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The impact of trade liberalisation on the

Iranian economy

By

Mashallah Salarpour

A paper for the ICBM Bangkok

November 2007


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Abstract

The war with Iraq and the subsequent embargo caused the economy of Iran to deteriorate

from 1979 to 1988. The economic role of the Iranian government expanded during that

time. The government rationed food and intervened in the pricing of most commodities. Italso paid subsidies on food, petrol and other productive inputs.

To revive the economy, three five-year development plans were implemented after the end

of the war with Iraq in 1988. Rations and subsidies were removed and the domination of

the government over the economy was reduced by the deregulation of prices and exchange

rates after 1989. Further, the government presence in the economy diminished in size by

privatization from 1989 to 1993. The economy of Iran grew significantly in the third five-

year development plan (2000-2005). Tariffication of non-tariff barriers, facilitating exportsand unifying exchange rates were successfully achieved during 2005.

This study explains the results of trade reforms for a scenario where the government

achieved the above aims and also reduced tariffs for all imported commodities under the

Uruguay Round (UR) since 1995. The Computable General Equilibrium (CGE) analysis

and input-output data for Iran using a base year, 1991, were applied simulating the short

and long-run effects under the UR. It was proposed that 24 per cent and 27 per cent

decreases in ad valorem tariffs on imported agricultural and non-agricultural commodities,respectively, could occur in the short run from 1995. The same scenario was simulated in

the long run to examine the impact of trade reforms on Iran for the past decade. The

macroeconomic and sectoral results of this scenario were analysed by considering the

projections.

The results confirm a positive impact on the economy of Iran if tariffs were reduced under

the UR. Employment was estimated to grow by 2.4 per cent and real GDP increased by

0.71 per cent in the short run and real GDP rose by 3.47 per cent in the long run. The

aggregate capital stock and average real wage rose by 11.99 and 8.24 per cent, respectively,

in the long run.


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Introduction

Governments in many countries have established many programs to keep their producers

producing by supporting the domestic price. They levy import tariffs, allocate quotas or pay

subsidies to defend their farmers and manufacturers. Thus, governments have implemented

protection programs in developed countries in the hope (not always realised) that they will

enable their producers to compete on the world market. In addition, sophisticated

technologies, scale economies, provision of finance, high purchasing power and strong

currency are other key factors creating success in trade with other countries. World trade is

governed by a variety of agreements.

Trade negotiation in the Dillon, Kennedy and Tokyo rounds caused substantial trade reform

in industrial products in the early half of last century, while the members of WTO signed

the Uruguay Round Agreement on Agriculture (URAA) to reduce agricultural support and

protection in 1994 (Athukorala, 2004). Most of the GATT rules were previously for

manufacturing goods and domestic agricultural products were supported by import quotas,

some non-tariff barriers (NTBs), and export subsidies but these restrictions should be

removed under the URAA. Before URAA, most developed and developing countries had

high levels of support for agricultural producers. For instance the USA and the EU spent

US$26 billion in 1986 and US$34 billion in 1988, respectively, to support their agricultural

producers (Overseas Development Institute, 1995).

Under the Uruguay Round, members of WTO agreed in 1994 that developed countries

would reduce tariff rates on agricultural products by an average of 36 per cent and on

manufacturing goods by an average of 15 per cent over 6 years. Developing countries

would cut the tariffs on agricultural products by an average rate of 24 per cent and onmanufacturing by an average rate of 27 per cent over 10 years (World Trade Organisation,

2006). The URAA rules include three areas: market access, domestic support, and export

competition. Market access consists of removing all non-tariff barriers and converting into

bound tariff then also reducing tariff levels. Under URAA, developed countries should

reduce tariffs by 36 per cent overall or a minimum of 15 per cent within 6 years and


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developing countries by 24 per cent overall or a minimum of 10 per cent during 10 years.

The members of WTO also agreed to remove export subsidies and domestic support.

Developed countries reduce export subsidies by 21 per cent over 6 years and developing

countries by 14 per cent over 10 years from the base year under URAA (Regmi et al.,

2000).

The reduction of tariffs and tariff quotas leads to growth in trade in developed and

developing countries; whereas, it decreases government revenue especially in developing

countries. Government revenue of some countries strongly depends on trade taxation. For

example, Swaziland and Uganda tariff revenues were more than 40 per cent of all

government revenue (Gallagher, 2006). The percentage share of tariffs in the Iranian

government revenue was about 28 per cent in 2004 (Central Bank of Iran, 2005).

Three development plans have been implemented by the government since 1989 to increase

the rate of economic growth in Iran. The first five-year development plan covered the

period from 1989 to 1994, and targeted a reduction in the size of the government through a

privatization program, the removal of subsidies on food and medicine, and deregulation of

investment and prices. Most prices were deregulated, a majority of subsidies were removed

and non-oil exports volumes rose considerably.

The second five-year development plan between 1995 and 1999 was designed to reduce

subsidies on fuel (gas, petrol, gasoline), improve non-oil exports, and develop the capital

market and stock exchanges. Non-tariff export barriers were eliminated in this plan but it

was unsuccessful in achieving its targets. The reasons for this failure are explained in

chapter two. In particular, the economic growth of Iran was curtailed by a dramatic fall in

the oil price in 1998.

The third fiveyear development plan targeted the removal of all non-tariff barriers to

foreign trade, replacing them with tariffs. A facilitatory policy was designed to expand

investment in industrial activities and export production in free trade zones. Reductions in

fuel subsidies, programs to facilitate exports and a single exchange rate were also

introduced in this plan. The results of this plan were notable: employment rose, the GDP

growth rate was more than 5 per cent and non-oil exports grew rapidly because of trade


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reforms. More explanation on the Iranian development plans, trade and monetary policies

is offered in the next chapter.

The above-mentioned tariffication of non-tariff barriers, unifying exchange rate and the

removal of all non-oil export barriers were done in the third five-year development plan asthe country was aspiring to join the WTO. Economic policy in each development plan was

based on advice from the International Monetary Fund (IMF). The International Monetary

Fund (2004) acknowledged that the Iranian GDP growth rate was high (6.5 per cent) in

2004 because of an increase in the oil price, and increased private and foreign investment.

Manufacturing, mining, and employment rose, and domestic demand leapt as a result of an

expansionary monetary policy. But inflation remained at 15.5 per cent at the same time.

Iran had applied for WTO membership 19 times but had been rejected by the USA before

giving permission to attend as an observer in May 2005. This study attempts to analyse the

impacts of trade liberalisation on the economy of Iran for the past decade.

The economy of Iran

The economy of Iran

The economy of Iran before the revolution (1973-1978)

The Iranian economy has undergone positive and negative changes, promotion and

disruptions, over the past 32 years (1973-2005). Oil export revenues have been around 80

per cent of total export earnings, about 50 per cent of the government revenue and about 20

per cent of GDP in Iran (Alexander's Gas&Oil Connections, 2002). Fluctuations in the oil

price have had significant effects on the revenue of the government and created a lot of

problems and shocks to the economy of Iran. A rise in the price of oil is favourable for the

Iranian economy whereas a decline in oil prices causes economic crises. When OPEC

adopted price-setting policies for oil, the price of oil rose sharply between 1973 and 1977.

This price rise led to the successful implementation of the fourth and fifth development

plans (1969-77) and an annual growth in GDP of more than 10 per cent during this period.

Pre-revolution Iranian GDP approximately doubled during the eight years (1969-1977).


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The first international oil price crisis in 1973 increased financial inflows to Iran and caused

a substantial increase in the money supply. Thus, inflation grew dramatically between 1973

and 1977. After 1977, the price of oil fell to about US$15 per barrel, which led to a decline

in Iranian government revenue. Oil revenue dropped from US$20,713 million in 1977 to

US $17,867 million in 1978. The government borrowed from the Central Bank of Iran. A

sharp decrease in GDP by 12 per cent below the peak level recorded in 1979 resulted due to

cuts in the budget in 1978. Because of the economic recession that followed, the gap in the

level of income grew quickly, making Iranian people dissatisfied with the government in

early 1979 (United Nations Industrial Development Organization, 1999).

The economy after the revolution (from February 1979 to October 1980)

A change in government in February 1979 led to a rapid decline in GDP of about 8 per centbecause of transitional dislocation. The second international oil crisis in late 1979 and 1980

allowed the current account of Iran to recover, leading to a current account surplus of some

US $12 billion. A trade embargo by Irans greatest trading partner (the USA) at the time

weakened the economy of Iran because Iran was strongly dependent on imported American

commodities. However, the oil price continued to rise and oil revenue increased, so

demand for goods went up and inflation rose 21 per cent by 1980 (United Nations

Industrial Development Organization, 1999). As 50 per cent of government revenue is due

to oil earnings (Esser, 2005) the Iranian government plays a crucial role in the provision of

foreign currency (Moradi, 2002). Prior to the revolution, the gap between the official and

free exchange rates was small. It widened dramatically from 1979. These exchange rates

closed in 1992 when the government of the time introduced a new exchange rate regime.

Eight years of war (1980-1988)

Another external shock to the Iranian economy occurred when Iraq attacked Iran in

October 1980. A substantial decrease in international oil prices added to the war shock

between 1982 and 1986. These events prompted a substantial reduction in Irans foreign

exchange earnings and forced the government to increase borrowing from the banking

system. The government raised the countrys money supply by approximately 18 per cent

from 1979 to 1988, and the annual inflation rate reached 19.3 per cent. By the time Iran


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signed a cease-fire with Iraq in 1988, its economy was extremely weak and its population

had grown from 37.2 million to about 52 million. The first decade after the revolution

(1979-1989) was characterized by declining per capita income, inflationary pressures, and a

lack of employment opportunities for unskilled labour. The importance of the government

in the economy expanded rapidly after 1979. Eight years of bombing of cities and

infrastructure wore the people down and collapsed the economy of Iran. A decline in oil

prices from US$30.60 per barrel to US$13.30 caused a reduction in oil earnings from about

US$20,000 million to about US$ 6,250 million per year and produced a budget deficit, a

reduction in the money supply and further inflationary pressure during the period from

1982 to 1986. Therefore, the government rationed some foods and established an institute

to control the wholesale and retail prices of goods. Five-year development plans and

recovery

Literature review

Many world-wide studies are available for review, but here our aim is to focus on the

Middle East and application CGE model in Iran

Static models

The static CGE model is a generalization of the simple input-output (I-O) model. It

comprises equations of consumption demand and production supply, demand for factors

and intermediate goods, market clearance, income and expenditure of government and so

on. The functions of demand for factors and intermediate commodities are derived in the

model and the data are required in I-O form for one year. Cobb-Douglas production and

utility functions are used, resulting in calculations which are simpler with linear and

nonlinear equations. Furthermore, they can write a complicated model and calibrate it in

the linear functions. CGE models are based on neoclassical general equilibrium theory

(Monaco, 1997).


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Atici (2002) studied the impacts of full trade liberalisation on household groups in the

Turkish economy using a static-CGE model. He considered three scenarios: the removal of

tariffs, elimination of the export subsidy, and elimination of both tariff and export

subsidies. The results show that tobacco production decreased by about 31 per cent and

manufactures by 2 per cent while other agricultural outputs such as agribusiness and

services increased in the first scenario of a tariff cut. The first scenario had an influence on

increasing household income at different levels in urban and rural areas but the revenue of

Turkeys government declined by 18 per cent. Moreover, it led to a 19 per cent

depreciation in the Turkish currency. The second scenario expanded agribusiness

government revenue and the exchange rate by 2.36, 3.76 and 1.67 per cent respectively but

other effects were less than one per cent. The third scenario had a decrease in tobacco and

manufactures output, similar to the first scenario, but household incomes declined because

of the reduction in factor earnings. However, the elimination of export subsidies

compensated for the loss of government revenue in comparison to the first scenario (from

18 per cent to 13 per cent).

Konan and Maskus (1999) analysed tax reform and tariff unification in Egypt. They

improved an earlier Egyptian CGE model to simulate the impact of reforms in the tax

system, capital tax and tariff structure on welfare in Egypt. The results of tax reform were a

one per cent gain in welfare in respect to fixed factor prices and the exchange rate. Konan

and Maskus studied the impacts of trade policy reform alone as well. Firstly, tariff rates on

all imports were unified at 10 per cent; secondly, they tested the model under a free trade

agreement with the European Union; and finally, they assessed full unilateral tariff

liberalisation. The results of shocking the model by the three trade policies indicate the

largest gain from unification at 10 per cent; the FTA with EU lowered welfare. In the full

trade liberalisation scenario, the welfare gain was 0.89 per cent and there was a smalldepreciation in Egypts currency value. When the reform was a complex of tariff and tax

reforms, the welfare gain rose to 1.09 per cent. Konan and Maskus concluded that tax and

trade limitations led to a distortion of commodity consumption and capital usage and that

reform would bring a welfare gain to Egypt.


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Khondker and Raihan (2004) used a standard multi-sector, multi-factor and multi-

household CGE model to examine the impacts of policy reforms on allocation of resources,

income distribution and poverty for Bangladesh. Their model calibrates the social

accounting matrix (SAM) of Bangladesh to 1995/1996. This model has three sectors

(Agriculture, Industry and Services) and two institutions (1-Household 2-both Government

and rest of the world). Agriculture is disaggregated to crops and non-crops; crops consist of

traded products and non-traded products such as rice. Non-crops are branched into two

groups, traded and non-traded. Traded crops include items such as livestock and fish,

whereas non-traded are domestic fixed goods (for example, forestry). Households were

disaggregated into rural and urban. Also, each of these categories are disaggregated into

three further groups. Rural has three levels: the first group is household labour, the second

group is small farmers and the third group is large farmers. Urban is comprised of low

skilled, medium skilled and professionals. Equivalent variations (EV) and Foster-Greer-

Thorbecke (FGT) measures were applied to forecast welfare and poverty changes in

Bangladesh. The model is simulated by applying three shocks: tariffs are eliminated

completely and new taxes are imposed to fix government revenue, ready-made garments

export is decreased by 25 per cent in quantity, and remittances to Bangladesh are increased

by 50 per cent.

The effects of these shocks show that complete trade liberalisation results in a welfare loss

for households. Households are worse-off in rural regions and poorer households in urban

areas suffer from higher welfare losses. The results of FGT measures show higher poverty

in urban than in rural areas. The second shock generates a fall in total exports and

consequently a decrease in GDP. Declining GDP aggravates welfare when it is calculated

by equivalent variation analysis. Finally, increasing remittances only raises urban incomes

and does not lead to increases in total benefits as most people who send money from

overseas to Bangladesh emigrated from cities.

The results of a tariff reduction in Pakistan were estimated by Sidiqui and Iqbal (2001). A

CGE model was built and data used based on a SAM for 1989/90. It is a neoclassical model

and has a constant elasticity of transformation (CET) assumption for the domestic market

and exports, and constant elasticity of substitution (CES) assumption for imported and

domestically produced goods. The production function is Cobb-Douglas with constant


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returns to scale and unit elasticity of substitution between inputs. It has two factors, labour

and capital. This model comprises five sectors: agriculture, industry, education, health and

others. Four institutions are described: households, firms, government and the rest of the

world. The institutions receive income from the endowments of primary factors and their

rental values, which in turn are used for consumption and investment. If the exchange rate

is fixed and the current account balance is exogenous, prices of imports will decline by

16.37 per cent when the tariff rate is reduced by 80 per cent. This tariff reduction causes

increases in real income due to price decline and an improvement in income equality. The

share of labour in GDP increases while that of capital decreases.

Siddiqui and Kemal (2002) studied the effects of remittances, trade liberalisation and

poverty in Pakistan using the same CGE model and SAM data. The model entailed two

simulations. The first simulation eliminated tariffs and the second used a decrease in

remittance inflow. The tariff reduction produced more welfare gain for urban than for rural

regions and the decrease in poverty was greater in urban areas than in rural areas. There

was a positive correlation between remittance inflow and both welfare and poverty

reduction.

Daryanto (1999) researched the role of agriculture in the growth of the Indonesian

economy. He used a CGE model for Indonesia and emphasized agriculture. A decline in

the price of oil and agricultural exports, agricultural development and tax policy were some

of the changes that he used to get results. The effects of an oil price reduction by 50 per

cent showed a strong linkage between the government budget and the rest of the economy.

Consequently, a decline in oil price decreased welfare in urban areas. A decrease in the

export price of agricultural products diminished agricultural production and as a result

farmers real income decreased in Indonesia.

Chadha et al. (1997) analysed the impacts of economic reform in India in a study done for

the National Council of Applied Economic Research (NCAER) using a CGE model.

Reform was described by a reduction in tariffs and Non Trade Barriers (NTBs) on imports,

and these reforms plus a reduction in export subsidies. A five per cent increase in GDP was

identified as a result of full reform in India. Trade liberalisation brought about a positive


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shift in agriculture and efficiency, and a significant improvement was found in Indias

manufacturing sector.

Japans Official Development Assistance (ODA) delivers government aid to developing

countries. One of the ODA schemes is providing loans to developing countries at lowinterest rates, dependent on whether or not the initial payment is to be paid back. Kawasaki

(2002) assessed the effects of ODAs loan on six Asian countries: China, Indonesia,

Malaysia, Philippines, Thailand and Vietnam. He also studied the impacts of unilateral

trade liberalisation of Japanese imports from those countries. In order to analyse these

impacts, a GTAP model was adopted and simulated. This model is not a forecasting CGE

model and only shows the difference between when cooperation measures were applied

and when they were not. The assessment shows that investment and the real GDP of the six

Asian countries receiving loans increased because of the ODA loans. Also loans to these

countries produced economic welfare gains, but the welfare gains to Japan from trade

liberalisation were much greater.

Application of CGE Model for Iran

Several researchers have applied the CGE model to Iran since 1995. A static CGE model

has been adopted to study the effects of trade reform and subsidy reduction on energy,

medicine, food and agriculture in Iran. These policies could have negative and positiveeffects on the economy and each sector of economic activity if implemented. In this section

a number of CGE assessments are reviewed and the impacts of trade liberalisation and

subsidy reduction on the economy of Iran are explained briefly.

A multi-sector CGE model was used by Jensen and Tarr (2002) to analyse the impacts of

trade, foreign exchange and energy policy reforms on welfare in Iran. They highlighted two

exchange rates in 1999: the official rate and the market exchange rate for a US dollar. The

difference between these exchange rates provided a subsidy for imports equal to 79 percent. They also pointed out that the prices of petrol and gasoline were 10 per cent of the

world price in Iran, and that the government paid a subsidy on petroleum products of

between 74 and 94 per cent. There were 20 types of households, 10 urban households and

10 rural households with different levels of income in the model. They found that

tariffication and a reduction in the tariff rate to 15 per cent caused an increase in aggregate


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welfare by 5.5 per cent. If this scenario is combined with the elimination of non-trade

barriers, the incomes of the poorest rural and urban household could increase by 20 and 11

per cent respectively. Furthermore, the combination of exchange rate unification and

energy reform (removing all energy subsidies) would increase aggregate welfare by 39 per

cent. The poorest rural households gained (239 per cent) and the poorest urban households

gained (116 per cent) as a result of the energy reform. Jensen and Tarr estimated that the

aggregate welfare gains for the Iranian economy were 50.7 per cent due to applying zero

tariffs, unification of the exchange rate and zero petroleum subsidies. They also argued that

there is a great opportunity for Iran to help the poor with direct income payments.

Salami et al (1995) presented a paper using the CGE model about Irans economy at the

2002 Annual Meeting of Canadian Economics Association held at University of Calgary .

They simulated the CGE model of Iran in the short run. The results showed that factor-

neutral technical change had a positive effect on the imports of non-trade and competing

sectors, but a negative effect on exports. The growth of the neutral technical rate of change

on factors would lead to an increase in employment and real GDP, but it could cause a

trade deficit. Conversely, labour-saving capital-using technical change showed a negative

effect on employment and GDP while resulting in growth of imports and exports. The

subsidy reduction would decrease employment and real GDP in Iran.

Esalmi (2005) studied the effects of agricultural land productivity on the economy of Iran

using a 25-sector CGE model and Iranian inputoutput table for 1991. The model was

simulated for the elimination of domestic and international market barriers. His results

revealed that removing trade barriers will increase agricultural land productivity if it

includes a suitable trade policy. Furthermore, an increase in the agricultural sector leads to

growth in food manufacturing and employment. This policy also decreases food prices and

causes an increase in welfare, real GDP and food security.

Likewise, Zolnoor(2002) assessed the effects of trade liberalisation on the economy of Iran

by applying a CGE model. Using input-output data for Iran with the base year 1991, he

points out that trade liberalisation increases GDP. In addition, an increase in manufacturing

tariffs leads to growth in agriculture, manufacturing and the construction sectors but a

decline in services.


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Methodology: The Iranian CGE Model

The Iranian CGE model is calibrated with the input-output table based on data of 1991. The

theoretical structure of the model will now be explained.

Structure of production

Each industry can produce several commodities by using a number of inputs. According to

specific assumptions, a multi-input, multi-output production structure is applied in the

model. The relationship between inputs and outputs can be formulated by a production

function. Inputs are composed of primary factors, intermediate goods and other costs.Figure A-1 illustrates schematically the structure of production. Primary factors (land,

capital and labour) are combined with the constant elasticity of substitution (CES) function

at the bottom level of the nested structure. A CES production function was used to combine

land, labour and capital in producing units of primary factor in the formulation of equation

4-1.

1,

1,

)(

=

= ijnh

jiijj XAZ

i =1,, h and j =1,,n (4-1)

Where Zj the CES is production function for industry j or is the aggregate factors for

industry j.A is a positive coefficient, ij is a distribution parameter with i from 1 to h for

primary factors (Capital, Labour and Land) and 1 to n for industries. Xij is primary factor i

used in industryj, is a substitution parameter that is greater than zero and the elasticity of

substitution is equal to +11

.

This structure was selected for all industries because we assume that the structure of

production is the same in different sectors in Iran. Moreover, this assumption decreases the

number of equations and calculations required. The domestically-produced and imported

intermediate inputs are combined in the same way, using the CES form. Among


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intermediate inputs, there is imperfect substitution. In addition, at a higher level (Activity),

aggregate intermediate and aggregate primary inputs are combined with other costs through

a Leontief production function to produce outputs. Aggregate primary factors, intermediate

inputs and other costs cannot be substituted for each other. The Leontief production

function is equivalent to a CES production function with the substitution elasticity set to

zero. It is a fixed proportion production function that factors are always used in fixed ratios.

This function only operates along the ray where it shows a constant ratio of factors.

Figure A-1 The Structure of Production

Demand for primary factors (labour, land and capital)

To determine the composition of demand for primary factors, total primary factor

costs)(

1

=

h

i

iiXP are minimised subject to the following production function:

pp

i

n

i

ijXZ

1

1

)(

=

= (4-2)

The associated first-order conditions are:

Domestic Good 1 Imported Good 1Capital

Im orted Good GDomestic Good G

LabourLand

CESCES

Good GGood 1

CES

Primary factorsup to

Other Costs

Output

Leontief


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)1(

1

)1(

+

=

+

=

=

h

i

iikk

k

kXX

X

ZP (4-3)

Where

is the Lagrange coefficient.

Thus

+=

1)(k

i

i

k

i

k

X

X

P

P

(4-4)

Then substituteXi into the production function and solve forXk to derive conditional factor

demand for primary factors in the form:

)1(

1

1

1

+

+

=

ave

kkk

PPZX

(4-5)

The percentage change form of this equation is:

)( avekk ppzx = where k= land, labour and capital (4-6)

and avep is the average price.

=

=h

i

iiave PSp1

,

+=

1

1and

++

++

=

11

1

11

1

ik

iii

P

PS ,

is a parameter and S is the share of costs for each primary factor.

Equation (4-6) shows that a percentage increase in output and average price of other factors

leads to a percentage increase in demand for this input. For instance, if the prices of land

and capital are increased, demand for labour will grow relatively. A contrary relationship is

portrayed between demand for labour and its price, where a one per cent increase in labour

price decreases demand for labour in the percentage form.

Equation (4-6) is rewritten with technical change as:

xk-ak= z-(pk+akpave) (4-7)

where akis technical change for each factor.


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Technical changes are constant in the CGE model, but if they do change the improvement

in technology (the growth of the technical change) reduces demand for inputs. For instance,

demand for labour often declines when technology replaces labour. In equation (4-7), the

technical change has a direct negative effect and an indirect effect on the demand for

factors. Depending on the elasticity of substitution among factors, an increase in the

technical change of one factor reduces demand for it.

Household demand

The nesting structure for household demand is illustrated in Figure A-2. At the bottom

level, domestic and imported goods are consumed by residents according to a constant

elasticity of substitution (CES) function. Utility per household is derived from the Klein-

Rubin utility function:

c

ccc

XQ

U )(

1=

(4-30)

where Q is the number of households; Xc is total consumption of good C; c is the

subsistence level of consumption of good C; and c is the marginal budget share of good c.

0 c 1 and c=1. To determine the source-specific commodity demand, the utility

function is maximised subject to household budgets (PcXc). Equation (4-31) shows its

percentage form:

xH

cs H

cs = xH

c-s H

[pH

cs + H

cs - pH

c-s] (4-31)

wherexHcs is the percentage change of household demand for commodity C and source S,

xH

c-s is household demand for the import/domestic composite of commodity C in

percentage form. Hcs is a households basic taste change;pH

cs is the percentage change in

the purchase price of commodity c from source s. pHc-s is the percentage change in the

value of the import/domestic composite of commodity c and H is the Armington elasticity

of substitution between import and domestic commodities for households.


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Figure A-2 The structure of Household Demand

Demand for the import/domestic composite of commodities has a positive effect on

household demand for commodity Cand source S. An increase in the purchasing price of

commodity C decreases household demand for commodity C. The price growth of

commodities which can be replaced with good Cin consumption causes a rise in demand

for S. A change in household taste for a commodity alters demand for it and for substitute

commodities. If this change is negative, the demand for the commodity will be reduced. A

negative change in household tastes for substitute commodities for commodity Cleads to

an increase in the demand for commodity C.

Consumption demand for imported and domestic goods is divided into two sections. There

are demands for luxury and subsistence categories. A households budget is spent on twokinds of goods, subsistence and luxury goods, thus:

XT(c) = Xsub(c)+Xlux(c). (4-32)

Domestic good 1 Imported good 1 Imported good CDomestic good C

CES CES

Good CGood 1 Up to

Klein Rubin

Household Utility


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Total household demand is separated into demand for subsistence goods (Xsub) and luxury

goods (Xlux). If Vc was the household budget, optimal expenditure on goods would be

equal to this budget such that:

Vc =PcXc (4-33)

where Xc.is the subsistence category and PcXc is expenditure on each subsistence good.

Hence, the sum of the households luxury costs is derived as follows.

C = V -PcXc (4-34)

Expenditure on luxury goods is derived from the remainder of the household budget after

spending on subsistence goods. Therefore, the household expenditure function contains the

cost of subsistence and luxury goods (equation 4-35).

PcXc = Pcc + c(V-PcXc) (4-35)

Or

PcXc = Pcc + cC (4-36)

where c is luxury good c and c is the marginal budget share of good c (0c1 and

c=1). Total household demand for a commodity as a percentage change is derived by

differentiating equation (4-35) with respect to x and dividing PcXc resulting in:

xc =c( - pc) (4-37)

where c equals

=

c

c

cc

c

XXP

C 1 , with its supernumerary proportion of total expenditure on

Xc, and = dC/Cis the percentage change in aggregate expenditure for luxury goods.

Equation (4-38) shows the percentage change in total household demand:

xH= xsub + xlux (4-38)

where demand for supernumerary goods in percentage changes is written as:

xlux + pc = wlux + alux (4-39)

pc is the consumer price index, wlux is total nominal supernumerary household expenditure

and alux is the taste change for supernumerary demand.


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Also the total demand for subsistence can be seperated by:

Xsub = Q Asub (4-40)

WhereAsub is the individual household subsistence level (Horridge, 2003).

Its percentage change form is:

xsub = q + asub (4-41)

Here q is the number of households and asub is a taste change for subsistence demand.

Results and conclusion

Table a.1 Macroeconomic Results of Trade Reforms under UR

(Percentage changes)

Variable Description Short run Long run

Employ_ireal wagex0gdpexpx3totdelBx0imp_cp3totp4totp5totp6totx1cap_i

x1prim_ix2tot_ix5tot

Aggregate employment: wage bill weightsAverage real wageReal GDP from expenditure sideReal household consumption(Nominal balance of trade)/[nominal GDP](change) Import volume index, duty-paid weightsConsumer price indexExports price index, local currencyGovernment price indexInventories price indexAggregate capital stock, rental weights

Aggregate effective primary factor useAggregate real investment expenditureGovernment consumption

2.450*0.710*-0.0210.99-13.52-4.14-15.07-16.920*

1.060*0*

0*11.993.47-2.830*17-13.95-7.62-10.66-15.488.24

3.878.92-2.83

*- Exogenous variables which were not changed in the simulations based on assumptions

The macroeconomic impacts of trade reforms on GDP and overall employment are

significant. Real GDP might expand over 0.71 per cent in the short run. (see Table above).

Falling domestic prices of inputs encourage export producers to produce more. With zero

change in real wages, the results in the short run show a 2.4 per cent increase in demand for

labour. The labour-intensive and export industries can expand employment.

Table a.1 illustrates the striking outcome of a 22.77 per cent increase in exports. Imports

could get a boost because of falling prices in the domestic market (by 11 per cent) through

the tariff reduction. Thus, this could produce a deficit in the trade balance. The delB


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proportion (Nominal trade balance/[nominal GDP]) shows a deficit in the trade balance (of

0.02 per cent) due to the reduction in tariffs.

Similarly the CGE model is simulated by a 24 per cent decrease in the tariff on agricultural

products and a 27 per cent tariff reduction on non-agricultural goods. The results show an11.99 per cent rise in the average real wage is due to tariff reductions under the UR.

The implementation of the model has been explained and then the results of both the short-

run and the long-run tariff reduction under the Uruguay Round have been analysed in this

chapter. The results were divided into macroeconomic and sectoral results. As is shown by

the results discussed in preceding sections, Iran would gain from tariff cuts, boosting

production in export and export-related industries. In addition, industries which employed

abundant factors might expand and the sectors servicing these industries could also grow in

the long run. Trade liberalisation in the long run would have a stronger effect than in the

short run on production, level of exports, and employment.


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