somewhat more than 0.6 for Ω. For practical purposes, the elasticities in developing countries could be approximated as 0.65.

Regarding regional averages, the North America region (NAR) and the Europe and Central Asia (ECA) groups have the highest elasticities. They are followed by the Middle East and North Africa (MENA), East Asia and the Pacific (EAP), Latin America and the Caribbean (LAC), South Asia region (SAR), and Sub-Saharan Africa (SSA). The order generally follows the average regional income. Where some regions have mixed incomes, the table shows the average differences between high-income and developing countries. The only high-income country in SSA in 2015 was Seychelles, while Mauritius is approaching this category. The pattern generally supports the hypothesis that trade elasticities increase with per-capita income.

Figure 3 shows the scatter plots of the elasticities against GDP per capita in 2015 U.S. dollars, the constant price series base year in the estimation and income group classification.<sup>19</sup> The simple correlation of the variables is about 0.71 for both the σ and the Ω cases. The regression line in each plot confirms an approximately positive relationship.<sup>20</sup> The graphs could also easily be non-linear, flat for much of the lower income levels, then dispersing and rising rapidly at higher income at around $22,000 (log of 10). The dichotomy of elasticities at about 1.0 is consistent with the summary in Table 2.

The split of elasticities at 1.0 between low and high-income countries is also consistent with the trade theory behind the 1-2-3 model (see Devarajan et al. 1997 and other studies in the sub-section on the 1-2-3 model). When the world price of imports (say) rises in an economy, there are two effects: an income effect (as the consumer's real income is now lower) and a substitution effect (as the domestic good now becomes more attractive). The resulting equilibrium will depend on which effect dominates. When σ< 1, the income effect dominates. The economy contracts the output of the domestic good and expands that of the export commodity. To pay for the needed, imperfectly substitutable import, the real exchange rate depreciates. However, when σ> 1, the substitution effect dominates. The economy's long-term response is to contract exports (and hence also imports) and produce more of the domestic substitute. For most developing countries, it is likely that σ< 1, so that the standard policy advice to depreciate the real exchange rate in the wake of an adverse terms-of-trade shock is correct.<sup>21</sup> For developed economies, one might reasonably expect substitution elasticities to be high. In this case, the response to a terms-of-trade shock is a real appreciation, substitution of domestic goods for the more expensive (and non-critical) imports, and a contraction in the aggregate volume of trade. In all countries, one would expect substitution elasticities to be higher in the long run. The long-run effect of the real exchange rate will thus differ, and may be of the opposite sign from the short-run effect.

Another example relates to the revenue effects of tariff reforms. Devarajan, Go, and Li (1999) show how the fiscal impact of tariff liberalization also depends on the substitution elasticity between foreign and domestic goods. Unless there is an upward shift in output productivity, a reduction in tariffs will invariably involve losses in revenue for much of the plausible range of the trade elasticities unless compensated by increases in domestic taxes. There is no Laffer Curve for import tariffs.

> 19 We also tried two altermative income per capita measurements from the World Bank WDI – the 2015 gross national income per capita using the Atlas and purchasing power parity methods. The patterns of the scatter plots remain largely the same. Because some countries have missing observations using these methods, we did not choose them.

> 20 The R-squared of the regression line is about 0.50 in both cases. The regression coefficient in each case is positive and significant at prob=0.05.

> 21 This is confirmed in the empirical estimation of substitution elasticities in Devarajan, Go and Li (1994).

16