The following are the main reasons for unfavorable and declining terms of trade of less developed countries:
1. Prebisch’s Arguments:
Prebisch has given the following arguments explaining the declining tendency of terms of trade of the less developed countries.
(i) Nature of Product:
The less developed countries are mainly primary producing countries. Their exports mostly include primary products and their imports include capital goods. On the contrary, the developed countries produce and export manufactured goods.
The terms of trade between the primary products and manufactured products are generally determined against the former and in favour of the latter.
(ii) Effect of Technical Progress :
Prebisch has argued that industrial countries keep the whole benefit of their technical progress, whereas the primary producing countries transfer a part of the fruits from their own technical progress to the industrial nations.
According to him, money incomes and prices have risen more rapidly than productivity in industrial countries, whereas in the primary producing countries, the gains in productivity have been distributed in the form of price reductions. This has led to the deterioration of terms of trade of the primary producing countries.
(iii) Different Market Conditions :
Export prices in the industrial countries do not fall as a result of technical progress because (a) the manufacturers operate under monopolistic conditions in the product market; and (b) they do not operate under competitive conditions in the factor market, i.e., labour market is dominated by trade unions.
Thus, the benefit of the improved technology is not transferred to the consumers in poor countries. The producers in the poor countries, on the other hand operate under competitive conditions both domestically and internationally.
Thus, as a result of technical progress in these countries, prices fall and the benefits flow to the consumers in the rich countries.
(iv) Price Movements through Business Cycles :
Prebisch attributes the contrasting behaviour of prices in the industrial and primary producing countries to the different movements of primary product prices and industrial prices over successive business cycles.
The prices of primary products have risen sharply in the prosperous periods and have fallen in the downswing of the business cycle.
In contrast, although manufacturing prices have risen in the upswing of the cycle, these have not fallen so much in the depression because of the rigidity of industrial wages and price inflexibility due to monopolistic conditions.
Thus, over successive cycles, the gap between the prices of the two groups of commodities has widened, and the primary producing countries have suffered an unfavourable movement in their terms of trade.
(v) Disparity in Demand :
Declining terms of trade of the less developed countries is also due to long-term disparity in the demand for manufactures 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 is because of two reasons: (a) Due to the operation of Engel’s law, as incomes rise, the proportion of expenditure on food declines.
Thus, the demand for food increases less rapidly than the rise in income, (b) The demand for raw materials is restricted by competition from synthetic or man-made substitutes.
2. Other Reasons:
Some other causes of adverse terms of trade of the less developed countries are as follows:
(i) Backward Technology:
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.
(ii) High Population Growth
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.
(iii) Lack of Import Substitutes :
Poor countries are greatly dependant on the advanced countries for their imports and have not developed import substitutes. On the other hand, the advanced countries are not so much dependant on the poor countries because they are capable of producing import substitutes. Thus, the poor countries have weak bargaining position in the international trade.
(iv) Lack of Adaptability :
Unlike, the advanced countries, the less developed countries cannot quickly adapt their supply of goods which are high in demand and whose prices arc 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.