Behavior of the TT:

The likely evolution of the 'IT, a feature of classical analysis, was resurrected in a development context by Prebisch.  In classical  economics scarcity  of land would lead to an increase in primary prices and the terms of trade for primary products would  improve. This would make further  industrial  investment unprofitable and economic growth would grind  to a  halt and the economy would reach the stationary state.  In more recent times, this line of argument has been adopted by various environmentalists  starting  with the Club of Rome analysis.

Prebisch argued that developing countries could not adopt  a  development strategy based on growth  of the agricultural sector and export of the resulting higher output. Any  attempt to raise the growth rate of an economy would require a higher investment ratio and  larger imports of capital  goods  since developing countries do not have a large domestic capacity  to produce capital goods. But  export earnings would grow only slowly because terms of  trade would decline  as more agricultural  goods were exported. Consequently, export earnings would be insufficient  to finance the imports of capital goods,  leading to BOP problems, and so attempts  to raise the growth  rate would be fulliflied.

Prebisch  provided a detailed statistical  analysis  for his contention  that  the  terms of  trade of developing countries were deteriorating. He could not find data  for the terms of trade of developing countries,  so he calculated the TT df  the UK. Since the UK  was mainly an exporter of manufactures and  an importer of  Prebisch found that the  TT of the UK had  improved between  1870  and  1938 and therefore concluded that the TT of developing countries had deteriorated.

This procedure adopted by Prebisch was criticised on several grounds.

1)  It was not valid to use the inverse of the UK's TT as  representing the TT of developing counties, because the UK's NBTT was not representative of industrial countries  as a whole.

2)  Furthermore, the UKimported primary commodities  from  developed countries, and prices of primary commodities from developed countries could have declined while prices  of primary commodities from developing countries could have increased.

3)  Exports are valued on a f.0.b.  basis and  imports on  a c.i.f. basis.  Then prices of imports ihto  the UK may have declined because of a fall in ship- ping costs since import prices include  freight charges. But then the fall  in import prices in  the UK  could occur without  a  fall in  the  prices  of commodities exported by  developing countries. So the UK's  TT  could improve without worsening  the terms of trade of LDCs.

4)  The usual method of calculation of price  indices doesn't  take account of introduction of new goods and quality differences.  Both apply mainly to manufactures,  thereby biasing  the results.

Apart from these criticisms  of Prebisch's historical analysis, economists  found no evidence to support the case for a deterioration  in the TT in the immediatepost Second World War decades.

Let us first examine the criticism that the TT  of  the UK  was not representative of developed countries  as  a  whole.  After painstaking analysis Sparos concluded  (p.53), 'the  leap from  the evidence  of  ~ntain's  NBTT  to an inference about the relative price of phmary products vis-a-vis manufactures in world-wide trade was not misleading as to direction though  it  gave  an exaggerated impression of  the magnitude of  the deterioration'.  We  now examine the bias  from  not  distinguishing  between  primary  exports  of developed and developing countries.  An analysis of the TT  of  the US, which imported mainly tropical products and exported other primary commoditiesimproved during this period. Also,  an  analysis of the TT  for  agricultural products in European  trade, namely, the prices of agricultural products  exported by European countries relative to prices of agricultural products imported byEuropean countries, found that these had improved.