Factors affecting the long run trend of the Terms of Trade for developing countries
Most Third World countries have been faced by a fall in their terms of trade over the long run. There are a number of factors which contributed to this result, namely: -
The income-elasticity of demand for primary products
These countries export primary products like basic foodstuffs which may be considered to be "necessities" on which a decreasing proportion of income is likely to be spent as these incomes rise. Countries relying on basic foodstuffs and other primary product exports may therefore find their exports growing more slowly than those of individual countries exporting manufactured goods.
The discovery of synthetic materials
Over a whole range of items, the substitution of synthetic man-made products has reduced the market for particular primary products. The long term trend in the market shares of natural and synthetic products is likely to be influenced by a "ratchet" effect. When prices of natural products are high, due to cyclical fluctuations or temporary shortages, research into possible synthetic substitutes will be encouraged. When prices of natural products revert to more normal levels, these products may have permanently lost a further part of the market.
Raw material - saving innovations
This is likely to apply to technical change aimed at economizing the use of raw material's in industry. Periodic high prices will stimulate the search for and application of raw material saving process. Technical change aimed at a progressive reduction in costs per unit of output directly by permitting industrial output (and thus income) to expand in greater proportion than the demand for materials.
Agricultural protection and import substitution in developed countries
The protectionist policies within the industrial countries which aim to raise the incomes of farmers and other primary producers like fishermen by placing tariffs or quotas on competing imports have also affected the terms of trade for developing countries. As a result, many industrial countries have become almost self-sufficient in producing grains, sugar (from beet), livestock products, and even tobacco and wines. Sometimes the policies have been directed at saving foreign exchange as well as maintaining domestic incomes and employment, and have not only been confined to primary products. Indeed, restrictions on access to markets for manufactured goods by developing countries at large, or potentially large, export industries like India's textiles have forced developed countries to sell more primary products instead. Thus even without tariffs or quotas, therefore, the expansion in primary product exports is likely to result in a decline in their commodity terms of trade in the many cases where the exports are likely to result in a decline in their commodity terms of trade in the many cases where the price-elasticity of demand in industrial countries is very low. When in addition, these primary products face tariff or quota restrictions, the deterioration in the terms of trade will be greater.
Diminishing returns in agriculture and limited natural resources
Whatever the income-elasticity of demand for primary products, continuous expansion of industrial output means a continually increasing requirement of raw materials. If the supply of land suitable for various agricultural products is limited, the law of diminishing returns may apply, leading to increasing scarcity of such products, and a rise in their prices.
Technical progress in manufacturing
Although technical progress in the industrialized countries should, through the market mechanism, have been shared between the industrial producers and the producers of primary products, according to Raoul Presbich, this desirable development has been
frustrated. On the one hand, industrial monopolistic practices and trade union action producing cost-push inflation in the developed countries have persistently raised money wages in these countries and, with these, the prices of manufactured goods. In contrast, competition among primary producers, and the ineffectiveness of trade unions in the agricultural sectors of these economies, has kept down the prices of raw materials. In fact the benefits of any cost-reducing innovation in these countries is likely to be passed on, as a result of competition, to industrial consumers in the form of reduced prices.