Effects of changes in the terms of tradeWho benefits and who suffers when the

terms of trade change?

Terms of trade and balance of trade

As we established last week, a country’s terms of trade improves when their export prices increase or their price of imports fall. However, whether their balance of trade improves or worsens depends of the price elasticity of demand for these exports and imports.

Do you recall what the Marshall-Lerner condition states?

LDCs and MDCs Developing countries are more at risk to changes in

terms of trade because of their overreliance on a few primary commodities for export income.

Developed countries have a greater variety of goods to export and therefore have less exposure to the changes in terms of trade

Changes to the balance of trade

If a country experiences an improvement in its balance of trade, several benefits may appear, including economic growth, more investment in capital goods, higher standards of living, and lower prices for consumer and capital goods

When a country’s balance of trade falls, money leaves the country, reducing investment and making development goals difficult to reach

Problems for LDCs The main problem for LDCs has been the steady fall

in non-oil commodity prices. Since 1900, the price of these commodities has fallen steadily, and since 1980, the prices of sugar and cotton have fallen more than 50%. LDCs rely on selling these commodities for income.

Income elasticity of demand

If you remember, the YED for primary commodities is inelastic. So when the rest of the world sees their incomes rise, the LDCs do not export much more.

Conversely, the YED for manufactured goods is elastic, so when incomes rise, people demand much more of these goods, and MDCs see large increases in export income

More problems for LDCs In recent years, technology has allowed producers of

primary commodities to increase their production significantly. This has lowered the price of their exports greatly, but the inelastic YED nature of these goods means that demand has not kept up.

If that wasn’t enough… MDCs often subsidize their producers of primary

commodities, keeping the world price low and reducing potential export markets for LDCs. This makes a bad situation even worse.

A ray of hope? Nope! Even when LDCs see some improvement in incomes,

the elastic nature of YED for manufactured goods means that they end up buying more manufactured goods and brand name goods from MDCs, thus worsening their balance of trade situation

Productivity and wages In MDCS, improvements in worker productivity lead

to higher wages because of union influence and a limited number of workers. The goods produced increase in price as a result, keeping export income high.

LDCs rarely have organized unions and so much available labour that wages tend to remain extremely low. As wages remain low, prices of exports also remain very low, keeping worker incomes from increasing.

Oligopoly power! Oligopolists produce much of the exports in MDCs

and behave to keep prices from falling.

In LDCs, producers of primary commodities tend to be small scale producers who compete and keep prices very low.

LDC woes For LDCs, low prices of commodity exports ensure

that export earnings do not increase, declining incomes are seen, employment levels fall, less investment is made, poverty continues, little growth and development occurs, and the balance of payment situation remains bleak.