Declining Terms of Trade and the Prebisch-Singer Hypothesis

Declining Terms of Trade

The Prebisch-Singer hypothesis

Terms of trade: what are they?

Terms of trade measures the rate of exchange when two countries trade.

It can be calculated by the following formula:

                         

Terms of trade:Index of export price  X100

        Index of import price 

The Prebisch-Singer hypothesis

Two economists Prebisch and Singer examined data over a period of time and came to the conclusion that the terms of trade for primary product exports tend to decline. There are two main reasons for this:

1. Increases in productivity have meant that the prices of primary products have been declining. Demand for certain ones has been falling too e.g. copper.
2. As countries get richer (which is natural) demand for secondary and tertiary products rises on a larger scale then primary goods because primary goods have a lower income elasticity of demand.

Essentially LDCs are able to import much less than they export unless as the Clarke Fisher model suggests they tap into new sectors. 

Evaluation 

• Depends on the product some countries have developed on the basis on primary products e.g. Botswana has develop through diamonds and Middle East through oil.
• According to comparative advantage if a country produces that product more efficiently should not change even if terms of trade are declining.
• In the middle of 2008, (global recession) price of manufactored goods fell while primary products rose sharply.
• Terms of trade should improve as primary product prices rise because of an increase in demand caused by a population increase and the development of countries like India and China.
• Prices fluctuate so it is difficult to make accurate conclusions.