Course: Economics SSE, Topic: UNIT 2: TERMS OF TRADE.

General

UNIT 2: TERMS OF TRADE.
Unit Competency:
Learners will be able to describe the terms of trade in LDCs.
Introductory activity
Using the case study below, visit the library or the internet or any economics
source and research about international trade, using the gained knowledge
and understanding, share and discuss the questions that follow.
In 2017, Rwanda exported her tea to Brazil and in turn imported guns from
there. The price of tea per ton was 800 dollars while that of a gun was
1,700 dollars. The next year i.e. 2019, tea prices in the world market fell
by 20% while that of guns remained constant.
a) What economic term do we call the relationship between Rwanda’s
export prices and import prices?
b) Calculate the terms of trade for Rwanda in 2017 and 2019 respectively.
c) Describe the nature of terms of trade of Rwanda in 2017 and 2019
respectively. Support your answer.
d) How can terms of trade be expressed?
2.1: Meaning and Forms of Terms of Trade:
Activity 2.1
Analyse the case study below, undertake research from any relevant economic
source within your reach and discuss the questions that follow;
In 2018, to purchase laptops from China, it required Rwanda to export 200 tons
of coffee there. Suppose each ton of coffee cost $20 and that of laptop is $60;
i) How many laptops did Rwanda purchase from China using her tons of coffee?
ii) What economic term is given to relationship between the value of Rwanda’s
coffee and China’s laptops?
iii) Describe what the term named above means to an economy.
iv) Describe how the different forms of terms of trade can be expressed.
2.1.1: Meaning of terms of trade:
Terms of trade (TOT) refers to the relative price of exports in terms of imports.
It is the ratio of export prices to import prices. It can be interpreted as the
amount of import goods an economy can purchase per unit of export goods.
I.e. import purchasing power of exports. For example, if an economy is only
exporting Flowers and only importing telephones, then the terms of trade are
simply the price of flowers over the price of telephones. In other words, how
many telephones can you get for a unit of flowers sold? Since economies
typically export and import many goods, measuring the terms of trade requires
defining price indices for exported and imported goods and comparing the two.
A rise in the prices of exported goods in international markets would increase
the terms of trade, while a rise in the prices of imported goods would decrease
it. For example, countries that export oil products will see an increase in their
terms of trade when oil products’ prices go up, while the terms of trade of
countries that import oil products would decrease. An improvement of a nation’s
terms of trade benefits that country in the sense that it can buy more imports for
any given level of exports. The terms of trade may be influenced by the exchange
rate because a rise in the value of a country’s currency lowers the domestic
prices of its imports but may not directly affect the prices of the commodities it
exports. Terms of trade is the ratio of a country’s export price index to its import
price index, multiplied by 100.
Terms of trade can be expressed as;
TOT= ×100 or TOT= 100
Where; Px = average price index for exports, Pm = average price index for
imports
Basically, TOT is Export Price over Import price times 100. If the percentage
is over 100% then an economy is doing well (Capital Accumulation) thus
favourable terms of trade. When this persists year after year, a country is
said to have ‘improving terms of trade’.
If the percentage is under 100% then an economy is not going well (More
money going out than coming in) thus unfavourable terms of trade. When
this persists year after year, a country is said to have deteriorating terms of
trade.
2.1.2: Forms of Terms of Trade
Terms of trade are categorized into two, namely;
a) Barter / commodity terms of trade
b) Income/ monetary terms of trade
c) Barter/ commodity terms of trade.
Barter / commodity terms of trade is the relationship between export prices
and import prices. I.e. the ratio of average price index of exports to the
average price index of imports. Symbolically, it can be expressed as:
Barter terms of trade= 100
Where P = price, the subscript x =exports and m =imports.
Taking 2018 as the base year and expressing Rwanda’s both export prices
and import prices as 100, if we find that by the end of 2019 its index of
export prices had fallen to 80 and the index of import prices had risen to
180. The terms of trade had changed as follows:
Barter TOT =100= 100 = 44.4
It implies that Rwanda’s terms of trade declined by about 55.5 per cent in
2019 as compared with the 2018, thereby showing worsening of its terms
of trade.
If the index of export prices had risen to 190 and that of import prices to
185, then the terms of trade would be
Barter TOT =100= 100 =102.7.
This implies an improvement in the terms of trade by 2.7 per cent in 2019
over 2018.
a) Income/ monetary terms of trade
This refers to the ratio of the value of exports (revenue from exports) to the price
index of imports. This index is calculated by dividing the index of the value of
exports by an index of the price of imports. This is called the “Export Gain
from Trade Index.”
It can be expressed as;
Income TOT= or
Example 1:
Taking 2017 as a base year and expressing Rwanda’s both export prices and
import prices as 100, if in 2019, the price of exports (PX) is 140, price of
imports (Pm) is 90 and quantity of exports is 80 then income terms of trade is;
= 124.4.
It implies that there is improvement in the income terms of trade by 24.4percent
in 2019 as compared with 2018.
Example 2:
Taking 2018 as a base year again, and expressing Rwanda’s both export prices
and import prices as 100. If in 2019 Price of exports = 80, Price of imports
=180 and Quantity of exports =120, then
Income TOT = 53.3
It implies that the income terms of trade have deteriorated by 46.7% percent
in2019 as compared with 2018.
A rise in the index of income terms of trade implies that a country can import
more goods in exchange for its exports. A country’s income terms of trade may
improve but its commodity terms of trade may deteriorate. Taking the import
prices to be constant, if export prices fall, there will be an increase in the sales
and value of exports. Thus, while the income terms of trade might have improved,
the commodity terms of trade might have deteriorated.
The income terms of trade, is called the capacity to import. In the long-run,
the total value of exports of a country must equal to its total value of imports, i.e.,
or . Thus determine which the total volume that a country can import is.
Application activity 2.1
a) Under what circumstances may the capacity of a country to import
i) Increase.
ii) Decline.
b) Describe the different directions the terms of trade position of a country
can take.
c)If in 2019 Rwanda exports 1000 tons of hides and skin to Brazil each at
US$ 500 in exchange for cars each at US$2000
i) What are we aiming at in looking at prices of imports and exports plus
their quantities?
ii) Describe the relationship between Rwanda’s export and import values.
iii)Calculate the income terms of trade and barter terms of trade in 2019
and interpret your findings.
2.2: Nature and how to improve the terms of terms of trade
for developing countries.
Activity 2.2
Developing countries are always interested in the trend in export and import
prices and also more concerned about the trends in their export earnings
and import payments. This is because these trends in turn determine
the long-term trend in the balance of payments on current account and
indicate whether future balance-of-payments difficulties are likely to arise.
(https://link.springer.com)
a) From the extract above, why do developing countries mind about
keeping track of the trend of export and import prices?
b) Basing on the extract above, carry out research to identify and
describe the trend of export and import prices for developing countries.
c) What causes the trend mentioned above for developing countries?
d) Suggest possible measures that developing countries should
undertake to streamline its export import price relationship.
2.2.1: Nature of terms of trade for developing countries:
Most LDCs have unfavourable and deteriorating terms of trade. The
following are the main reasons for unfavorable and declining terms of trade of
less developed countries:
Causes of deteriorating Terms of Trade in LDCs
- The less developed countries are mainly primary producing countries.
Their exports mostly include primary products which are price and income
inelastic, but their imports include capital goods which are expensive. Thus,
the terms of trade for LDC’s are always unfavourable and deteriorating year
after year.
- Adoption of raw-material saving techniques by developed countries which
reduces the demand for LDC’s export.
- Most of the international trading policies are influenced by MDCs which
favour them however disfavor LDCs. For example, LDCs are price takers in
the world market hence their export prices are usually low, making them to
have unfavourable terms of trade year after year.
- Discovery of substitutes such as synthetic fibers e.g. plastics, nylon, which
replace natural fibers in LDCs. This reduces on the volume of exports for
LDCs.
- Price movements through business cycles: The prices of primary products
rise sharply in the prosperous periods and fall in the downswing of the
business cycle. Thus, over successive cycles, the prices of the primary
products have always fluctuated, and the primary producing countries have
suffered an unfavourable movement in their terms of trade.
- Long-term disparity in demand for manufactured and primary products. In
the industrial countries, the income elasticity of demand for primary products
is inelastic (i.e., less than one), while in the poor countries, the income
elasticity of demand for manufactured goods is more elastic (exceeds one).
This brings about unfavorable terms of trade year after year.
- The less developed countries use backward technology as compared to
the developed countries. As a result, their relative productivity is low, cost
ratios are high, and price structure is also relatively high. This leads to the
adverse terms of trade for the poor country, placing it at a disadvantageous
bargaining position.
- Most of the less developed countries experience overpopulation and high
population growth. As a result, there is high internal demand for the goods
and low exportable surplus. Moreover, the import demand of these countries
is highly inelastic. This causes their terms of trade to fall.
- Lack of Import Substitutes: Poor countries are greatly dependent on
the advanced countries for their imports and have not developed import
substitutes. On the other hand, the advanced countries are not so much
dependent on the poor countries because they are capable of producing
import substitutes. Thus, the poor countries have weak bargaining position
in the international trade.
- High transport costs: Most LDCs are land locked countries, this makes
it difficult to link to regional or international markets make it difficult for
trade development in the country. Therefore, making it costly to transport
commodities to and from international markets, adversely affecting their
terms of trade.
- Unlike, the advanced countries, the less developed countries cannot quickly
adapt their supply of goods which are high in demand and whose prices are
rising. The reasons for this are: backward technology, market imperfections,
immobility of factors of production, etc. Thus, the terms of trade of less
developed countries tend to deteriorate and these countries fail to reap
gains by increasing their supplies of exports during inflation due to Lack of
adaptability.
- Most LDCs produce more less the same products which leads to limited
market among themselves. They therefore tend to increase their export
shares to MDCs by reducing prices, yet they have to continue importing
manufactured goods from MDCs which are highly priced.
- Most LDCs lack a considerable manufacturing sector as a result of political
instability and insecurities, thus reduce the volume of manufactured
commodities that would be exported.
- Lack of diversification in production in LDCs; Most LDCs depend on a few
traditional cash crops like tea, coffee, cotton tobacco, sisal, cocoa etc. which
limits the amount of income they get from exports compared to developed
countries that export to LDCs a wide variety of manufactured goods.
2.2.2: How to improve Terms of Trade for LDCs
Most LDCs face unfavourable terms of trade, an indication that LDCs do not
favourably enjoy the benefits from international trade. This implies they always
export much and get little imports. LDCs should adopt any of the following
policies in order to improve their terms of trade so as to enjoy more benefits
from international trade.
- Carry out adequate market research so as get enough information to
widen markets for their commodities. This enables them to access new
clients and overcome supply constraints domestically, regionally and
internationally.
Human resource development through education and training so as to
reduce expenditure on imported labour force which is always expensive.
- Promote peace and security in all parts of their countries so as to instill
confidence, for their security and property as well, among both local and
foreign investors.
- Ensure good governance for example, by fighting against all forms of
financial indiscipline like corruption and embezzlement of government
funds in all sectors which promotes transparency and efficiency thus
increased gains from trade.
- Promote regional integration and economic cooperation among
developing countries. by trading among themselves in order to avoid
exploitation by developed countries. For example, Rwanda is already a
member to regional and international bodies like East African Community
(EAC), Common Market for Eastern and Southern Africa (COMESA)
and its free trade area and is able to access the whole market without
any barriers to trade.
- Promote the development of private sector so as to promote efficiency
in production and increase the exploitation of idle resources which
increases export volume thus increasing gains from international trade.
- Make all possible efforts to establish business legal reform task force
mandated to reform all business laws which will create conducive legal
environment for trade by both local and foreign investors and increase
the gains from international trade among themselves.
- Establish financial sector task force with the mandate of solving all
problems in the financial sector. This will help avail easy and cheap
credit facilities to potential investors and business class which boosts
their productive levels thus increasing the export base.
- Establish the trade points which will provide all trade related information;
this becomes an opportunity as trade information will be easily obtained
in one place. This attracts different investors from within and outside the
country’s economy thus promoting production directed towards export
and or reducing import expenditure.
- Enhance the establishment of permanent national and international trade
fair grounds which creates an opportunity for trade development as it
gives business men a chance of regular expositions which helps them in
sell and advertisements of their products.
- Enhance the establishment of business development centers (BDS)
which facilitate easy coordination of business activities in rural areas to
promote continuous and coordinated production.
- Establish Export processing zone which facilitate trade development
in particular and development in general. This helps transform their
commodities into finished products so as to increase the export value
and gains from trade as well.
- Form producer cooperatives and associations to bargain for higher prices
for their exports. Governments should take initiative in cooperatives
development so as to create an opportunity for trade development, as
from a strong cooperative movement trade is improved.
- Take up strong measures to control population growth e.g. through family
planning campaigns so as to increase on the level of exports and reduce
the volume of exports as well.
- Diversify domestic production so as to reduce dependency on few
traditional exports where terms of trade are unfavourable and keep on
fluctuating.
- Adopt Import substitution strategy so as to minimize import expenditure
- Research innovations and inventions so as to promote technological
development and use of intermediate technology to reduce expenditure
on expensive capital.
Application activity 2.2.
a) Examine the possible causes of changes in the terms of trade for
developing countries.
b) Explain the effects of deteriorating terms trade in your country.
End unit assesment
1 a. What distinguish barter terms of trade from income terms of
trade?
b. Study the table below showing terms of trade for a country
(2012-2016) and answer the questions that follow;
Calculate the terms of trade for the years 2015 to 2019
ii) Explain the nature of terms of trade between 2016 and 2019
and support your answer.
2. a) Why have terms of trade tended to move against developing
countries’ economies?
b) Does favourable terms of trade mean favourable balance of
trade?

Economics SSE

General

UNIT 2: TERMS OF TRADE.

UNIT 2: TERMS OF TRADE.

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