In comparison to advanced countries, underdeveloped countries have, usually, unfavorable terms of trade. The reasons for this tendency are not far to seek. The following causes are responsible for such a phenomenon:

1. High Cost-ratios:

As compared to advanced countries, underdeveloped countries have high cost-ratios on account of the low productivity of factors of production.

2. Backward Technology:

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Underdeveloped countries are in a backward state of technology; hence, their relative productivity is low, so the cost of production and domestic price-structure is relatively high. This puts the poor country at a disadvantageous bargaining position, consequently the terms of trade are settled in favour of the advanced country.

3. Primary Products:

Underdeveloped countries are usually agrarian economics. Their exports consist of primary products and imports consist of capital goods. Again in these countries agricultural production is very much prone to the operation of the law of diminishing returns due to lack of mechanisation and agricultural reforms.

On the other hand, industrial production in advanced countries is subject to the law of increasing returns due to improved and changing technology. Thus, terms of trade between the exchange of primary products and industrial products are always settled in favour of the latter and against the former.

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Usually, the pattern of production and trade in developed (DCs) and less development countries (LDCs) indicate that the demand of the DCs for primary product imports from LDCs is inelastic. Moreover, the supply of primary products by the LDCs also tend to be inelastic. With low desires of elasticities of demand and supply, the equilibrium terms of trade is determined unfavourably in the case of LDCs.

4. High Population Growth:

Most of the underdeveloped countries are over-populated and their growth rate is also high. Consequently, there is a high internal demand for the goods produced in general which causes low exportable surplus with these countries.

Again, the relative import demand of these countries is also high and inelastic. This causes their terms of trade to deteriorate.

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5. Greater Dependency:

Poor countries are greatly dependent for their capital goods requirement and other needs on the advanced countries. They have no other alternative in view of the absence of import substitution. While, advanced countries are least dependent on the poor countries as they are capable of producing import substitutes. Hence, poor countries have always weak bargaining power, so they have to accept even terms of trade which are very much against their interest.

6. Lack of Adaptability:

Advanced countries can quickly adapt the production of such goods which are high in demand and whose prices are rising faster than the goods whose prices remain steady or declining. Underdeveloped countries lack such adaptability on account of their primary production, backward state of technology, market imperfections, immobility of factors of production and the over-all rigidity of their economy as a whole.

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As such, the terms of trade of underdeveloped” countries tend to deteriorate when inflation starts in manufactured goods at a faster rate, while the world prices of agrarian output remain more or less steady.