No. 3 - Department of Treasury - The Western Australian Government

Western Australian Economic Summary2006 No.3Is Output the Key?The close connection that economics generally assumes betweenproductivity and economic welfare is based on the expectation that thecapacity of an economy to produce is closely linked to the capacity of itscitizens to consume.For an economy in economic isolation, this is necessarily true, as the onlygoods and services available for consumption are those produced locally.Price movements do not affect overall economic welfare, as a price changethat benefits one group (e.g. producers) disadvantages another (e.g.consumers).However, when economies trade, this is not necessarily the case. The goodsand services available for domestic consumption comprise not only localproduce, but also the things that can be exchanged for local produce 1 .Changes in a country’s export prices relative to its import prices (the “termsof trade”) can therefore have significant effects on its capacity to consume,largely independent of its capacity to produce.In practice, for most economies over the longer term, these terms of tradeeffects on potential consumption are fairly small relative to the influence ofdomestic production. This is because exports typically represent a relativelysmall share of total production, and because terms of trade swings areseldom sufficiently pronounced to have a large effect, and anyway tend tobalance out over time.For example, Productivity Commission commissioned Meyrick andAssociates to undertake a quantitative study of the effect of changes in theterms of trade on living standards in Australia.The main conclusion from this study is that, taken over long time period ofseveral decades, changes in the terms of trade have relatively little impact onwelfare 2 .This is because welfare benefits from improvements in the terms of trade inone period have been offset by losses from subsequent deteriorations in theterms of trade.However, because the study covers the period 1960 to 2004, it omits thecontinued upswing in the terms of trade since the survey period and thusarguably understates the importance of the terms of trade on welfare 3 .1 An open economy might also consume more than it produces by running a tradedeficit, but that is not relevant to this article.2 Over the past four and a half decades, changes in terms of trade have increasedreal income by less than 5% in aggregate.3 Since 2004 the terms of trade have risen by more than 15%.64 Department of Treasury and Finance