Terms of Trade

A country's terms of trade refer to the relative values of its exports and imports. When the terms of trade are good, a country sells, on average, relatively high-valued commodities (e.g., manufactured goods) and imports relatively low-valued ones (e.g., agricultural products). This situation generates foreign revenues that allow the country to earn revenues with which to pay off debt or reinvest in infrastructure or new technologies.

Unfortunately, many less developed countries (LDCs), with economies distorted by centuries of[Page 481] colonialism in which they became suppliers of minerals and foodstuffs, have poor terms of trade; that is, they export relatively low-valued goods and must import expensive, high-valued ones. Primary commodities account for roughly 70% of the total exports of developing countries. Many LDCs rely heavily on exports of goods such as petroleum, copper and iron ore, timber, bananas, coffee, and fruits. Lacking domestic production capacities, they must import items such as automobiles, pharmaceuticals, and machine tools. The worldwide glut in raw materials, including petroleum, wheat, and many mineral ores, has depressed the prices for many LDC exports. Without indigenous manufacturing, many are forced to sell low-valued goods such as bananas for high-valued ones such as computers.

The proceeds from these exports are needed to pay for imports of manufactures, which are vital for continuing industrialization and technological progress. Shifts in the relative prices of commodities and manufactures, therefore, can change the purchasing power of the exports of LDCs dramatically. The situation is exacerbated because many of these low- and middle-income countries are vulnerable, single-commodity-dependent ones.

The economies of many LDCs are characterized by structural rigidity. They cannot alter the composition of exports rapidly in response to changing relative prices. Thus, if their commodity export prices decrease, they have no alternative but to accept declines in their terms of trade. This situation makes it difficult to generate foreign revenues and exacerbates these countries' debt problems. Furthermore, poor terms of trade perpetuate these LDCs' cycle of poverty; low foreign revenues yield little to reinvest, helping to create a shortage of capital and resulting in low rates of productivity.

Another factor that may lead to worsening terms of trade is technological advances in developed countries. Advanced technology enables industrial economies to (a) reduce the primary content of final products, (b) produce high-quality finished products from less valuable or lower-quality primary products, and (c) produce substitutes for existing primary products (e.g., synthetic rubber for naturally grown rubber). These developments are irreversible. The demand for many primary products may be inelastic for price decreases, but in the long run it may be very elastic for price increases. A rise in the price of a raw material provides an incentive for industrial research geared to economizing on the commodity, substituting something else for it, or producing it in the importing country.