple discrete choice model of demand, where consumers
choose a single import good from a set of dierentiated products with multiple dimensions
of characteristics, and show how this model can be used to estimate own- and cross-price
elasticities of import demand. I then add a supply side to the model, and show how equi-
librium prices and import market shares of competing goods can be obtained, along with
additional elasticities for exchange rates, taris, and other distance costs.
2 Literature Review
The model in this paper inherits primarily from the industrial organization literature on
aggregated discrete choice models, as this literature is more focused on the estimation of
cross-price elasticities than the trade literature
2
. Much of the literature addresses the chal-
lenge of estimating substitution patterns between related goods given data limitations. In
theory, the market share of each product in a set of J competing products can be estimated
1
Henceforth, BLP
2
Grossman (1982) is a notable exception in the trade literature, as he estimates cross-price elasticities
between identical goods across developed countries and less-developed countries. However, his paper does
not consider the eects of competing products, or identify the eects of price changes on individual countries.
1
as a non-parametric function of the prices of all J products. However, this requires estimat-
ing a substantial number of coecients indeed, even if each market share were a linear
function of industry prices, one would have to estimate J
2
price coecients.
One strain of the literature attempts to alleviate the data burden by making structural
assumptions about how consumers value product characteristics. Bresnahan (1981) posits a
one-dimensional vertical discrete choice model of demand, where consumers choose one
good from a set of goods that are dierentiated by a single scalar characteristic which
is valued idiosyncratically. Consumer choices are aggregated to deliver analytic market
shares. While the model can be estimated with reasonable amounts of data, it implies that
substitution only occurs to and from the nearest neighbors of a good whose price has changed.
Logit and nested-logit discrete choice models (eg, Berry (1994), Goldberg (1995)) also yield
analytic market share solutions, but imply substitution patterns that are based solely on
existing market shares, or are determined a priori by dening layers of nested groups (in the
case of nested-logit models). These restrictions are due to the fact that preferences across
the characteristics of goods are constant for all consumers in these models, so that market
share elasticities do not reect individual tastes for particular characteristics.
Random coecients models such as those used in BLP allow more exible substitution
patterns that depend, in part, in idiosyncratic preferences for the characteristics of each
good: When the price of a good changes, marginal consumers who valued the characteristics
of that good more highly than average will be more likely to choose a good with similar
characteristics, ceteris paribus. The assumptions of these models have intuitive value: con-
sumers have dierent preferences for product characteristics, and products similar to the
one that each chooses are the closest substitutes for that product. Unfortunately, random
coecients models generally do not yield analytic solutions for market shares, and require
the estimation of additional parameters to specify the distributions of coecients for product
characteristics - and, hence more data. It is from this class of models that I derive my model
of import demand.
3 Model
3.1 Demand
Consumers from a single country choose one product from a set of J products, both domestic
and imported, according to the utility function:
U
ij
= X
j

i
+
i
p
j
+
j
+
ij
where: j indexes products; i indexes consumers; X
j
is a vector of product characteristics;
p
j
is the nal price of product j, inclusive of all costs incurred to obtain the product;
i
is a vector of idiosyncratic parameters for preferences over product characteristics;
i
is an
2
idiosyncratic price parameter;
j
is an product characteristic for product j that is unobserved
to the econometrician, but may be observed by producers of j prior to pricing; and
ij
is an
idiosyncratic preference shock particular to consumer i and product j.
Each preference parameter
im
, corresponding to the m
th
product characteristic of X, is
distributed normally, by assumption:

im
N(
m
,
m
), m
Similarly:

i
N(,

)
Also, by assumption:

ij
Type 1 Extreme Value, iid over i and j
The inclusion of the
j
term in utility addresses the concern that, as econometricians, we
may not observe all product characteristics over which users have preferences. Such product
characteristics not only aect market shares, but may also inuence pricing decisions (the
Estimation section discusses this point further). For structural integrity, Berry (1994)
argues that unobserved product characteristics should be treated identically to X
j
, and not
introduced linearly into market share equations merely as a way of explaining dierences
between estimated and observed market shares.
The Type 1 Extreme Value distribution of the residual term
ij
is a common assumption
in many aggregated discrete choice models, since it yields analytic market share solutions in
several classes of models conditional on individual preference parameters (see Cardell (1997)
for a description of the properties of the distribution). The distribution is characterized by
the PDF:
F(
ij
) = exp(exp(
ij
))
p
j
, the nal unit price paid by consumers for product j in the consumers currency, is con-
structed as follows:
p
j
= v
j
E
s
i
+
s
j
+ CIF
j
(1)
where: v
j
is the price paid to the producer, in the currency of the producers country; E
s
i
and
s
j
are the exchange rate and per-unit tari applicable between the countries of the
supplier of j and the consumer, respectively; and, CIF
j
is the cost of insurance and freight,
incurred in the consumers currency. In this specication, I assume that all distance costs of
3
trade are absorbed by insurance and freight costs; however, the model can be easily modied
to include an additional parameter in this equation, to represent additional distance costs
related to the diculties of conducting international trade, such as cultural and linguistic
barriers (see the Conclusions section).
Given the utility specication, market shares for each product can be determined by
aggregating the choices of each consumer. Let A
j
be dened as the set of parameters
= [
i
,
i
] and shocks which lead a consumer to choose product j:
A
j
(X, p, ) = {(, )|U
ij
(; ) > U
ik
(; ), k = j}
where: X is the matrix of product characteristics for all products j, and p is the vector of
prices for all products j. Then, the market share of product j, dened over both domestic
and foreign goods, is given by:
s
j
(X, p, ; ) =
_

_
I((, ) A
j
(X, p, )) f(d, d
i
, d
i
)
While this is generally not analytically solvable, the Type 1 Extreme Value distribution
of allows a dimension of the integral to be removed, along with the indicator function I().
Rearranging:
s
j
(X, p, ; ) =
_

_
[
_
I((, ) A
j
(X, p, )) f(d)] f(d
i
, d
i
)
s
j
(X, p, ; ) =
_

_
exp(X
j

i
+
i
p
j
+
j
)

kM
j
exp(X
k

i
+
i
p
k
+
k
)
f(d
i
, d
i
) (2)
where M
j
is the set of products in the same market as j. Note that market shares in
this model are a function of the prices for all products within the same market; this feature
distinguishes this model from many others in the trade literature, and allows the computation
of cross-price elasticities.
3.2 Supply
While the demand side of the model alone can be estimated to provide own- and cross-price
elasticities for market shares, I add a supply side to allow the estimation of equilibrium
changes in prices and market shares of all goods, following a change in the price of a good,
an exchange rate, or a tari. I assume that producers play a static pricing game under con-
ditions of monopolistic competition, produce one product each, and face constant marginal
costs mc
j
when producing product j. Prots are given by:

j
= (p
j
mc
j
)Ms
j
4
where M is the size of the market. mc
j
, in turn, is determined by product characteris-
tics, their respective cost parameters , and a cost variable
j
that is unobservable to the
econometrician, but observable to rms prior to pricing:
mc
j
= exp(X
j
+
j
)
The assumptions on the structure of marginal cost correspond to those made in BLP,
and the authors show that the results they obtain under these assumptions are robust to
more general specications.
Assuming that market size is not aected by a rms pricing decisions, rst order condi-
tions for price setting yield the following:
p
j
(X
j
, s
j
,
j
; ) = exp(X
j
+
j
)
s
j
ds
j
/dp
j
(3)
Given parameters and , and the demand and cost unobservables and , Equations
2 and 3 can be solved simultaneously to determine equilibrium prices and market shares
3
.
4 Estimation
4.1 Data
I estimate the model above using monthly data on US imports of wine from 5 countries, from
2002 to 2006, obtained from the US Census Foreign Trade Division. The dataset provides
the country of origin for the wine, which I take to be a product characteristic
4
, along with
other characteristics of the wine (See Table 2).
While the dataset provides the prices paid to suppliers, the per-unit costs of shipping
and insurance, CIF, were only available for a smaller dataset. I used the smaller dataset
to estimate coecients on the main determinants of CIF, using the following specication:
CIF
j
=
0
+
v
v
j
+
1
D
1,j
+ +
n
D
n,j
+
m
month
j
+
q
ln(q
j
)
3
See Caplin and Nalebu (1990) for sucient conditions for the uniqueness of this equilibrium.
4
Country of origin is arguably a characteristic of wine over which consumers form preferences, since each
country has unique climate and terrain conditions that inuence the taste of the wine produced.
5
Table 1: Market Shares by Country of Origin, 2006
Spain France Chile Italy Australia
January 0.0490 0.1461 0.0911 0.3298 0.3840
February 0.0644 0.1763 0.1119 0.3513 0.2961
March 0.0602 0.1779 0.0928 0.4071 0.2619
April 0.0626 0.2002 0.0906 0.3636 0.2830
May 0.0738 0.1774 0.0851 0.3794 0.2843
June 0.0676 0.1639 0.0811 0.3999 0.2875
July 0.0704 0.1613 0.0736 0.3571 0.3375
August 0.0687 0.1390 0.0942 0.4118 0.2863
September 0.0693 0.1846 0.0960 0.3459 0.3042
October 0.0733 0.2160 0.0769 0.4110 0.2229
November 0.0768 0.2226 0.0950 0.3827 0.2229
December 0.0615 0.1628 0.0986 0.3717 0.3054
Table 2: Market Shares by Wine Type, 2006
Sparkling Red White Fortied
January 0.0459 0.5723 0.3600 0.0218
February 0.0624 0.5721 0.3460 0.0195
March 0.0607 0.5470 0.3709 0.0214
April 0.0698 0.5680 0.3375 0.0247
May 0.0568 0.5564 0.3637 0.0232
June 0.0551 0.5530 0.3631 0.0288
July 0.0737 0.5312 0.3704 0.0247
August 0.0771 0.5128 0.3862 0.0240
September 0.1137 0.5114 0.3464 0.0285
October 0.1342 0.4837 0.3596 0.0225
November 0.1240 0.5144 0.3282 0.0334
December 0.0780 0.5568 0.3306 0.0346
6
Table 3: CIF Coecients for 5-Country Sample

0

v

1

2

3

4

m

q
0.5797 0.0268 0.0113 0.1129 0.0763 -0.0024 -0.0323 0.0167
(0.0648) (0.0411) (0.0357) (0.0372) (0.0349) (0.0017) (0.0051) (0.0002)
where: D
1,j
... D
n,j
are country dummies; month
j
is the month of observation, indexed in
one month increments; and, q
j
is the quantity of wine shipped (in liters). I assume that
CIF is log-linear in q
j
, based on the observation that per-unit bulk discounts for freight
increase less than linearly with weight. Comparing regressions using the ln(q
j
) term and
using q
j
support this intuition, as
q
is statistically signicant using the log-linear form (see
Table 3), and insignicant otherwise.
I use the coecients in Table 3 to estimate CIF values for each observation in the primary
dataset, and add these to the supplier prices, v, and taris, , obtained from the Harmonized
Tari Schedule of the US International Trade Commission. The sum yields the nal prices
paid by the consumer, as per Equation 1
5
. I assume that data for each month constitutes
a single market. Since observations within each market are contemporaneous, and market
share calculations do not depend on data from observations outside of the market, prices are
not adjusted for ination. I calculate the market share of each product as the quantity of
the product sold as a fraction of the total quantity sold amongst the products in the sample
6
.
4.2 Estimation Procedure
The estimation procedure follows several strategies outlined in BLP and Berry (1994),
adapted for use with the import demand model. Since market shares in Equation 2 are
not analytic due to idiosyncratic preference terms, I begin by simulating these preferences,
conditional on . The simulated market shares are then:
s
j
(X, p, ; ) =
1
NS

ns
exp(X
j

ns
i
+
ns
i
p
j
+
j
)
1+

kM
j
exp(X
k

ns
i
+
ns
i
p
k
+
k
)
where each
ns
i
and
ns
i
term is drawn from distributions with means given by
m
and
terms, and standard errors given by
m
and

terms.
The estimation of , the demand-side unobservable, is a signicant problem, since no
analytic inversion of s
j
(X, p, ; ) generally exists. However, BLP show that the operator
5
Since data are already in US dollars, I do not require the exchange rate specied in Equation 1.
6
Note that misspecication of the size of the market is irrelevant to the estimation of the parameters
of interest, given the utility specication of the model. Only the relative market shares of the considered
products aect my results.
7
T(
j
) =
j
+ ln(s
j
) ln(s
j
(X, p, ; )
is a contraction mapping. Thus, interatively applying the operator given an initial vector
of guesses
0
allows

to be calculated for any , solving the equation:
ln(s
j
) = ln( s
j
(X, p,

; ), j
The supply side unobservable is easily inverted from Equation 3, allowing the unobserv-
able to be solved given , ,

, and a numerically estimated derivative

d s
j
(X, p,

; )/dp
j
:

j
= ln(p
j
+
s
j

d s
j
(X, p,

; )/dp
j
) X
j

To proceed, I calculate method of simulated moments (MSM) estimators

and , cor-
responding to the demand-side and supply-side parameter vectors that cause the model to
most closely match the data.
To do this, I make the following moment assumptions about unobservables:
E
_

j
|
X
j

X
j
_
= 0
E
_

j
|
X
j

X
j
_
= 0
where

X
j
is a vector of the sums of the characteristics for all products in M
j
besides j.
Note that
j
and v
j
are likely not orthogonal, here: it is quite conceivable that supplier
pricing decisions are partly inuenced by product characteristics that I do not observe,
so that
j
and v
j
are correlated. Similarly, since CIFj is calculated using v
j
(since the
insurance component of CIF
j
is presumably related to v
j
), it is also potentially correlated
with
j
. Although taris
j
are quite plausibly orthogonal to
j
and
j
(especially considering
that the US market for wine is a small fraction of the world market, and therefore a small
fraction of sales to the average supplier),
j
lacks variation across observations. Instead, I
use an instrument for price adapted from BLP,

X
j
, which provides adequate variance
(it is dierent for each observation in a market, since it excludes that observation), and is
plausibly orthogonal to the unobservable terms.
These moment assumptions provide a basis for the objective function to minimize:
G(, ) =
1
N

j
_

j
,
j

_
X
j

X
j
__
with G(, ) = 0 at (, ) = (
0
,
0
), the true values of the parameters.
There are three types of variance in these estimates: the variance induced by the CIF
data generating process, V1; variance induced by the MSM data generating process, V2;
and, variance induced by simulation, V3. If the variance induced by each is independent,
then they can be summed when estimating the total variance:
8

V =

V 1 +

V 2 +

V 3
where

V 1 is calculated from the CIF estimation;

V 2 is the averaged square of the objective
function for the MSM estimation, holding the simulated idiosyncratic tastes constant; and,

V 3 is the square of the objective function for the MSM estimation, averaged over boot-
strapped samples of idiosyncratic tastes for product characteristics, and holding the data
constant. The variance of the estimators is then approximated by:
V ar(

, ) = (

A)
1

V A(

A)
1
Results for the estimation are provided in Table 4. Most of the and (mean) pa-
rameters for the distributions of product characteristic preferences have low standard errors,
and (the coecient for price) is both statistically signicant and negative, as expected.
However, many of (standard error) parameters for the distributions have high standard
errors. This suggests that the eects of idiosyncratic deviances from mean parameters were
not clearly identied in the data, although average tastes and cost parameters were clearly
identied.
The coecients can be used to calculate own-and cross-price elasticities for each of prod-
ucts in each market; Table 5 displays these elasticities for the 3 products with the largest
market shares in December 2006.
The columns of Table 5 indicate the product whose price is changed, while each row
represents the elasticity of a dierent product with respect to the price change. Thus, the
diagonal elements of the table are own-price elasticities, and the o-diagonal elements are
cross-price elasticities. These results are intuitively appealing: own-price import elasticities
of demand are negative and close to unity, while cross-price elasticities of competing products
are positive, and relatively inelastic.
Combining supply- and demand-side parameters and the computed cross-price deriva-
tives, one can simultaneously solve Equations 2 and 3 to obtain equilibrium prices and
market shares. The eects of changes in taris, exchange rates, and shipping charges can
thus be calculated: a change in a tari, for example, yields a specic change in the prices
of aected products, as per Equation 1. The change in product price then implies change
in market share from Equation 2, and a set of derivatives, d s
i
/d
j
, i M
j
,which can again
be used to solve for equilibrium changes for each product i using Equation 3.
4.3 Conclusions
This paper presents a structural model of import demand and supply, and shows a method
of estimating the model to yield own- and cross-price elasticities, and the equilibrium price
9
Table 4: MSM Estimation Results
Coecient Std Error

0
-7.4702 0.2428

Spain
-0.9659 0.5003

France
1.3082 1.1129

Chile
-1.3810 0.6030

Italy
1.1847 0.5974

Australia
4.4948 0.7461

sparkling
6.4889 0.7446

red
5.2708 0.7481

white
4.0281 0.7487

fortified
0.9543 0.7463
-0.2301 0.0102

Spain
0.0118 0.0092

France
0.0303 0.0101

Chile
0.0089 0.0109

Italy
0.2100 0.2040

Australia
0.0102 0.0097

sparkling
0.0108 0.0008

red
0.112 0.1085

white
0.0069 0.0099

fortified
0.1057 0.0440

a
0.0118 0.0076

0
0.4001 0.3832

Spain
0.7892 0.0771

France
1.0922 0.3086

Chile
-0.1719 0.0909

Italy
0.9155 0.1914

Australia
0.4841 0.1195

sparkling
0.6938 0.2390

red
0.0490 0.0120

white
-0.3116 0.0849

fortified
-0.5932 0.4990
Table 5: Own- and Cross-Price Import Elasticities of Demand For Sample Products
dp1 dp2 dp3
E1 -0.9024 0.1816 0.2015
E2 0.2489 -1.2171 0.2701
E3 0.1745 0.1693 -0.8374
10
and market share changes corresponding to changes in prices, taris, or exchange rates.
The results of the estimation procedure using wine import data conrm the feasibility of
estimating the model given availabe data.
An extension to the model adds an unobservable distance cost to Equation 1, to account
for cultural, linguistic, and other unobservable barriers that vary with the distance over which
a transaction occurs. While distance costs may correspond directly to countries of origin,
prohibiting the separate identication of distance costs and country-specic preferences given
the current model, the independence of a countrys distance from the US market and its
domestic market price, v
j
, can be exploited to identify these costs with additional structure.
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12