Friday, August 28, 2009

Terms of Trade (TOT), and its Types

The ratio of exports to imports is called terms of trade (TOT). The concept of terms of trade (TOT) can better be understood by analysing different types of terms of trade which are as:

1. Commodity or Net Barter Terms of Trade:

If one good is considered export good and the other good is supposed import good then “the ratio between prices of exports to price of imports is given the name of net barter terms of trade”. If we include so many goods then the ratio of price index of exports to price index of imports is called net barer terms of trade.

2. Income Terms of Trade:

The income terms of trade allows the capacity to import of a country on the basis of imports.

3. Single Factor Terms of Trade:

Single factor terms of trade shows the amount of imports which can be obtained against the domestic factor employed in export sector.

4. Double Factor Terms of Trade:

Such terms of trade measures that how much of factors used in export sector could be substituted against how much of factors employed in import sector.

5. Utility Terms of Trade:

The utility terms of trade is presented to explain welfare changes. The utility terms of trade indicates the total amount of gain from trade, as excess of total utility which is obtained from imports over the total sacrifice of utility in surrender of export.

Causes of Deterioration of Terms of Trade of the Developing Countries like Pakistan

It has been observed that terms of trade is going against the developing countries like Pakistan. It is due to the following reasons.

1. Export of Agricultural Goods: Unluckily the exports of under-developed or developing countries like Pakistan are agricultural goods like cotton and rice etc. In international markets there are heavy fluctuations in the prices of these goods. If there is bumper crop any year the price of that good falls as such goods can not be stored and they have to be sold even at lower prices. Accordingly the terms of trade goes against under developed countries.

2. Low Income and Price Elasticities of Demand: Income and price Elasticities of demand for the exports of developing countries like Pakistan are very low. Income elasticity of demand is low because the foreigners are not badly in need of exports of under-developed countries. Therefore even at lower prices the exports of poor countries do not increase. More over there are a variety of substitutes against the exports of under-developed countries as the case of polyester against cotton etc.

On the other hand in the case of developing countries people spend a major share of their incomes on luxuries. In this way they have lower income elasticity of demand for the goods exported by under-developed countries. Thus when we have the poor income and price Elasticities of demand the terms of trade is going against us.

3. Desire for Industrialization: The poor countries are economically backward and they have the desire to industrialize themselves as soon as possible. For this purpose raw material, machinery, bulldozers and automobiles. The developed countries having monopolies sell such products at higher price. It means what is sold by under-developed countries have to be sold at lower prices and what is purchased by under-developed countries have to be purchased at higher prices. In such situation terms of trade is going against developing countries.

4. Increase in Population: In poor countries like Pakistan there is big population pressure and major part of increase in population is comprised of unskilled labour. The exports of under-developed countries are also labour intensive. Therefore, the wages because of increasing number of labour are going down. Accordingly the exports of under-developed countries are also getting cheaper with the result that terms of trade is going against them.

5. Lack of Trade Unions: In case of US and Europe trade unions are very much effective. Accordingly trade unions are always found hectic in raising the wages, while they never let the wages to come down. On the other hand in the case of developing countries the trade unions have always been weak and ineffective. As a result the wages can be depressed down. With this domestic goods will be produced cheaper, and exported at lower prices. In this way terms of trade will remain against developing countries.

6. International Recession: In 1973 Arabs increased the prices of oil from $3 to $11 per barrel. Afterwards the prices of oil went on increasing. As a result on the one side international inflation emerged, and on the other side the demand for big automobiles and machinery consuming more oil decreased. With this the unemployment spread. More particularly in late 70’s and in early 80’s the recession clutched US and other European economies. Their incomes fell and they reduced the demand of their imports. Consequently, the exports from under-developed countries decreased along with fall in their prices. Again the event of 11th September 2001 also led to create recession in US.

Moreover when price fell in Europe and US due to recession, the wages and profits should also have come down. But because of ‘Ratcher Effect’ the wages and profit did not come down. The Western producers had no alternative except to make the prices of their goods inelastic and maintain their profits by charging higher prices for their products from poor countries. In this way the terms of trade went against under-developed countries.

7. Technical Progress: Japan, US and European countries have had a great technical progress. They are well emerged, in inventions and innovation. They are developing round about techniques of production, particularly which could reduce the requirements of raw material. As 35% cotton and 65% of polyester is being used in the production of shirts. The nylon is being used in the production of tyres. In such situation the prices of exports from under-developed countries are falling with terms of trade going against them.

8. Supply of Goods and Market Structure: In case of markets of developed countries the oligopoly and monopolistic competition like situations prevail. The big firms have dominated the export sector. Consequently they often restrict the output in order to raise the prices of their products. On the other hand, the competitive conditions prevail in the export sectors of under developed countries as a result the prices of export goods are low. Thus when the exports of under-developed countries command lower prices and imports of them have to be purchased at higher prices the terms of trade goes against them.

Measures to Improve Terms of Trade Under-Developed Countries:

1. The developing countries should export manufactured goods rather agricultural and primary goods.

2. In order to industrialize their economies developing countries should depend upon their own resources. They should reduce their dependence on imports.

3. Population in under-developed countries should be controlled so that demand for imports could decrease.

4. Such measures be taken at international level that prices of raw material and primary goods at world level could be stabilized. The buffer stock schemes be initiated i.e. the goods be purchased and stored when their prices are falling and they be sold when their prices are rising.

If the developing countries would adopt such measures as mentioned above their terms of trade will improve.

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