TERMS OF TRADE

IB ECONOMICSA COURSE COMPANION (2007)

P303-313

TERMS OF TRADE

• The Terms of Trade is one of the big problems facing many developing countries.

• This does not simply mean that face obstacles in the international trading system – it has a very specific meaning in context.

TERMS OF TRADEDefinition & Formula

• Mathematically, the terms of trade is an index that shows the value of a country’s average export prices, relative to their average import prices. It is calculated with a simple equation:

Terms of Trade (TOT) =

Weighted Index of average export pricesWeighted Index of average import prices

X 100

TOT is a Weighted Index

• The indices of export and import prices are weighted to reflect the relative importance of different goods and services to the country’s export revenue and import expenditure.

YEAR Index of average export prices

Index of averageImport prices

Calculation Terms of Trade

1 100 100 100 x 100100

100

2 102 100 102 x 100100

102

3 106 104 106 x 100104

101.92

4 110 110 110 x 100110

100

5 108 106 108 x 100106

101.89

Hypothetical Terms of Trade Figures - Example

EXPLANATION OF TABLE TOT FIGURES

• Year 1 is the base year so the value is set at 100.

• In Year 2 export prices rise and import prices stay where they are so the value of TOT rises to 102. This represents an improvement in the TOT. This means on average, the country’s exports will now buy 2% more imports than they did in the previous year.

EXPLANATION OF TABLE TOT FIGURES

• In Year 3, although export prices rise again there is an increase in import prices. The TOT values falls a little to 101.92. In this situation there has been a deterioration in the TOT, which means that a given amount of exports can buy fewer imports than in Year 2.

• However, the TOT in year 3 are still better than in Year 1. • In year 4, import prices rise by relatively more than export

prices and so the value of the TOT falls again back to 100. Therefore in Year 4, a given amount of exports will buy the same amount of imports as year 1.

• In year 5 export prices fall but import price fall by more. This leads to an improvement in the TOT and the value rises to 101.89.

YEAR Index of average export prices

Index of averageImport prices

Calculation Terms of Trade

1 100 100 1002 110 115 953 111 1144 115 1135 117 115

Hypothetical Terms of Trade Figures - Exercises Task:1. Below are the indices for export prices and import prices for a hypothetical country. Calculate the Terms of Trade for each year.2. In a paragraph response, explain the trends in the terms of trade from Year 1 to Year 5.

Cleary identify years when there was an improvement and deterioration in the TOT.

Trends in the TOT for a Hypothetical Country: Paragraph Response.

Response

When will the TOT improve?

If export prices rise relative to import prices, OR if they fall by relatively less than import prices fall, then the TOT will improve.

When will the TOT deteriorate?

If import prices rise by more than export prices, OR they fall by relatively less than export prices fall, then the TOT will deteriorate.

Benefits when the TOT improves:

• If the TOT improves, then a given quantity of exports will buy a larger quantity of imports than before.

• It is possible to talk about a “basket” of exports, in the same way as is inflation is measured.

• If the price of a basket of exports falls, then a country will need to sell more exports in order to keep imports at the same level.

CAUSES OF CHANGES IN A COUNTRY’S TOT IN THE SHORT RUN

Short Run changes in the TOT may be caused by the following: Changes in the Conditions of

Demand & Supply. Changes in Relative Inflation

Rates. Changes in Exchange Rates.

SHORT RUN CHANGES IN TOTDemand

• If the demand for exports changes (ie, the demand curve shifts), then there will be a change in the prices of exports.

• Prices of competitive goods in other countries may change, affecting the competitiveness of the exports.

• Incomes in importing countries may change, affecting the demand for imports.

• Consumer tastes may change for the goods and services that the country exports.

SHORT RUN CHANGES IN TOTSupply

• Changes in supply may also have a noticeable effect upon the price of exports.

• If a number of countries experience an increased supply of a certain product, perhaps because weather conditions are favourable, the its price will fall.

• The effect of such a change on TOT depends on the importance of the overall exports of the goods.

SHORT RUN CHANGES IN TOTChanges in Inflation Rates

• If the inflation rates in one country are higher than in another, then their export prices will begin to rise.

• This will result in an improvement in the TOT, but whether or not its lead to improvement in the CAD, will depend on the PED for exports.

SHORT RUN CHANGES IN TOTChanges in Exchange Rates

• A change in the value of a country’s currency will lead to a change in the price of the exports relative to imports.

• The change in the exchange rate may be through market forces or as a result of government intervention in the foreign exchange market.

LONG RUN CHANGES IN TOT

Long-run changes in TOT have various causes:

Income changes Improvements in Productivity

LONG RUN CHANGES IN TOTIncome Changes

• Rising incomes, especially in developed countries, lead to an increase in demand for secondary and especially, tertiary products, whose income elasticity of demand tends to be income elastic.

• This has an obvious effect on upon the relative prices of the types of products.

• The TOT of developed countries, which produce more secondary and tertiary products tend to improve relative to the TOT of developing countries, many of whom are much more dependent upon the exporting of primary products, whose income elasticity tends to be income-inelastic.

• In effect, there is a change in world trade patterns.

LONG RUN CHANGES IN TOTProductivity

• Long run improvements in productivity within a country will lead to a gradual deterioration in the TOT for that country because their real prices will not rise significantly.

• However the country exports would be more competitive on the international markets and the so the result could be more positive, if demand for the exports is elastic.

PRICE ELASTICITY OF DEMAND FOR EXPORTS

• The price elasticity of demand for exports is a measure of the responsiveness of the demand for exports, when there is a change in the price of exports.

• It is measured by the following equation:

PEDexports = Percentage change in demand for exports

Percentage change in the average price of exports.

Elastic Demand for Goods

• If the demand for exports is elastic, then a change in the average price of exports will lead to a greater proportional change in the demand for them.

• This would be favorable to a country where export prices were falling, since export demand would rise by proportionally more than the prices fell leading to an increase in export revenue.

• Most exports certainly in the long run, face elastic demand, i.e. a value of PEDexports that is greater than one

• However, many commodities (raw materials, such as oil, coffee, cotton, rice and sugar) tend to have inelastic demand.

PRICE ELASTICITY OF DEMAND FOR IMPORTS

• The price elasticity of demand for imports is a measure of the responsiveness of the demand for imports when there is a change in the price of imports.

• It is measured by the equation:

PEDimports = Percentage change in demand for imports

Percentage change in the average price of imports

Inelastic Demand for Imports

• If the demand for imports is inelastic, then a change in the price of imports will lead to a smaller proportional change in the demand for them.

• This would not be good for a country where import prices were rising, since import demand would fall by proportionally less than the prices increased.

• Most imports certainly in the long run face, inelastic demand (i.e. a value of PEDimports, that is greater than 1)

• However, commodities tend to have inelastic demand.

How beneficial is an improvement in the terms of trade?

• An improvement in the TOT is not necessarily the most desirable change.

• It is necessary to consider the effect of an improvement in the TOT on a country’s current account balance.

• The outcome will depend upon the reasons for improvement.

REASONS FOR IMPROVEMENT IN THE TOT: An Increase in Demand for a country’s exports

• A number of factors may cause demand for a country’s exports to rise.

Example: Consider the exports from country A.Prices in other countries may have risen,

making country A’s exports more competitive;Incomes in importing countries may have risen,

increasing their demand for imports.Consumer tastes may have changed in favor of

the goods and services that country A exports.

Increase in Demand for a Country’s Exports

An increase in demand for country A’s exports should be shown in your graph. When the demand increases, the average export price rises from P to P1. The quantity of exports demanded and supplied increases from Q to Q1. The higher export prices mean that the TOT has improve and total export revenue rises from 0PxQ to 0P1yQ1. This will lead to an improvement in the Current Account Balance. (CAD) An improvement in the TOT, when caused by an increase in demand for exports, leads to an improvement in the CAD.

Refer to the textbook – Economics a Course Companion, p307, for the relevant graph

Draw an Appropriate Graph below:

REASONS FOR IMPROVEMENT IN THE TOTHigher Export Prices caused by domestic inflation

• Relative export prices may increase, because a country is experiencing inflation that is higher than in the countries with which it trades.

• If this is the case, then there will be an improvement in the TOT.

• Whether this improvement in the TOT leads to an improvement in the CAD will depend upon the elasticity of demand for the country’s exports.

REASONS FOR IMPROVEMENT IN THE TOTHigher Export Prices caused by domestic inflation

• The demand curve for exports is normal and has the usual relationship with the MR curve and TR curve.

• As you should remember from microeconomics, the value of price elasticity on a demand curve falls as the price falls.

• There will be an elastic region of the demand curve and inelastic region.

The Demand for Exports & Exports Revenue

If the demand for exports is inelastic, (i.e. price is on the lower part of the demand curve), then an increase in price will lead to proportionally smaller decrease in demand and so total export revenue will rise. As shown in the diagram, an increase in the price from P to P1 leads to an increase in export revenue from ER to ER1. This will improve the CAD. An improvement in the TOT, when caused by inflation, leads to improvement in the CAD when demand for exports is inelastic.

If the demand for exports is elastic, (i.e. prices is on the upper part of the demand curve), then an increase in price will lead to a proportionately greater decrease in demand and so total export revenue will fall. As shown in the diagram, an increase in price from P2 to P3 leads to fall in export revenue from ER2 to ER3. This will depreciate the CAD. Therefore an improve improvement in the TOT when caused by inflation, leads to a deterioration in the CAD, when the demand for exports is elastic.

The explanation in this slide relates to the graph you will draw in the next slide space.

THE DEMAND FOR EXPORTS & EXPORT REVENUE – GRAPH (Refer to the textbook – Economics : A Course Companion, p308 to draw an appropriate graph for this topic)

The Demand for Exports & Export Revenue: Real World Applications

1. The Price Elasticity of demand for most exports tends to be elastic. For the majority of products sold on the export markets, there is much competition between countries and so demand tends to be elastic. It is generally commodities that face inelastic demand, so it is likely that most countries will be on the elastic part of the demand curve for their exports.

The Demand for Exports & Export Revenue: Real World Applications

2. Even if demand is on the inelastic part of demand curve, if relatively high inflation rates continue , then price of exports will eventually move into the elastic region of the demand curve.

THEREFORE, OVERALL AN IMPROVEMENT IN THE TOT DUE TO INFLATION GENERALLY LEADS TO DETERIORATION IN THE CAD.

THE SIGNIFICANCE OF DETERIORATING TOT FOR DEVELOPING COUNTRIES

• There are vast differences among developing countries.

• Many developing countries, but not all, are heavily dependent upon the exports one or two commodities for their export revenue.

Different Types of LDCS

We can identify the following types of LDCs:

Oil Exporting LDCs (eg: Angola & Yemen)Non-Oil Exporting LDCs (eg: Chad & Ethiopia)Maufacturers exporting LDCs. (eg:

Bangladesh) Service Exporting LDCs (eg: Maldives)

TRENDS IN COMMODITY MARKETS

• There has been substantial increase in the supply of commodities, mostly caused by improvements in technology.

• Eg: There has been a huge improvements in agricultural yields in the last 100 years, caused by better fertilizers, high degrees of mechanisation, and scientific research into plant disease.

• Technolgy has also allowed for the discovery of more minerals and also more efficient mineral extraction.

TRENDS IN COMMODITY MARKETS

• The discovery of synthetic replacements for natural commodities, such as synthetic rubber, man made fabrics and plastics replacing metals, has contributed to the slow increase in demand for the natural commodities concerned.

TRENDS IN COMMODITY MARKETS

• As developed countries have become richer and incomes have risen, the demand for commodities has not greatly changed, because their demand is income inelastic.

• At the same time, as income rises, the demand for manufactured goods and services has increased

• Demand for such goods tends to be more income elastic.

• This means that the demand for commodities has not risen as much as the demand for other products.

TRENDS IN COMMODITY MARKETSAgricultural Markets

• Agricultural products in developed countries have had a damaging effect on world agricultural markets.

• Price support schemes in the EU and the US, for example, have led to relatively high prices there and over production by domestic producers.

• The overproduction is then sold on the world markets, pushing down agricultural prices.

• For these reasons, developing countries often accuse developed economies of dumping agricultural products on the world market and so ruining their own agricultural industries.

TRENDS IN COMMODITY MARKETSTechnology Issues

• With huge leaps in technology over the last 50 years, many products have become smaller.

• For example, computers than once took up a whole room are now replaced by laptop computers of the same power.

• The miniaturisation of many products and the improvements in plastics technology has led to a fall in the demand for commodities that were traditionally used to make and package these products.

DEMAND FOR COMMODITIES It would be wrong to imply there has been a fall in demand for commodities. However, the combination of low income elasticity of demand, the increased use of synthetic substitutes and miniaturisation has led to relatively small increases in demand, as shown in this graph. Improvements in technology, along with agricultural policies in more developed countries have resulted in a large increase in supply, shown as b in the diagram. The result is that average commodity prices have fallen.

FALLING WORLD COMMODITY PRICES – GRAPH(Refer to the textbook – Economics a Course Companion, p310, and the draw the appropriate graph below)

TOT INDEX & COMMODITIES

• Given that the TOT index is based on the weighted average of export prices, those countries are dependent on commodities will see a fall in the index of their export prices and deterioration in their terms of trade.

• The deterioration in the TOT results in depreciating CADs.

• This is because the demand for commodities tends to be inelastic.

TOT INDEX & COMMODITIES

Example• Although the demand for copper from Zambia

is likely to be inelastic as there are alternative sources of copper, demand for copper as whole is inelastic as it is a necessary mineral in production with few substitutes.

TOT, IMPORTS & LDCs

• With falling export prices, the price of imports has risen relative to the price of exports.

• The goods that developing countries need to import are necessities such as components and other capital goods.

• As these goods are available domestically and are required for economic growth demand for them is inelastic

• A rise in import prices when demand for imports is inelastic results in an increase in import expenditure.

A DETERIORATION IN THE TOT & ITS NEGATIVE IMPACT OF LDCs

• Developing countries have to sell more and more exports in order to buy the same amount of imports.

• This is harmful enough, but in order to do this the developing countries then increase supply and this tends to push commodity prices down even more.

• This is a vicious cycle.

A DETERIORATION IN THE TOT & ITS NEGATIVE IMPACT OF LDCs

• Many LDCs have high levels of indebtedness.• Falling export prices and thus export revenue make it

harder to service their debt.• Indeed in extreme cases, this leads to countries having

to increase their borrowing and increasing their levels of indebtedness.

• This vicious circle links to the previous one.• It order to pay back their debts, many countries have

to increase their output of the commodities in which they have a comparative advantage.

• This increases the supply and drives the prices down.

A DETERIORATION IN THE TOT & ITS NEGATIVE IMPACT OF LDCs

• In order to increase the supply of commodities and gain more export revenue, some developing countries have overused their resources, resulting in negative externalities such as land degradation, desertification, soil erosion, and massive deforestation.

• This is not sustainable in the future

RISING COMMODITY PRICES IN THE FUTURE?? – CHINA & INDIA

• Commodities prices were generally declining up to about 2001.

• However, since then increasing commodity prices are largely a result of a growing world economy (minus GFC) and most importantly increased demand from economies such as China and India.

VOLATILITY & COMMODITY PRICES

• Commodity exporting countries are quite vulnerable to circumstances beyond their control

• The fact that export revenues can fluctuate significantly can make it difficult for governments to plan effectively for the future.

EXAMINATION QUESTIONSShort Answer Questions (10 marks each)

1. Distinguish between the balance of trade & the terms of trade.

2. Explain how high inflation is likely to affect a country’s terms of trade in the short run and the long run.

3. Explain how a deterioration in a country’s terms of trade will affect its trade balance if the demand for its exports and imports is elastic.

EXAMINATION QUESTIONSEssay Questions (10 marks each)

1a. Explain what is meant by a deterioration in a country’s terms of trade. (10 marks)

1b. Evaluate the significance for LDCs of a deterioration in the their terms of trade. (15 marks)