Explain the various concepts of terms of trade. Critically examine the behavior of terms of trade as explained by Prebisch
The “terms of trade” (ToT) is an important concept in international economics that measures the relative prices of a country’s exports to its imports.
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It is a crucial indicator of a country’s trade performance and its economic health in the context of global trade. Various concepts and theories related to terms of trade help explain how changes in trade dynamics affect economic welfare and development.
Concepts of Terms of Trade
- Net Barter Terms of Trade (NBT):
- Definition: The Net Barter Terms of Trade measure the ratio of the index of export prices to the index of import prices. It shows how many units of imports a country can buy with a unit of exports.
- Formula:
[
\text{NBT} = \frac{\text{Index of Export Prices}}{\text{Index of Import Prices}} \times 100
] - Interpretation: An increase in NBT indicates that a country can buy more imports for a given quantity of exports, which is beneficial for the country’s trade balance.
- Gross Barter Terms of Trade (GBT):
- Definition: The Gross Barter Terms of Trade measure the ratio of the volume of exports to the volume of imports. It is concerned with the quantity of goods exchanged rather than their prices.
- Formula:
[
\text{GBT} = \frac{\text{Volume of Exports}}{\text{Volume of Imports}} \times 100
] - Interpretation: This measure helps understand the volume of trade in terms of goods rather than their prices, providing insight into the real trade benefits.
- Income Terms of Trade (ITT):
- Definition: The Income Terms of Trade adjusts the net barter terms of trade by taking into account changes in the volume of imports and exports, reflecting how much income a country earns from its exports compared to the cost of its imports.
- Formula:
[
\text{ITT} = \frac{\text{NBT} \times \text{Volume of Exports}}{\text{Volume of Imports}}
] - Interpretation: This measure reflects how changes in the terms of trade impact the actual purchasing power of a country’s exports in terms of imports.
- Utility Terms of Trade:
- Definition: This concept extends the terms of trade by considering the utility or satisfaction derived from the goods traded. It incorporates consumer preferences and the utility gained from different goods.
- Interpretation: It provides a more nuanced understanding of trade benefits by considering not just prices but also the value and satisfaction derived from traded goods.
Prebisch-Singer Hypothesis
The Prebisch-Singer Hypothesis, developed by economists Raúl Prebisch and Hans Singer in the 1950s, is a critical perspective on terms of trade, particularly focusing on the long-term trends affecting developing countries.
Concept:
- Prebisch-Singer Hypothesis: The hypothesis suggests that the terms of trade for developing countries (primarily exporters of primary commodities) tend to deteriorate over time relative to developed countries (primarily exporters of manufactured goods). This means that developing countries face a declining value for their exports compared to their imports.
Key Points:
- Declining Terms of Trade:
- Relative Prices: Prebisch argued that the prices of primary commodities (like agricultural products and raw materials) tend to decline relative to the prices of manufactured goods over time. This is due to factors such as technological advancements in manufacturing, which increase productivity and reduce the relative cost of manufactured goods.
- Structural Differences:
- Economic Structure: Developing countries are typically dependent on a narrow range of primary commodities for export, while developed countries have diversified economies with a significant manufacturing sector. The structural differences create an imbalance in the terms of trade.
- Income Distribution:
- Unequal Distribution: The deterioration in terms of trade for developing countries can lead to reduced real income and economic growth, exacerbating income inequality between developing and developed countries.
- Economic Policy Implications:
- Import Substitution: Prebisch and others recommended policies such as import substitution industrialization (ISI) to reduce dependence on imported manufactured goods and develop domestic industries to counteract the negative effects of deteriorating terms of trade.
Critical Examination:
- Empirical Evidence: The hypothesis has been subject to scrutiny and debate. Some empirical studies support the idea that primary commodity prices tend to be more volatile and may decline relative to manufactured goods. However, other studies argue that terms of trade for some developing countries have improved or remained stable due to changes in global commodity markets and trade patterns.
- Globalization and Technological Change: Advances in technology and globalization have altered the dynamics of trade. For instance, some developing countries have diversified their economies and increased their share of manufactured exports, potentially mitigating the adverse effects predicted by the Prebisch-Singer Hypothesis.
- Policy Relevance: While the hypothesis highlights important issues regarding trade and development, the relevance of specific policy recommendations such as ISI has been questioned. Many developing countries have pursued different strategies, including trade liberalization and integration into global markets.
In summary, the Ricardian theory of comparative advantage focuses on the benefits of trade based on relative opportunity costs, while Adam Smith’s theory of absolute advantage highlights the advantages of efficiency in production. The Prebisch-Singer Hypothesis, on the other hand, provides a critical perspective on the long-term trends affecting terms of trade, especially for developing countries, emphasizing the need for careful consideration of economic policies and trade strategies.