Foreign Trade Behavior in a Small Open Economy (Belgium 1970-1980)

Author(s): Claudy G. Culem

Source: The Scandinavian Journal of Economics, Vol. 89, No. 1 (Mar., 1987), pp. 55-70
Published by: Wiley on behalf of The Scandinavian Journal of Economics
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Scand. J. of Economics 89 (1), 55-70, 1987

Foreign Trade Behavior in a Small Open

Economy (Belgium 1970-1980)
Claudy G. Culem *
University of Brussels, Belgium

Abstract
Unlike imports, an infinite price elasticity of supply is not a realistic assumption for exports,

especially in the short run and for a small country. This is why a simultaneous approach is
developed to appraise the export behaviour of the Belgian manufacturing industry during
the 1970s; both a supply and demand curve are specified and estimated simultaneously in
view of the two-way relationship between price and quantity. The estimates are used to

assess the stability of foreign trade, the pricing policy of exporters and the evolution of their
international market shares.

I. Introduction

A new and more realistic approach to export behaviour is applied to

the case of the Belgian manufacturing industry during the 1 970s, where
structural equations of export supply as well as demand are specified.
The two-way relationship between export quantities and export prices
enables them to be estimated simultaneously. Such a simultaneous
approach was first developed by Goldstein & Khan (1978). Explicit
specification of an export supply curve originated from the idea that,
on the assumption of decreasing returns to scale, no increase in
production for export can be expected in the absence of an export
price rise, at least in the short run.

As usual, export demand is accounted for by world income and

relative prices. On the other hand, three variables are expected to
determine the export supply volume. These are the ratio of export
*1 would like to thank SPPS (Belgian Science Policy Programming) and CIM for financial
support. Although responsible for any remaining errors, I am particularly grateful to Jean
Waelbroeck for helpful discussions and two anonymous referees for constructive comments
and criticisms.
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56 C. G. Culem

price to domestic production price, production capacity and the

pressure of domestic demand on capacity. However, if exporters
behave as price setters on international markets, a supply specification
with price rather than quantity as a dependent variable is more appro-

priate; see Haynes & Stone (1983). Both specifications of the supply
curve are tested in Section II and the pricing policy of Belgian
exporters is discussed in Section III.

Export supply and demand may reasonably be assumed to be in

equilibrium owing to the use of annual data. These data pertain to the

26 sectors that comprise the manufacturing industry. Such a disaggregation of observations not only enlarges the sample, but also allows us
to capture export supply and demand for relatively homogeneous
sectors and therefore ensures more efficient estimates.

Two further points raised in Orcutt's (1950) celebrated article are

also given careful consideration. First, lags are introduced in order to

obtain longer-run elasticities. Next, confidence intervals are computed

according to the technique recently suggested by Klepper & Leamer

(1984) that takes into account the presence of measurement errors in

all variables.

An import demand equation is also specified and estimated, again

on a sample of disaggregated data for the years 1970-80. Contrary to
exports, the supply curve may reasonably be handled by assumption,
i.e., by postulating an infinite price elasticity. Once all export and
import elasticities have been estimated, the stability of Belgian foreign
trade in manufactures can be tested.
To sum up, the purpose of this paper is first and foremost to provide
new estimates of the various elasticities related to Belgian foreign trade
in manufactures. These estimates are asserted to be of high quality and
reliability due to use of the simultaneous approach to export behaviour

and to the disaggregated nature of the sample. They are used to

appraise the stability of Belgian foreign trade in manufactures, the

pricing policy of Belgian exporters and the evolution of their international market shares during the 1970s.

II. Methodology
The Sample

The model is estimated from a mixed sample of cross-section and time-

series data. It consists of yearly observations (1970-80) disaggregated

Scand. J. of Econom ics 1 9 8 7

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Foreign trade behavior in a small open economy 57

according to the 26 sectors of the Belgian manufacturing industry

corresponding to the input-output classification.' We use data on

foreign trade and production in value which have been made compatible according to the ISIC (International Standard Industrial Classi-

fication) nomenclature by the World Bank Market Penetration Group.

They are available for Belgium as well as nine other industrialized
countries.

The Model

As implied in the introduction, we do not follow the usual practice of

estimating a world demand equation for an individual country's
exports on the assumption that the price is exogenous. Indeed, this
procedure boils down to assuming that the export supply price elasti-

city is infinite, which is not defensible except when industry has idle
capacity or is characterized by nondecreasing returns to scale. Rather,
following Goldstein & Khan (1978), we specify a system of simultaneous equations which account for the Belgian export supply of
manufactures (1) and the world demand for exports of Belgian manu-

factures (2). Equation (3) postulates the equilibrium between supply

and demand, both expressed in volume: suppliers remain on their supply curves and demanders on their demand curves. This seems reasonable when annual data are used. All variables are expessed in annual
percentage changes (denoted by dots), so that the estimates provide
elasticities. It also follows that when a variable is expressed as the ratio
of two other variables, this ratio becomes a difference.

Xbs= aPbx+ a2Plp+ a3Q6* + a4(D6 - D*)+ El (1)

Xbd= b, D*+ b2(Pbx - Pix) + E2 (2)
Xbs

Xbd

Xb.

(3)

The demand for exports of Belgian manufactures by the rest of the

world is accounted for by world income Dw, proxied by world

'The 26 sectors are: coke, oil refining, iron and steel, nonferrous metals, glass, cement,
nonmetallic and nonenergetic minerals, chemicals, fabricated metal products, agricultural
and industrial machinery, office machines and precision instruments, electrical machinery
and equipment, automobile vehicles, other transport equipment, meat, milk, other food
products, beverages, tobacco, clothing, textiles, leather, wood, paper, rubber and plastics.
The sector entitled "other manufacturing industries" is not included because of data limitations.
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58 C. G. Culem

exports,2 and by domestic Pbx and world Pwx export prices. For Dw, a
regression coefficient higher than unity indicates over-cyclical
behaviour, i.e. domestic exports respond more than proportionately to
world economic conditions. The coefficients of Pbx and Pwx are

constrained to sum up to zero, i.e., it is the relative price (Pbx/Pwx) that

matters and its expected sign is, of course, negative. Both Pbx and Pwx
are expressed in a common currency, the Belgian franc.
The hypothesis which warrants specification of an export supply
equation (1) is that an increase in export demand cannot possibly be
satisfied without a rise in export price, at least in the short run. In other
words, the export supply price elasticity is not infinite and returns to

scale are decreasing. A positive relationship is therefore expected

between export price and export supply.
Apart from the export price Pbx, three variables are expected to
have a significant influence on the supply of exports: the domestic
production price Pbp, which is assumed equal to the selling price on
the domestic market, production capacity Qb*, and a variable repre-

sentative of the pressure of domestic demand on production capacity

(Db/Dw).
Other things being equal, export supply is expected to be an increasing function of the ratio between export price and production price.
Indeed, when this ratio increases, i.e., when Pbx grows more rapidly
than Pbp, production for exports becomes relatively more profitable
and the supply of exports is enhanced. Estimations are carried out both
with and without constraining the coefficients of Pbx and Pbp to sum
up to zero. Three main arguments can be found in the literature which
account for possible discrepancies between domestic and export
prices: unequal price elasticities of domestic and foreign demand,

different cost structures for domestic and export production, and

market imperfections; see e.g. Goldstein & Khan (1985, p. 1047, footnote 14).
Relatively higher production capacity should favour a greater supply
of exports. Capacity is measured by the exponential production trend
over the years 1970-80. Measured in this way, capacity is clearly an

2World exports in volume are assumed to reflect the worldwide economic climate. They are
approximated by the total exports of the following 12 industrialized countries: Australia,
Belgium-Luxembourg, Canada, France, Italy, Japan, the Netherlands, West Germany, the
United Kingdom, Sweden and the United States.
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Foreign trade behavior in a small open economy 59

exogenous variable, which would not be the case if it had alternatively

been measured by production itself.

Comparatively less pressure of domestic demand is expected to

stimulate the supply of exports. Such pressure is measured by the ratio

of domestic Db to foreign demand Dw for domestic goods. Variables
Db and Dw are both introduced separately into the regression with
their coefficients constrained to equality, except for the signs. This is

assumed to grasp the rationing - or crowding-out - of exports in

favor of domestic consumption. The underlying hypothesis is that

domestic producers satisfy domestic demand first. In support, it is

usually argued that the domestic market is more easily accessible and at
lower cost (lower transport costs, no tariffs or other barriers to trade),
and that the selling price at home is higher due to the lower price
elasticity of demand. This hypothesis was tested for the U.S. and the

U.K. in a simultaneous equations model by Dunlevy ( 1980).

An alternative specification of the export supply curve may be
preferable, however. It consists of choosing the export price as the

dependent variable and may be written as in equation (1'). In this case,

the explanatory variables become the volume of exports, the production price, production capacity and the pressure of domestic consumption on the latter. Their expected signs are +, +, - and +,
respectively.

PbX=ciXb+c2Pbp+c3Qb*+c4(Db-Dw1)+ +. (1')
In the absence of lagged variables, there is no difference between (1')

and the previous specification (1), at least if the equation is estimated

by full information maximum likelihood, which is independent of the
normalization procedure. Things change, however, once lags are introduced, i.e., when dynamic adjustments are assumed. Indeed, in the
framework of equation (1'), prices might respond to lagged quantities,
which is obviously not possible according to equation (1). The alternative specification (1') therefore assumes that firms dynamically adjust
their export prices to market conditions rather than their export supply
to prices. This means that they enjoy some liberty in fixing their prices
and that they are price setters rather than price takers, at least in the
short run. This issue is discussed and tested in the U.S. and U.K. cases
by Haynes & Stone (1983). Let us quote the end of their conclusion.
"... the more appropriate specification of aggregate supply behaviour is
a supply-price not a supply-quantity formulation. A supply-price
specification is theoretically plausible when the assumption of perfect
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60 C. G. Culem
certainty for firms is relaxed to incorporate learning processes, delayed
adjustment, and price-quoting behavior. In this case, prices respond to

lagged quantities, and the traditional supply-quantity specification

cannot capture the dynamic supply behavior".

Equations (1) - or alternatively (1') - (2) and (3) form a system of

simultaneous equations where Xb and Pbx (at time t) are endogenous
and the other variables are exogenous or predetermined (lagged
variables). The order and rank conditions for identification are met for
each of (1), (1') and (2).

Let (4) be the behavioral equation which accounts for the volume
of the demand for imports of manufactures by Belgium and (5) an equi-

librium equation which says that importers remain on their demand

curves:

Mld = dD6 +d2(P6m-P6p)+c4 (4)

Mbd

Mb,

(5)

where, as above, the dots denote annual percentage changes. Two

variables are expected to explain the demand for imports of manufactures by Belgium: Db, domestic demand in volume, which is measured
by apparent consumption and whose expected sign is positive; and

(Pbm/Pbp), the ratio of the import price to the domestic production

price, both expressed in Belgian francs, and whose expected sign is, of
course, negative.
As usual in the case of a small country's imports, a horizontal supply
curve is postulated, i.e., infinitely elastic with respect to price. It follows

that Pbm is exogenous and that (4) need not be estimated by instrumental-variable techniques.
Estimation Methods
Two models of exports are estimated successively. The first consists of

the export supply-quantity equation (1) along with the export demand
equation (2) and the equilibrium equation (3). In the second, the export
supply-quantity specification is replaced by the export supply-price

specification (1'). The behavioural equations are first estimated by

weighted two-stage least squares (2SLS). These estimates are used as
starting values in a full information maximum likelihood estimation

procedure (FIML). The import demand equation (4), which is not

subject to any simultaneity bias, is estimated by weighted least squares

only (WLS). Multiple correlation coefficients are reported for all

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Foreign trade behavior in a small open economy 61

equations. It should be noted, however, that their interpretation is
doubtful in simultaneous models. Because they are bounded [- 00, 1],

small or even negative values do not mean that the fit is poor.
For all equations, heteroscedasticity is a priori suspected because of
the cross-section character of the sample. A first round of 2SLS estima-

tions provides residuals which are submitted to the heteroscedasticity

test of the likelihood ratio. For this purpose, the sample is split up into
26 classes which correspond to the 26 industrial sectors. When heteroscedasticity is revealed (which is the case for each equation), the
observations are weighted and then submitted to a second round of
2SLS estimations. The weighting factor in each class is the inverse of
the square root of its residual variance.
Moreover, confidence intervals are computed according to the

method recently proposed by Klepper & Leamer (1984), which takes

into account the presence of measurement errors in all variables

(denoted in the tables by K-L). As this method is still recent, we

describe it briefly here - or at least give an idea of it, while accepting
the risk of oversimplification. It is an extension of Frisch's (1934) result
whereby, in a model with two variables X and Y with measurement
errors in each, the true regression coefficient is consistently bound by

the regression coefficients of Y on X and of X on Y. Let Y be the

dependent variable in the equation to be estimated, and Xi, = 1, ...,ki

the explanatory variables measured with error. k + 1 different regres-

sion vectors can be estimated by using in turn Y(direct regression) and

the Xj (indirect regressions) as dependent variable. If not all k + 1

regression vectors belong to the same orthant, then the set of maximum

likelihood estimates is not bounded. In order to bound it, some a priori

information is needed, such as e.g. the maximum attainable value of the
multiple correlation coefficient if the measurement errors in the

explanatory variables could be removed, denoted R*2. The bounds on

the regression coefficients bj in the direct regression of Y on the Xj can
be computed as follows:

- lower bound: bj + 0(mj- bj),

-upper bound: bj + O(Mj - bj),
where 0 = (R*2 - R2)/( 1 - R2), Mj is the maximum and mj the minimum
regression coefficient for Xi among the k estimates. A useful statistic is
the maximum value of R*2 such that the maximum likelihood region
remains entirely included in the orthant defined by the direct regres-

sion vector of Yon the Xj. It is reported as R*2. Another attractive way
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62 C. G. Culem

of presenting the same information is to compute the maximum share g

of the unexplained variation of Y which can be attributed to measure-

ment errors, while keeping the maximum likelihood region bounded. g

is equal to (R*2 - R2)/(1 - R2).

III. Results
Exports

The estimation results relative to exports (both supply and demand

curves) are gathered in Tables 1-3. The estimations obtained using the
supply-quantity specification (1), i.e., assuming price-taking behaviour
of firms, are listed in Tables 1 and 2, while Table 3 shows those
obtained using the alternative supply-price specification (1').
Let us first postulate that exporters are basically price takers, so that
we estimate the system of simultaneous equations formed by (1), (2)
and (3). The estimation results with no constraint imposed on the
coefficients of Pbx and Pbp in (1) are reported in Table 1. The signs are
as expected for all the variables and most regression coefficients are
very significant, with the notable exception of lagged prices. This
means that the bulk of adjustment to prices of quantities supplied for
export takes place within one year. The export price elasticities
provided by the FIML and 2SLS estimations are very close to each
other and greater than unity, 1.221 and 1.440, respectively, if lagged
effects are neglected. The positive relationship between supplied
quantity and export price confirms the belief that, on average, marginal
costs are increasing.
Other things being equal and in particular the export price, the
export supply decreases when the production price goes up, i.e., when
production for the domestic market becomes relatively more profit-

able. (Recall that the production price is assumed equal to the selling
price at home or at least to be a good proxy for it.) Except for the signs,
the 2SLS 95 per cent confidence intervals of Pbx and Pbp overlap each
other in both time t and t - 1, so that we could run another 2SLS
estimation with the coefficients of Pbx and Pbp constrained to sum up
to zero in all periods. Although the same is not true at such a high level
of probability for the FIML estimation, a constrained FIML estimation
was also run. The results of the constrained estimations appear in Table
2. However, they do not need any special comment as they are fairly
close to the unconstrained estimations under discussion.
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Foreign trade behavior in a small open economy 63

Table 1. "Price-taking" export model, equations (1), (2) and (3)
2SLS

FIML

Equation (1) Dependent variable: Xbs

Pbx 1.440 (5.0) 1.221 (26.1)

Pbx(- 1) 0.106 (0.7) 0.043 (0.4)
Pbp - 0.992 (- 4.0) - 0.663 (- 5.7)

Pp (-1) -0.299 (-1.9) -0.298 (-1.7)

Qb* 0.467 (2.2) 0.069 (0.3)

(Db - Dw) - 0.287 (-4.5) - 0.220 (- 2.7)
R= - 0.86
RSS = 100233 SER= 21.0
Equation (2) Dependent variable: Xbd

Dw

0.805

(17.8)

0.821

(12.5)

(Pbx - Pwx) -0.557 (- 8.2) -0.877 (-15.5)

R2=

0.50

L=

-1756.83

t-values in parentheses; R2 = multiple correlation coefficient; RSS residual sum of squares;

SER standard error of the regression; L log of likelihood function.

Table 2. "Price-taking" constrained export model, equations (1), (2) and (3)
2SLS

FIML

Equation (1) Dependent variable: Xbs

(Pbx - Pbp) 0.934 (4.1) 1.509 (27.3)

(Pbx- Pbp) (-1) 0.163 (1.3) 0.280 (2.1)
Qb* 0.672 (3.4) 0.291 (1.2)
(Db - Dw) - 0.285 (-5.0) -0.303 (- 3.5)
R2= - 0.50

RSS=75258 SER= 18.1

Equation (2) Dependent variable: Xbd

Dw 0.806 (17.7) 0.993 (14.6)

(Pbx - Pwx) - 0.564 (- 8.1) -1.108 (-19.7)
R2= 0.49 L= -1768.47
t-values in parentheses; R2 multiple correlation coefficient; RSS residual sum of squares;
SER standard error of the regression; L log of likelihood function.

Capacity shows a significantly positive impact on export supply with

the 2SLS estimation, but not with FIML. According to the 2SLS
estimate, almost half of any capacity increase is used to produce for
exports. Growing relative pressure of domestic demand contributes to
the diversion of production towards the home market, to the detriment
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64 C. G. Culem

of exports. If the annual growth rate of Belgian domestic demand is 1

per cent higher than that of world demand, export supply decreases by
more than 0.2 per cent.

The estimation results of equation (2), which accounts for foreign

demand for Belgian industrial exports, are quite satisfactory as well,
insofar as the regression coefficients have the expected signs and are
highly significant.

The export demand elasticity with respect to world exports amounts

to 0.8 and is significantly less than unity. Indeed, the confidence interval for Dw at the 95 per cent probability level is approximately [0.7;

0.9]. 2SLS and FIML provide very close estimates. Foreign demand for
Belgian manufactured goods during the 1970s therefore grew at a
slower pace than overall world demand for exports. This may be a sign
of inadequate specialization and lack of flexibility in the manufacturing
industry. In any case, there has been a change for the worse. Indeed,
estimates obtained for previous periods by other authors indicate
greater responsiveness; see Waelbroeck (1962), Thys (1970),
Houthakker & Magee (1969) and Goldstein & Khan (1978).
As for the export demand price elasticity, it is less when estimated by
2SLS than by FIML: - 0.557 and - 0.877, respectively. In the latter
estimation, the upper bound of the 95 per cent confidence interval
almost reaches unity. Lags of the relative export price were experimented, but never turned out to be significant.

Alternatively it may be postulated that exporters of manufactured

goods exhibit some kind of price-setting behavior, at least in the short
run. In that case, it is (1') that must be estimated along with (2) and (3).

Equation (1') is the supply-price version of the export supply equation,

with the export price regressed on present and past quantities
exported. Estimates obtained by applying 2SLS and FIML to this
alternative system of simultaneous equations as well as K-L confidence
intervals are reported in Table 3. Although the 95 per cent confidence
intervals overlap each other for all variables, with the exception of Pbx
at time t, the 2SLS and FIML estimation methods do not provide very
close point estimates.

All regression coefficients are correctly signed and highly significant,

except that of the capacity variable which is not significant. In compari-

son with the supply-quantity specification, the multiple correlation

coefficient is higher, whereas both the sum of squared residuals (SSR)
and the standard error of the regression (SER) of the 2SLS estimation
are much lower. These are indications of a better fit and in all likeliScand. J. of Economics 1987

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Foreign trade behavior in a small open economy 65

Table 3. "Price-setting" export model, equations (1'), (2) and (3)

2SLS

K-L

FIML

(guess: R*2=0.62)
Equation (1') Dependent variable: Pbx

Xb 0.269 (4.4) [0.173; 0.274] 0.694 (16.7)

Xb(- 1) 0.088 (2.3) [0.038; 0.118] 0.225 (5.6)
Pbp 0.742 (14.8) [0.464; 0.742] 0.503 (6.6)
Pbp(-1) 0.137 (2.9) [0.062; 0.137] 0.208 (1.9)
Qb* - 0.048 (- 0.5) [-0.281; 0.317] - 0.178 (- 0.9)
(Db-Dw) 0.110 (3.2) [0.045; 0.170] 0.200 (3.4)
2= 0.42 R*2 = 0.76 (if Qb* neglected)
RSS = 24068 SER = 10.3 g=0.59

Equation (2) Dependent variable: Xbd

(guess: R*2 = 0.69)

Dw 0.800 (17.6) [0.739; 0.800] 0.832 (13.4)

(Pbx - Pwx) - 0.548 (- 8.1) [- 0.548; - 0.080] - 0.872 ( - 17.9)

2= 0.49 R*2 = 0.72 L =-1750.93
g= 0.45

t-values in parentheses; R2 multiple correlation coefficient; RSS residual sum of squares;

SER standard error of the regression; L - log of likelihood function. See the text for the
meaning of R*2, R*2 and g.

hood of the superiority of this alternative specification. The short-run

pricing policy of exporters therefore seems to conform better to the
price-setting hypothesis. This tends to confirm the conclusion of

Haynes & Stone (1983) for the case of Belgium, i.e., that exporters
quote prices in response to quantities exported, more or less by trial

and error. However, when the FIML estimation procedure is used, the

superiority of the present specification is marginal (compare the L

statistics, i.e., the logs of the likelihood functions, in Tables 1 and 3).
This is not surprising since the role played by lagged variables, the only

factor that can make the estimations of (1) and of (1') differ from each
other with FIML, is relatively secondary - which is not at all
unexpected with annual observations.
The export price is positively related to present and lagged export
volumes. Even though the lagged effect is significant as well, it is about

three times less important than the contemporaneous effect: 0.088

versus 0.269 for the 2SLS estimates and 0.225 versus 0.694 for the

FIML estimates. Therefore the bulk of adjustments take place within

one year. The export supply price elasticity can be derived from the
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66 C. G. Culem

present equation by taking the inverse of the coefficient of Xd. Its

longer-run value amounts to 2.8 with 2SLS and to 1.1 with FIML.

These figures can be compared with those obtained using the supplyquantity specification (1.4 with 2SLS and 1.2 with FIML) and by
Goldstein & Khan (1978) for quarterly data over the period 1955-70
(1.2). These comparisons lead us to prefer the FIML point estimate.
Another argument in favor of this preference is that the nonweighted
2SLS estimate of the coefficient of Xd, which is also unbiased, is fairly
close to the FIML estimate (0.508 at time t and 0.221 at time t - 1).
Next, the export price is strongly influenced by the domestic production price. When contemporaneous and lagged effects are added, the
point estimates provided by the two estimation methods for Pbp are
hardly less than unity. If their 95 per cent confidence intervals include
the value of one, the K-L confidence intervals suggest, however, that
the point estimates should be regarded as upper bounds. Since the
domestic production price may be thought to reflect fairly closely the
evolution of production costs, this shows that the latter are largely (if
not totally) passed on to the export price, although partly (15-30 per
cent) with a lag of one year. As Belgium is a small economy which
specialises in semi-fabricated products, this may seem surprisingly
suicidal in a period characterized by a stronger wage push than in most
other industrialized countries. However, it should be recalled that
Belgium experiences chronic overvaluation of its currency, so that
there may not be any room left for absorbing cost increases in profit
margins. Consequently this prevents domestic exports from keeping
pace with world exports, so that the manufacturing industry suffers
important losses of market shares on foreign markets.3
Greater production capacity favours a lowering of the export price.
This is not a significant determinant of the latter, however. On the
contrary, the variable which measures the pressure on capacity (Db/

Dw) is, along with Xb and Pbp, an important explanatory factor of

export price formation. Indeed, growing domestic demand leads to
significant upward pressure on export prices.
The estimates of the export demand equation (2) are not perceptibly

different from those obtained when the simultaneous estimation is

carried out using the supply-quantity specification, so that a new
discussion is not useful.
3This can be checked with the reduced form for quantities exported Xb, where the coefficient of the world exports variable Dw amounts to only 0.559 (computed from the FIML
estimates in Table 3).
Scand. J. of Economics 1987

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Foreign trade behavior in a small open economy 67

Table 4. Demandfor imports, equation (4)
WLS

K-L

(guess: R*2=0.67)
(Constant) 5.300 (11.1)
Db 0.579 (12.4) [0.345; 0.579]
(Pbm - Pbp) -0.592(- 4.3) [-0.592; -0.011]
(Pbm - Pbp)1. - 0.072 (-0.4) [-0.215; 0.305]
(Pbm - Pbp) ( - 1) - 0.455 (-3.4) [- 0.455; - 0.027]

(Pbm - Pbp)inp( - 1) 0.408 (2.1) [0.195; 0.633]

R2= 0.47 R*2 = 0.67(#)
g=0.38

t-values in parentheses; R2 multiple correlation coefficient. See the text for the meaning of
R*2, R*2 and g. (#) if (Pbm - Pbp)inp is neglected. The suffix "inp" indicates the interaction
term of the variable with a dummy variable representative of the sectors producing
intermediate or equipment goods (see footnote 5).

Imports

The estimation results of the import demand curve (4) are reported in
Table 4. The import demand elasticity with respect to domestic
demand amounts to almost 0.6.4 As for the price elasticity, it differs
between sectors which manufacture intermediate and equipment goods
(interaction terms are denoted by the "inp" suffix in the table) and those
which produce consumer goods.5 If it amounts to about - 0.6 for all
sectors at time t, it differs significantly between both types of sectors in
period t- 1. Indeed, it then amounts to - 0.5 for consumer goods and

to 0 for other goods. It follows that the longer-run elasticity is significantly higher for consumer goods: - 1.0 versus - 0.7. This is easy to
understand in the case of the small Belgian economy whose industrial
production relies heavily on imported inputs and needs, on average, at

least 40 francs of imported inputs for 100 francs of production (source:

1975 input-output tables). Finally, a constant is introduced into the
4Due to the use of disaggregated data, we introduce domestic demand (measured by

apparent consumption) as an explanatory variable of import demand rather than national

income, which is usually used. This might account for the relatively low elasticity, as
compared to those usually obtained, which are closer to unity.

5The difficulty of this subdivision lies in the fact that most sectors manufacture both
consumer and nonconsumer goods. Therefore, we had to make a partly arbitrary choice.
The following sectors were regarded as producing equipment and/or intermediate goods:

coke, oil refining, iron and steel, nonferrous metals, glass, cement, nonmetallic minerals,
chemicals, rubber, plastics, fabricated metal products, agricultural and industrial machinery,
office machines and precision instruments, electrical machinery and equipment (other than
cars), transport equipment.
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68 C. G. Culem

regression to capture the trend of import demand over the estimation

period (average yearly growth rate of 5.3 per cent). This provides a
much better fit without affecting the coefficients of the explanatory
variables to any large extent.
Exchange Rate Policy

Does a devaluation of the Belgian franc lead to improvement in the

trade balance for manufactured products? The well-known MarshallLerner condition as such may not be applied here since it assumes that
not only the import supply price elasticity but also the export supply
price elasticity is infinite. This hypothesis is rejected both by theory and
by our own estimations. Using the general formulation of the trade-

balance stability condition as in e.g. Lindert & Kindleberger (1982),

and assuming an infinite value for the import supply price elasticity
only, we get the following transformed condition:
(Vx! Vm) sx(dx + 1) + dm(sx-dx) < 0,

where Vx and Vm denote the value of exports and imports, dx and dm

the export and import demand price elasticities, and sx the export
supply price elasticity.

If we dismiss the estimate obtained by the weighted 2SLS estimation

procedure with the supply-price specification and accept a value somewhere between 1 and 1.5 for sx, the above inequality is already verified
for all types of goods within one year. It follows that Belgian foreign
trade with respect to manufactures may be believed to be stable. The

deterioration of the exchange terms following a devaluation is more

than offset by the substitution of domestic production for imports and
by the expansion of exports.6

During the 1970s and especially after 1974, the Belgian National
Bank followed a voluntary policy of overvalued currency, so that in
1980 the effective exchange rate of the franc had appreciated by 18 per

cent with respect to 1970.7 The idea was to slow down the price
increase of price-inelastic imported raw materials and thus imported

6However, with the 2SLS estimate of sX obtained on the assumption of some kind of pricesetting export behavior (1/0.269), the stability condition is still met (although with a oneyear lag only) for consumer goods, but not for intermediate and equipment goods.
7On the basis of the effective exchange rate of the Belgian franc computed by IRES with
respect to the currencies of Belgium's main trade partners, i.e., the United States, the United
Kingdom, France, Germany, Italy, The Netherlands and Japan.
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Foreign trade behavior in a small open economy 69

inflation. Our estimates lead us to believe that this had the adverse
effect of contributing to deterioration in the trade balance in manufactures.

IV. Conclusion

Completely new estimates of foreign trade elasticities for the Belgian

manufacturing industry over the years 1970-80 are presented.

Contrary to usual practice, not only the demand but also the supply
side of exports is specified and both are estimated simultaneously.
The positiveness of the export supply price elasticity illustrates that
returns to scale are decreasing and confirms that a price rise is needed,
at least in the short run, if producers are to supply additional quantities
for export. In all likelihood, such a price increase must be proportionately larger for a small country like Belgium. Indeed, as exports
represent a greater share of production (68 per cent of industrial
production in 1975; 85 per cent in 1980), the supply of exports may be
expected to be less price elastic. A reasonable guess regarding the
Belgian export supply price elasticity would lie somewhere between 1
and 1.5 which, as expected, is lower than the values obtained by
Goldstein & Khan (1978) for bigger countries (1.9 for France, 4.6 for
Germany, 6.6 for the USA and + oo for Japan).
The production price, a proxy for the selling price on the home
market, and the pressure of domestic demand on capacity are the other
two significant determinants of export supply. Ceteris paribus, a higher
production price and stronger domestic demand contribute to the

diversion of a significant share of industrial production away from

export markets and towards the home market.
Another particularly interesting elasticity is that of the demand for
Belgian industrial exports with respect to world exports, a proxy for
world income. It is significantly less than unity for the period under
study, which may indicate inadequate specialization and a lack of structural change and adaptation, particularly since the emergence of
competition from Japan and the so-called newly industrialized
countries.

The 1970-80 pricing policy of Belgian exporters of manufactured

products appears to conform to price setting-like behaviour which at
first seems surprising, given their overall specialization in semi-finished
and not very differentiated goods. Indeed, export prices are quoted not
only in response to present and lagged export performances, but their
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70 C. G. Culem
variations also closely reflect those of production costs. The squeeze of
profit margins due to a strong wage push and to the simultaneous
policy option of overvalued currency may be suspected of having
obliged exporters to pass on a greater proportion of production cost
increases to export prices than that compatible with preservation of

their international competitiveness and market shares.

Appendix: Data Sources

Exports, imports and production in value: World Bank Market
Penetration Group. The data are relative to the BLEU and not to
Belgium exclusively.

Belgian (BLEU more exactly) export, import and production price

indices: INS (National Institute for Statistics).

World export prices (proxied by EEC export prices): own computations based on OECD trade data.

References
Culem, C. G.: Echanges exterieurs de produits manufactures et restructuration industrielle

- Le cas beige 1970-1980. Recherches Economiques de Louvain 51, No. 1, 1985.

Dunlevy, J. A.: A test of the capacity pressure hypothesis within a simultaneous equations
model of export performance. Review of Economics and Statistics LXII, February, 1980.
Frisch, R.: Statistical confluence analysis by means of complete regression systems. Institute
of Economics, University of Oslo, 1934.

Goldstein, M. & Khan, M. S.: The supply and demand for exports: A simultaneous
approach. Review of Economics and Statistics LX, May, 1978.
Haynes, S. E. & Stone, J. A.: Specification of supply behaviour in international trade. Review
of Economics and Statistics LXV, November, 1983.

Houthakker, H. S. & Magee, S. P.: Income and price elasticities in world trade. Review of
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Lindert, P. H. & Kindleberger, C. P.: International Economics, R. D. Irwin Inc., 7th ed.,
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and Statistics XXXII, May, 1950.

Thys, F.: Essai d'explication 6conometrique des variations des exportations de 1'UEBL.
Cahiers Economiques de Bruxelles, No. 46, 1970.

Waelbroeck, J.: La demande ext6rieure et 1'6volution des exportations belges. Cahiers

Economiques de Bruxelles, No. 15, 1962.
First version submitted June, 1985;
final version received July, 1986.

Scand. J. of Economics 1987

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