The classical economists believed that the terms-of-trade of primary products would show long-term improvement vis-à-vis manufactures due to the operation of the law of diminishing returns in primary production and the law of increasing returns in manufactures. The policy implication of this classical proposition is that a primary-producing country need not industrialize to enjoy the gains from technical progress taking place in manufactures; free play of international market forces will distribute the gains from the industrial countries to the primary-producing countries through the higher prices of their exports of primary products relative to the prices of their imports of manufactures (that is, the terms-of-trade will move in favor of primary-product exporting countries).
The opposite hypothesis—the Prebisch-Singer hypothesis of long-term deterioration in the terms-of-trade of primary products—can be traced back to the early mid-twentieth-century writings of Charles Kindleberger. He thought it inexorable for the terms-of-trade to turn against primary producing countries because of the operation of Engel’s law—which states the demand for goods needed for bare subsistence such as food rises less than proportionately while demand for other luxury consumption goods rises more than proportionately—in the process of world economic growth and improvements in the standard of living. It was, however, a 1945 League of Nations report prepared by Folke Hilgerdt and its subsequent follow-up by the United Nations in 1949 that is actually the origin of the Prebisch-Singer hypothesis and the related debate. It was observed in these reports that during the sixty years preceding 1938 primary product prices had fallen relative to prices of manufactures.
In the 1950s both Raúl Prebisch and Hans Singer referred to this so-called historical fact and questioned the classical proposition and its implicit support for the colonial pattern of trade. It was pointed out that productivity increased faster in the industrialized countries (constituting the North or the industrial center) than in the primary-producing countries (constituting the South or the raw-material supplying periphery), so that the terms-of-trade should have moved in favor of the South, given the factors of free trade and competition. The South could have enjoyed the fruits of technical progress taking place in industry through free trade and specialization (in primary production) without going for industrialization, as suggested in the classical writings. But this did not happen as the available evidence showed. So the primary-producing countries were advised to pursue a vigorous policy of industrialization with the suspension of the free play of international market forces.
In the post–World War II period, the Prebisch–Singer hypothesis provided the theoretical basis for the policy makers of the newly independent countries to adopt a path of import-substituting industrialization (ISI) through protective commercial policy. The path of ISI in basically agricultural countries required imports of machines and technology. So, in the process of industrialization these countries began to face acute balance-of-payments problems. This led many southern countries to follow the path of export-oriented industrialization. Dependence on a few primary-product exports was reduced and these began to be substituted by manufactured exports.
Meanwhile, the emphasis of the Prebisch–Singer hypothesis shifted from the relations between types of commodities to relations between types of countries. The shift of emphasis too had its origin in the writings of Kindleberger in the mid- to late 1950s. He found no conclusive evidence of deterioration in the terms-of-trade of primary products, but he did have some evidence of a decline in the terms-of-trade of the primary-producing countries (South) vis-à-vis the industrialized countries (North). In fact, both Prebisch and Singer had in mind the concept of terms-of-trade between the North and the South. But, in the absence of appropriate data, they used the series on terms-of-trade between primary products and manufactures as a proxy, with the logic that primary products dominated the then export structure of the South and manufactures dominated that of the North.
The Prebisch-Singer hypothesis generated much controversy in the academic world. In their published papers, critics such as Jacob Viner (1953), R. E. Baldwin (1955), G. M. Meier (1958), G. Haberler (1961), R. E. Lipsey (1963), Harry Johnson (1967), Paul Bairoch (1975), Ronald Findlay (1981), and many others raised different statistical questions and discarded the hypothesis. Since the 1980s, a series of studies undertaken by John Spraos (1980), David Sapsford (1985), Prabirjit Sarkar (1986a, b, 1994, 2005), Sarkar and Singer (1991), E. R. Grilli, and M.C. Yang (1988), and many others questioned the validity of the criticism and provided strong statistical support for the Prebisch–Singer hypothesis, thereby bringing it back into the limelight.
The question that logically follows is what explains the deteriorating trends in the terms-of-trade of the South? The factor highlighted by Singer is the raw-material saving and/or substituting technical progress in the North which created a demand bias against southern exports in the process of growth of northern manufactures leading to a fall in the southern terms-of-trade.
In his 1950 work Prebisch tried to explain the phenomenon in terms of the interaction of the diverse economic structures of the North and the South with different phases of business cycles. In an upswing, wages and profit, and so prices, rise more in the North than in the South due to stronger labor unions and higher monopoly power of the northern capitalists. In the downswing, northern profits and wages do not fall much due to the same reason. The burden of adjustment falls on the raw material suppliers of the South; their prices fall more than the prices of manufactures.
The diverse economic structures created an asymmetry in the mechanism of distribution of the fruits of technical progress, argued Prebisch, Singer, and Arthur Lewis in their individual works published in the 1950s. In the North, technical progress and productivity improvements led to higher wages and profit while in the South, these led to lower prices. The North-South models of Findlay (1980) and Sarkar (1997 and 2001b) supported this asymmetry. Granted this asymmetry, the terms-of-trade would turn against the interest of the South in the process of long-term growth and technical progress in both the North and the South.
In 1997 Sarkar provided another explanation in terms of product cycles. A new product is often introduced in the North. Initially there is a craze for this product and its income elasticity is very high. Owing to a lack of knowledge of its production technique, the South cannot start its production. The South produces comparatively older goods with lower income elasticity. By the time the South acquires the knowledge, the North has introduced another new product. In such a product cycle scenario, the income elasticity of southern demand for northern goods is likely to be higher than that of the northern demand for southern goods. Under these circumstances, if both the North and the South grow at the same rate (or the South tries to catch up by pressing for a higher rate of growth), the global macro balance requires a steady deterioration in the terms-of-trade of the South vis-à-vis the North.
Many other theoretical models exist to explain the Prebisch-Singer hypothesis. As it is increasingly recognized to be a fact, not a myth, many other models will be forthcoming.
SEE ALSO Development Economics; Prebisch, Raúl; Singer, Hans; Terms of Trade; Unequal Exchange
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