Estimating import price elasticity while controlling for quality

Overview & Synopsis

Import price elasticity tends to be under-estimated due to the omission of quality effects. This dissertation aims to fill this gap by analyzing 1) how quality effects affect the estimation of import price elasticity, 2) the impact of quality innovation in the various goods sectors of an economy and 3) the limitations pertaining to the estimation of the true import price elasticity as well as the policy implications of quality innovation on trade. In order to adjust for quality effects, a quality proxy is constructed. This proxy considers the role of product innovation in the form of Research and Development (R&D) expenditure as well as externalities arising from the knowledge acquired in other sectors and countries. A gravity model is formulated to isolate the price effect from the quality effect in estimating the import price elasticity. A panel analysis is used, covering 9 European countries (Germany, Denmark, Spain, Finland, France, Ireland, Italy, Netherlands and United Kingdom) over the period of 1996 to 2003. The empirical results indicate that the import price elasticities are higher with adjustments for quality, although they do not reach unity as predicted by the theoretical elasticity of substitution. The high values of price elasticity show that quality innovation not only encourages trade but also encourages domestic consumption of local and better quality products. In particular, the sectors which recorded an import price elasticity superior to 1 are those which produce homogeneous and non-industrialized products like metal products, non-metallic mineral products, textiles, rubber and plastics. Exporting countries that gain the most through quality innovation are Spain, Finland and the UK. The role of quality innovation has a significant effect of increasing overall trade for the region. Quality innovation of 1% on the part of the exporters increases their exports by a range of 0.2 to 1.2 percentage points. As such, quality innovation should be strongly encouraged to increase trade flows of the countries so as to increase the economy‟s overall growth.