IB Econ Chap 26 Terms of Trade - Sunny Hills High School

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26 . Terms of trade
relative to the TOT oI developing countries, many of whom are
much more dependent upon the exponing of primary products,
whose income elasticity tends to be income-inelastic. In effect,
there is a change in world trade patterns.
Long-run improvements in productivity within a counry: This will lead
to a gradual deterioration of the TOT for that country because their
real prices will not rise significaltly. However, the country's exports
would be more competitive on the international markets and so
the result could be positive, if demand for the expots is elastic.
Long-run improvemmts in technology within a uuntry : This will lead
to lower costs of production, increases in supply, and lower
prices. If this occurs, then the country will experience a gradual
deterioralion in its TOT. This will, however, make the country's
exports more competitive and, if the elasticity of demand for its
exports is elastic, the balance of trade should improve.
Elasticity of demand for imports and expods
As you now realize, the concept of elasticity is very imponant in
economics. It is extremely relevant to our discussion of the TOT. We
need to go back to a discussion about the price elasticity of demand
for exports and imports in Chapter 24 to make an e{fective analysis
of TOT changes.
Price elasticity of demand for exports
As we know, the price elasticity of demand for exports is a measure
of the responsiveness of the demand for exports when there is a
change in the price of exports. It is measured by the equation:
Percentage change in demand for exports
PED....', = Percentage change in average price of erTorts
If the demand for exports is elastic, then a change in the average price
of exports will lead to a greater proportional change in the demand for
them. This would be good for a country where export prices were
falling, since export demand would rise by proponionately more than
the prices fell leadilg to an increase in export revenues. Most ex?orts,
certainly in the long run, face elastic demand, i.e. a value of PED."pon,
that is greater than I. However, many commodities (raw materials
such as oil, copper, coffee, cotton, steel, rice, sugar, and rubber) tend
to have inelastic demand.
Price elasticity of demand for imports
The price elasticity of demand for imports is a measure of the
responsiveness of the demand for imports when there is a change in
the price of imports. It is measured by the equation:
Percentage change in demand for imports
PEDi,rpofts : Percentage change in average price of imports
If the demand for imports is inelastic, then a change in the price of
imports will lead to a smaller proportional change in the demand Ior
them. This would not be good for a country where import pdces
were rising, since import demand would fall by proportionately more
than the prices increased. Most imports, certainly in the long run,
face elastic demand, i.e. a value of PED6oo,ts that is greater than I.
However, commodities tend to have inelastic demand.
Student workpoint 26.2
Be a thinker
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. On the
y-axis, write "Average price of
exports".
Student workpoint 26.7
Be a thinker
Draw a revenue box diagram to
show and explain the effect of
rising average import prices
on export expenditure when
demand for exports is inelastic.
Label the y-axis 'Average price
of imports".