Terms of Trade - HL Chapter 26

Terms of Trade Introduction  This is an index that shows the value of a country’s average export prices relative to their average import prices  Do not confuse this BoP which is the value of the total exports minus the value of the total imports  Terms of trade (TOT) = (weighted index of average export prices / weighted index of average import prices ) x 100  The indices of export and import prices are weighted to reflect the relative importance of different goods and services Watch this video wmqnCjjidEM

Terms of Trade Introduction  This table shows what the TOT index represents  Year 1 is the base year so the value is set at 100  In year 2 export prices rise and import prices stay where they are = rise in TOT to 102  This is an improvement  On average the country’s exports will now buy 2% more imports than the previous year  In year 3 although export prices rise again the increase in imports is greater  The TOT falls to  There has been a deterioration in the TOT  A given amount of exports buys less imports  It is still better than year 1 Insert table 26.1 p318

Terms of Trade Introduction  In year 4 the import prices rise by relatively more than export prices  The TOT falls back to 100  In year 4 a given amount of exports buys the same amount of imports as it did in year 1  In year 5 export prices fall but import prices fall more  There is an improvement in the TOT to  If export prices rise relative to import prices or fall less than import prices then the TOT improves Insert table 26.1 p318 Complete student workpoint 26.1

Short run causes Short run changes in the TO T may be caused by the following  Changes in the conditions of supply and demand  Demand  If the demand changes there will be a shift in the demand curve and the price of exports will change  Prices of competitive goods in other countries may change affecting the competitiveness of the exports  Incomes in the importing countries may change affecting demand  Consumer tastes may change  Supply  If a number of countries experience an increased supply of a certain product due to favourable weather conditions price will fall  Record wine harvests in Australia led to a 9% fall in average prices in 2006  The effect of such a change on the TOT depends on the importance of overall exports of the good

Long run causes Long run changes in the TO T have various causes  Change in world trade patterns due to income changes  Rising incomes especially in developed countries lead to an increase in demand for secondary and tertiary products whose income elasticity tends to be fairly elastic  The TOT of developed countries which produce more secondary and tertiary products tend to therefore improve relative to the TOT of developing countries (they are much more dependent upon the exporting of primary products who income elasticity tends to be fairly inelastic  Long run improvements in productivity within a country  Will lead to a gradual deterioration of the TOT for that country (real prices not significantly rising)  But…country’s exports will be more competitive and so the result could be positive if the demand for the exports is elastic

Long run causes  Long run improvements in technology within a country  Lower costs of production causes increases in supply and lower prices  This leads to a deterioration in the TOT  Exports will be more competitive  If the PED is elastic the BoP should improve A deterioration in the TOT is not necessarily bad – if export prices are falling the country will be more competitive Watch Economicspro Terms of tradeEconomicspro Terms of trade

Elasticity of demand for exports  The PED for exports = % change in demand for exports divided by the %change in average price of exports  If the demand is elastic then a change in price will lead to a greater proportional change in demand  This would be good if the export prices were falling  Most exports (or certainly in the long run) face elastic demand i.e. the value is greater than 1  Many commodities tend to have inelastic demand  Draw a revenue box diagram to show and explain the effect of falling average export prices on export revenues when demand for exports is inelastic (write avg price of exports on the y axis)

Elasticity of demand for imports  The PED for imports = % change in demand for imports divided by the % change in average price of imports  If the demand is inelastic then a change in price will lead to a smaller proportional change in demand  This would not be good for a country where import prices were rising  Most imports (or certainly in the long run) face elastic demand i.e. the value is greater than 1  Many commodities tend to have inelastic demand  Draw a revenue box diagram to show and explain the effect of rising average import prices on export expenditure when demand for imports is inelastic (write avg price of imports on the y axis)

How beneficial is an improvement in TOT?  It depends on the reason for the improvement  An improvement in the TOT caused by an increase in demand leads to an improvement in the current account balance which is beneficial  An increase in demand for exports causes an increase in the average export price  The TOT improves  Export revenue rises

How beneficial is an improvement in TOT?  An improvement in the TOT caused by domestic inflation leads to an improvement in the BoP when demand for exports is inelastic  An increase in relative inflation in the exporting country makes their goods relatively more expensive  If the PED is inelastic this will mean more revenue  On one hand this is good for the BoP but the inflation may not be good  If the demand for exports is elastic the revenue will drop and the BoP will deteriorate  The improvement in the TOT is not beneficial in this instance + = Inelastic PED for exports

How beneficial is an improvement in TOT?  Comparing this to the real world…  PED of most exports tends to be elastic due to the high levels of competition  Generally commodities face inelastic demand  Most countries will be on the elastic part of the demand curve for their exports  Overall this means that an improvement in the TOT due to inflation will generally lead to a worsening of the BoP

The significance of deteriorating TOT for developing countries  Although there are vast differences among developing countries many are heavily dependent on one or two commodities  Mali earns 93.6% of its merchandise export earning by exporting primary commodities  Almost all of Yemen and Angola’s export revenue comes from oil  The problem is that some developing countries are dependent on the export of non-oil commodities  Some of their barriers to growth and development are related to their terms of trade  There has been a downward trend in commodity prices for man years caused by  Substantial increases in the supply of commodities caused by improvement in technology e.g. better fertilisers  The discovery of synthetic replacements  The demand for commodities is income inelastic so even though developed countries have grown their demand has changed little  Price support schemes in developed countries e.g. the EU CAP have encouraged domestic production and reduced demand of imports from developing countries  Miniaturisation (smaller laptops etc) leads to less demand for plastics and the commodities that are used to make plastic  The effect of these can be seen in the diagram

The significance of deteriorating TOT for developing countries  Countries that are dependent on commodities will see a fall in the index of their export prices and a deterioration of their TOT  This leads to a worsening of the BoP because demand for commodities is inelastic  As the price falls, the revenue falls and so the BoP worsens  With falling export prices the price of imports has risen relative to the price of exports  The goods that developing countries need are necessities such as raw materials, components, and other capital goods  Because they are not available domestically and are required for economic growth demand for them is inelastic  The import expenditure will increase

The significance of deteriorating TOT for developing countries  The deterioration in the TOT for developing countries that depend on commodities has several harmful consequences  They have to sell more and more exports in order to buy the same amount of imports  This is a bit of a vicious circle because when they increase supply they push the price down further  Servicing debt becomes much harder  To service the debt they try to supply more and again push the price down  By trying to supply more developing countries will overuse their resources resulting in negative externalities such as land degradation, desertification, soil erosion, and massive deforestation  Recent times have seen an increase in commodity prices due to demand from India and China although whether this is sustained is questionable  The other issue is that commodity prices tend to be quite volatile meaning export revenues can fluctuate significantly making it difficult for governments to plan Create a presentation that answers the end of Chapter review questions on P329. The first 3 are 10 marks and the 4 th is a 15 mark. Remember what you need to include!!