Case 2.

Income Elasticity of Demand and the Balance of Payments

A problem for certain developing countries
When people are poor, they have to spend a large proportion of their income on basic goods such as food. As they get richer, so they can afford to buy an increasing proportion of luxury goods. This means that the income elasticity of demand for basic goods is likely to be low: their demand only rises slowly as incomes rise. The income elasticity of demand for luxury goods, on the other hand, is likely to be high. This has important implications for international trade. If a country exports basic goods with a low income elasticity of demand, and imports luxury goods with a high income elasticity of demand, it is likely to run into long-term balance of payments problems. As it grows richer, its demand for imports is likely to grow rapidly. As the rest of the world grows richer, however, so the demand for the countrys exports is likely to grow slowly. This has been one of the problems facing many developing countries. As exporters of commodities such as rice, sugar and tea, they have found that the demand for their exports has grown relatively slowly. As importers of manufactured products, however, their imports have grown relatively rapidly. This affects their terms of trade. The terms of trade are the average price of a countrys exports divided by the average price of its imports. If the demand for exports grows only slowly relative to imports, so the price of exports is likely to fall relative to imports: the terms of trade will deteriorate. More will have to be exported to buy the same quantity of imports. Between 1980 and 2004, the price of (non-fuel) commodities fell by 43 per cent, compared with world prices generally. The price of manufactured products imported from the major industrialised countries, by contrast, rose by 38 per cent. This represented a substantial deterioration in the terms of trade for many developing countries.

Recent developments
From 2002, world commodity prices began to rise in real terms. The reason was the rapid growth in demand for raw materials from newly industrialising countries, such as China, India and Brazil. In these countries, the income elasticity of demand for commodities is much higher than in the rich world, as they are growing from a much lower base, and a large proportion of investment is in building new heavy capital equipment and new infrastructure, both of which involve considerable use of raw materials. With faster economic growth in developing countries, even the the growth in demand for agricultural products outstripped the growth in supply and hence agricultural prices rose too (albeit not as fast as raw material prices). In 2001, the average prices of metals and minerals

were 82 per cent of their 1990 level. By April 2006, they were 200 per cent of their 1990 level, as the following chart shows.

W o rld c o mmo dity pric e s (1 9 9 0 = 1 0 0 )

3 50
E nergy index

3 00

Metals and m inerals index Agric ultural produc ts index

2 50

2 00

1 50

1 00

50

0 2 00 1

2 00 2

2 0 03

2 00 4

2005

2006
S o u rc e : W o rld B an k

A word of caution: income elasticity of demand is only one factor influencing the level of a countrys imports and exports, and only one factor determining its terms of trade.

Question Would you expect the demand for developing countries raw material exports to grow more rapidly or slowly over time? Does their growth give a good indication as to their income elasticity of demand?