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".
How beneficial is an improvement in the terms of trade? As noted earlier, an improvement in the TOT is not necessadly a good thing. We need to consider the effect of an improvement in the TOT on a country's current account balance. The outcome will depend upon the reason for the improvement. Possible reasons for improvement include the following. An increase in demand for a count{s exports A number of factors may cause demand for a country's exports to rise. Consider the exports ftom country A. Prices in other countries may have risen, making country .As exports more competitive; ilcomes in importing countries may have risen, increasing their demand for imports and so increasing demand for country As exports; and consumer tastes may have changed in favour of the goods and services that country A exports. An increase in the demand for country -4s exports is shown in Figure 26.1. When the demand increases the average export price rises from P to Pr. The quantity oI expons demanded and supplied increases ftom Q to Q1. The higher export prices mean that the TOT have improved, and total export revenue rises from OPXQ to 0PryQr. This will lead in tum to an improvement in the current account balance. We cal say that: o An improvement in the TOT when caused by an increase in demand for exports, leads to an improvement in the current account balance. Higher export plices caused by domestic inflation Relative export prices may increase because a country is experiencing inflation that is higher than in the countries with which it trades. If this is the case then there will be an improvement in the TOT. Whether this improvement in the TOT leads to an improvement in the orrent account balance will depend upon the elasticity of demand for the country's exports. The situation is shown in Figure 26.2. The demand curve lor exports is normal and has the usual relationship with the MR curve and the TR curve. As we know from microeconomics, the value ol price elasticity of demand on a demand curve falls as the price falls. There will be al elastic region oI the demand curve and an inelastic region. These are shown in Figtre 26.2. Il the demand for exports is inelastic, i.e. price is on lhe lower paft of the demand curve, then an increase in price will lead to a proportionately smaller decrease in demand and so total export revenue will rise. As we see in the diagram, an increase in price from P to PL leads to an increase in export revenue from ER to ERr. This will improve the current account balance. Therefore we can say that: o An improvement in the terms of trade, when caused by inflation, leads to an improvement in the current account balance when the demand for exports is inelastic. t 0 QQ' 26 . Terms of trade llll! Quantity ol exports Figure 26.1 An increase in demand for exports 6 ER. d rn. EER t E' 0 Figure export I ]K i TR (eipor6) tnelastic demand -.fr\ :,- -l- - - - ;\i. D (expofts) MR Quantity of exports 26.2 The demand for exports and revenue
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IB Econ Chap 26 Terms of Trade - Sunny Hills High School

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