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 servicesWatch this videohttp://www.youtube.com/watch?v=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 101.92 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 101.89

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 causesShort 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 causesLong 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 causesLong run improvements in

technology within a countryLower costs of production causes

increases in supply and lower pricesThis leads to a deterioration in the

TOTExports will be more competitiveIf 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 competitiveWatch Economicspro 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 improvementAn 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 improvesExport 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

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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 4th is a 15 mark. Remember what you need to include!!