Terms of Trade
Terms of Trade
By terms of trade, economists generally mean commodity terms of trade (CTT), or net barter terms of trade (NBTT), given as a price or unit value ratio. For this ratio, it is appropriate to use the term unit value rather than price because different heterogeneous commodities are aggregated into a single commodity category such as exports or imports.
Commodity terms of trade of a country are defined as the unit value (price) of exports of the country divided by its unit value (price) of imports. Commodity terms of trade between two regions, say, the North (industrially developed) and the South (less developed), is defined as the unit value (price) of exports of the North to the South divided by the unit value (price) of exports of the South to the North. The commodity terms of trade index measures unit gains from the trade amount—imports (i.e., the volume of imports) that are available for one unit of exports.
The income terms of trade (ITT) is an index of the value of exports divided by the unit value (price) of imports—the value of exports measured in terms of import goods. It corresponds to the commodity terms of trade multiplied by the volume of exports. ITT measures the purchasing power of exports—the amount of imports that can be financed by the total exports.
The use of ITT is often recommended in order to correct shifts in the commodity terms of trade for changes in the volume of exports. A fall in the terms of trade may be desirable if it leads to a significant expansion in export volumes so that the value of exports rises. As a result the capacity to import rises. The income terms of trade index is designed to measure the net effect of a change in the commodity terms of trade on the capacity to import or on the purchasing power of exports.
In the dynamic context of world economic growth, the volume of exports of a country or region often shows a trend growth exceeding the rate of decline (if any) of the commodity terms of trade, leading to a rise in its ITT. The ITT of a country or region can rise along with its trading partner as both can experience absolute gains from trade. To measure the relative gains from trade, Prabirjit Sarkar (1986b) recommended the use of the ITT of one country or region as a ratio of that of the other.
In the process of growth, technical progress takes place and factor productivity improves. As a result, the cost of production may decline and prices may fall. A decline in the commodity terms of trade may be precisely attributable to this technical progress and cost reduction. To net out this effect of technical progress on commodity terms of trade, the concept of factorial terms of trade is used. If the effect of technical progress on export prices or export unit values is taken into consideration, this leads to single factorial terms of trade. If the effects of technical progress on both export and import prices or unit values are taken into account, this leads to double factorial terms of trade.
To construct single factorial terms of trade (SFTT) of a country or region, its CTT is multiplied by some index of factor productivity in its export sector. To construct double factorial terms of trade (DFTT) of a country or region, the SFTT is deflated by the index of factor productivity in the export sector of its trading partner. So DFTT is CTT multiplied by the ratio of the indexes of factor productivity in the export sectors of the trading partners.
Because the factorial terms of trade is used as an indicator of changes in welfare, which means changes in real income per head, labor productivity is often used in the calculation of factorial terms of trade. The SFTT index bears on a country’s absolute welfare, while the DFTT index bears on relative welfare between trading countries as pointed out by the British economist John Spraos (1983).
There is much controversy regarding the long-term movements of the terms of trade of the South vis-à-vis the North. This dispute centers on the Prebisch-Singer (PS) hypothesis, which is associated with the works of two United Nations economists, Raúl Prebisch and Hans W. Singer. The essence of the PS hypothesis is the long-term decline in the DFTT of the South vis-à-vis the North. In the absence of appropriate historical data since the last quarter of the nineteenth century both Prebisch and Singer used CTT of primary products vis-à-vis manufactures as the proxy of the DFTT of the South vis-à-vis the North for two reasons. First, the South constituted mainly primary-product exporting countries in contrast to the manufacture exporting countries constituting the North. Second, presuming that the technical progress and labor productivity improvements took place at a higher rate in the North than in the South, a decline in the CTT of the South would imply a further decline in the DFTT of the South.
The Prebisch-Singer hypothesis was virtually discarded in mainstream economics in the face of strong statistical objections against it. Since the 1980s, a series of studies undertaken by Spraos (1980), David Sapsford (1985), Sarkar (1986a, 1986b), Sarkar and Singer (1991), Grilli and 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 core of the PS hypothesis has a divergence implication: In the process of long-term decline in the terms of trade of the South, the standard of living of the poor South cannot be expected to catch up with that of the rich North. Both Prebisch and Singer argued that the fruits of technical progress taking place in the northern export sector were distributed among the northern people through higher wages and profits, leading to rising standards of living because of strong labor unions and high monopoly power of the capitalists. But the fruits of technical progress in the southern export sector were transmitted to the North through lower export prices because of surplus labor, leading to weak labor unions and the lack of monopoly power of the southern capitalists vis-à-vis their northern counterparts. Thus the process of evolution and growth of the world economy through technical progress led to uneven development (as observed by Sarkar in 2000) and a long-term decline in the DFTT of the South.
SEE ALSO Development Economics; Prebisch, Raúl; Prebisch-Singer Hypothesis; Singer, Hans; Trade; Unequal Exchange
Grilli, Enzo R., and Maw Cheng Yang. 1988. Primary Commodity Prices, Manufactured Goods Prices, and the Terms of Trade of Developing Countries: What the Long Run Shows. World Bank Economic Review 2: 1–47.
Sapsford, David. 1985. The Statistical Debate on the Net Barter Terms of Trade between Primary Commodities and Manufactures: A Comment and Some Additional Evidence. Economic Journal 95 (379): 781–788.
Sarkar, Prabirjit. 1986a. The Singer-Prebisch Hypothesis: A Statistical Evaluation. Cambridge Journal of Economics 10 (4): 355–371.
Sarkar, Prabirjit. 1986b. Patterns of Trade and Movements of Interregional Terms of Trade between the Developing and the Developed Market Economies, 1950–1980. Economic Bulletin for Asia and the Pacific 37 (2): 1–13.
Sarkar, Prabirjit. 2000. North-South Uneven Development: What the Data Show. Review 23 (4): 439–457.
Sarkar, Prabirjit, and Hans W. Singer. 1991. Manufactured Exports of Developing Countries and Their Terms of Trade since 1965. World Development 19 (4): 333–340.
Singer, Hans W. 1950. The Distribution of Gains between Investing and Borrowing Countries. American Economic Review 40 (2): 473–485.
Spraos, John. 1980. The Statistical Debate on the Net Barter Terms of Trade between Primary Commodities and Manufactures. Economic Journal 90 (357): 107–128.
Spraos, John. 1983. Inequalising Trade? A Study of Traditional North/South Specialisation in the Context of Terms of Trade Concepts. London: Clarendon Press.