In comparison to advanced countries, underdeveloped countries have, usually, unf

avorable terms of trade. The reasons for this tendency are not far to seek. The
following causes are responsible for such a phenomenon:
1. High Cost-ratios:
As compared to advanced countries, underdeveloped countries have high cost-ratio
s on account of the low productivity of factors of production.
2. Backward Technology:
Underdeveloped countries are in a backward state of technology; hence, their rel
ative productivity is low, so the cost of production and domestic price-structur
e is relatively high. This puts the poor country at a disadvantageous bargaining
position, consequently the terms of trade are settled in favour of the advanced
country.
3. Primary Products:
Underdeveloped countries are usually agrarian economics. Their exports consist o
f primary products and imports consist of capital goods. Again in these countrie
s agricultural production is very much prone to the operation of the law of dimi
nishing returns due to lack of mechanisation and agricultural reforms.
On the other hand, industrial production in advanced countries is subject to the
law of increasing returns due to improved and changing technology. Thus, terms
of trade between the exchange of primary products and industrial products are al
ways settled in favour of the latter and against the former.
Usually, the pattern of production and trade in developed (DCs) and less develop
ment countries (LDCs) indicate that the demand of the DCs for primary product im
ports from LDCs is inelastic. Moreover, the supply of primary products by the LD
Cs also tend to be inelastic. With low desires of elasticities of demand and sup
ply, the equilibrium terms of trade is determined unfavourably in the case of LD
Cs.
4. High Population Growth:
Most of the underdeveloped countries are over-populated and their growth rate is
also high. Consequently, there is a high internal demand for the goods produced
in general which causes low exportable surplus with these countries.
Again, the relative import demand of these countries is also high and inelastic.
This causes their terms of trade to deteriorate.
5. Greater Dependency:
Poor countries are greatly dependent for their capital goods requirement and oth
er needs on the advanced countries. They have no other alternative in view of th
e absence of import substitution. While, advanced countries are least dependent
on the poor countries as they are capable of producing import substitutes. Hence
, poor countries have always weak bargaining power, so they have to accept even
terms of trade which are very much against their interest.
6. Lack of Adaptability:
Advanced countries can quickly adapt the production of such goods which are high
in demand and whose prices are rising faster than the goods whose prices remain

steady or declining. Underdeveloped countries lack such adaptability on account

of their primary production, backward state of technology, market imperfections
, immobility of factors of production and the over-all rigidity of their economy
as a whole.
As such, the terms of trade of underdeveloped" countries tend to deteriorate whe
n inflation starts in manufactured goods at a faster rate, while the world price
s of agrarian output remain more or less steady.

The following are the main reasons for unfavorable and declining terms of trade
of less developed countries:
1. Prebisch's Arguments:
Prebisch has given the following arguments explaining the declining tendency of
terms of trade of the less developed countries.
(i) Nature of Product:
The less developed countries are mainly primary producing countries. Their expor
ts mostly include primary products and their imports include capital goods. On t
he contrary, the developed countries produce and export manufactured goods.
The terms of trade between the primary products and manufactured products are ge
nerally determined against the former and in favour of the latter.
(ii) Effect of Technical Progress :
Prebisch has argued that industrial countries keep the whole benefit of their te
chnical progress, whereas the primary producing countries transfer a part of the
fruits from their own technical progress to the industrial nations.
According to him, money incomes and prices have risen more rapidly than producti
vity in industrial countries, whereas in the primary producing countries, the ga
ins in productivity have been distributed in the form of price reductions. This
has led to the deterioration of terms of trade of the primary producing countrie
s.
(iii) Different Market Conditions :
Export prices in the industrial countries do not fall as a result of technical p
rogress because (a) the manufacturers operate under monopolistic conditions in t
he product market; and (b) they do not operate under competitive conditions in t
he factor market, i.e., labour market is dominated by trade unions.
Thus, the benefit of the improved technology is not transferred to the consumers
in poor countries. The producers in the poor countries, on the other hand opera
te under competitive conditions both domestically and internationally.
Thus, as a result of technical progress in these countries, prices fall and the
benefits flow to the consumers in the rich countries.
(iv) Price Movements through Business Cycles :
Prebisch attributes the contrasting behaviour of prices in the industrial and pr
imary producing countries to the different movements of primary product prices a
nd industrial prices over successive business cycles.

The prices of primary products have risen sharply in the prosperous periods and
have fallen in the downswing of the business cycle.
In contrast, although manufacturing prices have risen in the upswing of the cycle
, these have not fallen so much in the depression because of the rigidity of ind
ustrial wages and price inflexibility due to monopolistic conditions.
Thus, over successive cycles, the gap between the prices of the two groups of co
mmodities has widened, and the primary producing countries have suffered an unfa
vourable movement in their terms of trade.
(v) Disparity in Demand :
Declining terms of trade of the less developed countries is also due to long-ter
m disparity in the demand for manufactures and primary products.
In the industrial countries, the income elasticity of demand for primary product
s is inelastic (i.e., less than one), while in the poor countries, the income el
asticity of demand for manufactured goods is more elastic (exceeds one).
This is because of two reasons: (a) Due to the operation of Engel's law, as inco
mes rise, the proportion of expenditure on food declines.
Thus, the demand for food increases less rapidly than the rise in income, (b) Th
e demand for raw materials is restricted by competition from synthetic or man-ma
de substitutes.
2. Other Reasons:
Some other causes of adverse terms of trade of the less developed countries are
as follows:
(i) Backward Technology:
The less developed countries use backward technology as compared to the develope
d countries. As a result their relative productivity is low, cost ratios are hig
h, and price structure is also relatively high. This leads to the adverse terms
of trade for the poor country, placing it at a disadvantageous bargaining positio
n.
(ii) High Population Growth
Most of the less developed countries experience overpopulation and high populati
on growth. As a result, there is high internal demand for the goods and low expo
rtable surplus. Moreover, the import demand of these countries is highly inelast
ic. This causes their terms of trade to fall.
(iii) Lack of Import Substitutes :
Poor countries are greatly dependant on the advanced countries for
and have not developed import substitutes. On the other hand, the
tries are not so much dependant on the poor countries because they
f producing import substitutes. Thus, the poor countries have weak
sition in the international trade.

their imports
advanced coun
are capable o
bargaining po

(iv) Lack of Adaptability :

Unlike, the advanced countries, the less developed countries cannot quickly adap
t their supply of goods which are high in demand and whose prices arc rising. Th

e reasons for this are: backward technology, market imperfections, immobility of

factors of production, etc.
Thus, the terms of trade of less developed countries tend to deteriorate and the
se countries fail to reap gains by increasing their supplies of exports during i
nflation.