Elasticity of the Supply for Imports and Exports
To evaluate the effect of depreciation on the balance of payments, we are required to know the magnitude of the elasticity of demand for and supply of exports and imports.
Most of these estimates are disappointingly low and lead to the conclusion that depreciation is an ineffective remedy for disequilibrium in the balance of payments. These estimates, however, are generally unreliable and suffer from a downward bias because of several factors discussed below:
First, it is doubtful if the true elasticity of demand can be measured from the available data. The only available data for measuring the elasticity of demand is the historical record of the prices and quantities.
If a curve is fitted to this historical data relating to prices and quantities it will not represent a demand curve. This historical price-quantity data shows not only a demand relation but also a supply relation between the prices and quantities.
If the demand and supply depended exclusively on price, the various points on the curve obtained by fitting the historical price-quantity data will indicate nothing but the points of intersection of the demand and supply curves whose shapes are not known actually.
The curve obtained by fitting the prices-quantity data will represent a demand curve only if: the amounts demanded depended solely on price; and the amounts supplied depended exclusively on variables other than the price.
Similarly; the curve will represent a supply curve if: the amounts supplied depended solely on price; and the amounts demanded depended exclusively on factors other than the price. If both the demand and supply depended on variables other than the price, the curve will represent neither a demand curve nor a supply curve.
Second, most of the estimates of price elasticity of demand relate not to a single commodity but to an aggregate of a large number of heterogeneous commodities.
The concept of a demand for a bundle of commodities of changing composition is very slippery and the concept of the elasticity of that demand becomes well high unmanageable. The methods employed for constructing the aggregative demand curve have been very rough.
Usually, it has been constructed from the historical data relating to the total exports (imports) and the average exports (imports) price. The aggregating process involves many errors and biases. It is a generally admitted fact that price changes are larger for commodities the demand for which is comparatively inelastic, e.g., foodstuffs, raw materials etc.
This means that most of the price changes in the price indices of aggregate exports (or imports) are for commodities with inelastic demand. This gives a downward bias to the aggregative elasticity of demand.
A more refined way of calculating the aggregative elasticity of demand would be to calculate the elasticity of demand for each individual commodity and thereafter to calculate the aggregative elasticity of demand by attaching a suitable weight to the elasticity of demand for each individual commodity.