Essay on the Terms of Trade and Economic Development

It is held that favourable terms of trade are very significant for the rapid economic development of the less developed countries. When a country has favourable terms of trade, it can import a larger quantity of goods for the given amount of exports. Thus, the availability of resources, in the country increases so that, rapid growth becomes possible and national income rises. Nurkse’⁴ thus, regards the advantageous terms of trade as the potential source of capital formation.

However, the development through improved terms of trade becomes possible only if the additional resources thus, made available are saved and invested fruitfully. If the additional resources realised by the improvement in the terms of trade are consumed away and not invested, there will be no capital formation or economic development.

Moreover, the favourable effect of the improvement in the terms of trade may be offset by certain adverse circumstances, as stated below, and rapid economic development may not be realised. These adverse circumstances are:

1. When the improvement in the terms of trade is materialised through restricted exports, resources may remain underutilised in export industries. Thus, the scope of employment, output and income may be limited.

2. If the improvement in the terms of trade is due to high cost of production as a result of inflation, the adverse effect of inflation on the development process will supersede the favourable effect of terms of trade.

3. Further, when the terms of trade are improved by the price rise in exports due to a fall in the supply of exports, the adverse effect lies in the reduction of aggregate exports, so that, relative import capacity may actually decline.

As such, the effect of improved terms of trade on development should be examined cautiously in relation to other pertinent effects like changes in supply, demand, quantum of exports, and imports, employment and income and prices in the country.

Thus, it may be laid down that, other things being equal, there can be no theoretical dispute on the role of the favourable terms of trade in economic development of the primary producing countries. In practice, however, it has been observed that the terms of trade in these poor countries are not improving but actually deteriorating in spite of inflation, scarcity and low productivity in these economies as against abundance and high productivity and relative price stability in advanced countries. This deterioration is due to the following reasons:

1. Population in poor countries is large and growing faster than in advanced countries. Thus, poor countries’ demand for imports of capital equipments, etc., are rising faster as against the more or less steady demand for primary exports by the advanced countries.

2. Concentration and expansion of the export industries in the less developed countries have lowered the prices of their exports in the competitive world market.

3. Affluence in domestic production in the advanced countries has decreased their demand for imports from poor countries.

4. Recent technological advancement and other inventions have caused a further decline in raw material import needs of developed countries. For instance, inventions of synthetic substitutes like synthetic rubber, plastics, aluminum, etc. for natural raw materials like jute, cotton, etc. have already affected the exports of less developed nations.

5. The income elasticity of demand of advanced countries for poor countries’ primary products and minerals is very low. On the other hand, the income elasticity of demand by poor countries for the manufactured goods of advanced nations is relatively high.

6. Further, a greater degree of flexibility exists in the diversified economies of the industrial countries than those of the subsistence sectors of poor countries. Thus, when world prices of certain commodities are decreasing, industrial nations can easily shift the production of these goods to the production of other goods where prices are not falling. Such adaptability is lacking in the subsistence sectors of the less developed countries, hence, their terms of trade cannot be improved.

7. Lastly, the poor countries have a weak bargaining power in the world market, because of the perishable nature of their exportables. Thus, they have to depend much more on developed countries both for their imports and exports than vice versa. As such, the terms of trade are set always in favour of the advanced nations, despite GATT and UNCTAD’s proposals for better and improved economic and trade relations.