Income Elasticity of Demand and the Balance-of-Payments

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Excerpt from Thirlwall (see bottom of post):

The income elasticity of demand for products and the balance of payments

According to Prebisch, the second factor working to the disadvantage of developing countries is the balance-of-payments effects of differences in the income elasticity of demand for different types of product. As mentioned, it is generally recognised and agreed that the income elasticity of demand for most primary commodities is lower than that for manufactured products.

On average, the elasticity is probably less than unity, resulting in a decreasing proportion of income spent on those commodities (commonly known as Engel's Law). 

In the two-country, two-commodity case the lower income elasticity of demand for primary commodities means that for a given growth of world income the balance of payments of primary-producing, developing countries will automatically deteriorate vis-a-vis the balance of payments of developed countries producing and exporting industrial goods. 

A simple example will illustrate the point (see also Chapter 7, p. 183).

Suppose that the income elasticity of demand for the exports of the developing countries is 0.8 and that the growth of world income is 3.0 per cent: exports will then grow at 2.4 per cent. Now suppose that the income elasticity of demand for the exports of developed countries is 1.3 and the growth of world income is 3.0 per cent; exports of developed countries will then grow at 3.9 per cent. 

Since there are only two sets of countries, the developing countries' exports are the imports of developed countries and the exports of developed countries are the imports of the developing countries.

Thus developing countries' exports grow at 2.4 per cent but imports grow at 3.9 per cent; developed countries' exports grow at 3.9 per cent and imports at 2.4 per cent. Starting from equilibrium, the balance of payments of the developing countries automatically worsens while that of the developed countries shows a surplus. 

This has further repercussions on the terms of trade. With imports growing faster than exports in developing countries, and the balance of payments deteriorating, the terms of trade will also deteriorate through depreciation of the currency, which may cause the balance of payments to deteriorate even more if imports and exports are price inelastic.

Moreover, this is not the end of the story if we take the per capita income growth between developed and developing countries. If population growth is faster in developing countries, the growth of income must also be faster than in the developed countries if the per capita income growth rates are to remain the same.

This will mean an even faster growth rate of imports into developing countries and a more serious deterioration in the balance of payments.

And if the goal is to narrow the relative or absolute differences in per capita income between developed and developing countries, the balance-of-payments implications will be even more severe. 

In the example previously given, which ignores differences in population growth, it is easily seen that the price of balance-of-payments equilibrium is slower growth for the developing countries. If their exports are growing at 2.4 per cent, import growth must be constrained to 2.4 per cent, which means that with an income elasticity of demand for imports of 1.3, income growth in the developing countries must be restrained to 2.4/1.3 = 1.85 per cent for balance-of-payments equilibrium.

In the absence of foreign borrowing to bridge the foreign exchange gap, or a change in the structure of exports, the result of different income elasticities of demand for primary and manufactured products is slower growth in the primary-producing countries - perpetuating the development 'gap'. 

In the absence of protection, the only other alternative is deliberate depreciation of the currency. This has several disadvantages. For one thing the price elasticities of exports and imports may not be right for foreign exchange earnings to be increased, and second, depreciation will encourage production in existing activities, the concentration on which contributed to the balance-of-payments difficulties in the first place.

There are certain equilibrating mechanisms in existence that may reverse the tendencies referred to, but they are likely to be weak and fairly slow in operation. First of all, it cannot be assumed that the industrial structure of the developing countries will remain unchanged. Over time it is natural that the proportion of total resources employed in the production of manufactured goods should increase, decreasing the rate of increase of imports of manufactured goods. Second, assuming that money income and the population grow at the same rate in both sets of countries, if the terms of trade are deteriorating for the developing countries, then real per capita income cannot be growing so rapidly in the developing countries.

Thus even with a high income elasticity of demand for imports in developing countries, the absolute increments in imports may eventually equal exports through a terms of trade effect. 

Prebisch recognised this latter equilibrating mechanism, but rejected reliance upon it because of the sacrifice of real growth that it clearly involves. For terms of trade and balance of payments reasons (which are connected), Prebisch therefore argued for the protection of certain domestically produced goods, and for monopoly export pricing by developing countries to protect their interests (as OPEC did in 1973).

Prebisch's balance of payments argument reinforces the classical infant-industry and optimum-tariff (terms of trade improvement) argument for protection.

There are several benefits that Prebisch expected from protection:

• Protection would enable scarce foreign exchange to be rationed between different categories of imports, and could help to correct balance-of-payments disequilibrium resulting from a high income elasticity of demand for certain types of import.

• It could help to arrest the deterioration in the terms of trade by damping down the demand for imports.

• It provides the opportunity to diversify exports and to start producing and exporting goods with a much higher income elasticity of demand in world markets.

Following our earlier argument, however, protection by tariffs is only appropriate if the arguments for protection do not arise from domestic distortions.

Source: (Thirlwall, Growth and Development, 2006, pp 440-441)