Are the terms of trade for primary product-based economies falling?

Why do some countries manage to capitalise being primary product-based economies while others flounder and fall behind those who have taken the manufacturing route?

In Africa, Ghana, Kenya, and many other nations specialise in primary products. Kenya’s exports include tea, coffee, cut flowers, and agriculture. According to trading economics reports “Kenya’s Imports of goods and services as a percentage of GDP in 2021 was 20.16 per cent whilst exports of goods and services as a percentage of GDP stood at 11.26 percent.”

While some developing nations have opened up their borders for trade thereby taking advantage of opportunities presented by economic development, many have not and, are instead taking measures by balkanising trade borders. The question to ask is “are terms of trade of primary product-based economies deteriorating?”

In economics, the Prebisch Singer hypothesis argues that the price of primary commodities declines relative to that of finished goods over the long-term. This causes the terms of trade of primary product-based economies to decline. Is this what we are witnessing in Kenya and other primary product-based economies?

As of 2013 recent statistical studies have given modern support for the idea. The idea was initially developed by Hans Singer in 1948-49 and expanded by Raul Prebisch shortly thereafter. Since then it has served as a major pillar of dependency theory and policies such as import substitution industrialisation. A common explanation for this supposed phenomenon is that manufactured goods have a greater income elasticity of demand than primary goods, especially food.

Therefore, as incomes rise, the need for made goods increases more rapidly than the demand for primary products. In addition, primary products have a low price elasticity of demand so a decline in their prices tends to reduce revenue, rather than increase it.

This theory implies that the very structure of the global market is responsible for the persistent inequality within the world system. This provides an interesting twist on the new market's interpretation of the global order, which faults difference in the power relations between core and periphery states as a chief cause for economic and political inequality.

Developing nations

However, the Prebisch Singer theory also works with different bargaining positions of labour in developed and developing nations. The hypothesis enjoyed a high degree of popularity in the 1960s and 1970s with neo-Marxist developmental economics and even provided a justification for an expansion of the role of commodity, futures exchange as a tool for development.

 Singer and Prebisch noted a similar statistical pattern in long-run historical data on relative prices but such regularity is consistent with a number of different explanations and policies stances. Later in his career, Raul Prebisch argued that due to the declining balance of trade, developing countries tried to have a diversified economy and lessen dependence on primary commodity exports by developing the manufacturing sector.

The hypothesis has lost some relevance in the last 30 years as exports of simple manufactures have overtaken primary commodities exports in most developing countries. Much of the recent research focuses less on the relative sizes of primary products and manufactured goods and more on the relationship between the prices of simple manufactured items produced by developing countries and of complex manufactured commodities made by advanced nations.

The Prebisch Singer hypothesis argues that the prices of primary commodities will decline over time relative to manufactured goods, which leads to a decline in terms of trade for developing countries. This is because developing countries are usually the exporter of primary products and developed nations are the producers and exporters of finished goods.

International trade

 However, through this relationship, Prebisch and Singer focused on the rising per capita income gap between developing and developed world arising due to international trade.

According to them, due to the static specialisation in the production of primary commodities, the developing world has been excluded from enjoying the fruits of technological progress, mainly found in industrial relations.

They based these of three facts. First, developing countries specialise in the production and export of primary commodities. This is evident in Kenya as the leading revenue from exports is horticulture and tea.

Industrialised countries such as the United States, China, Japan, European Nations, and many others specialise in production and export of finished products. Technical progress is mainly concentrated in industries. Terms of trade of primary goods relative to manufactured goods have declined since the 19th Century.

Austrian economist Ludwig Von Mises said “manufacturing and commercial monopolies owe their origin not to a tendency imminent in a capitalist economy but to governmental interventionist policy directed against free trade and laissez-faire.” Due to these facts developing countries have failed to benefit from the technical progress and have suffered from declining terms of trade.

The classical economists, however, had an exactly opposite approach to what was conceived by Prebisch and Singer. They thought that primary products will over time experience a rise in terms of trade relative to manufactured goods.

Diminishing returns

They based their argument on the basis that diminishing returns operate in primary products while production and manufactured items experience increasing returns. Also, the technical progress in manufacturing will exceed that of primary products and hence the supply of manufactured products will grow faster than the supply of primary commodities.

The Prebisch Singer hypothesis has generated much debate and many economists such as Gerald Meier, Robert Baldwin, and others criticise the theory on the grounds that it will be reasonable to treat the relative prices of goods as equivalent to terms of trade.

Developing countries do not export only primary goods and developed countries do not only specialise in manufactured goods. Commodity prices cannot be treated as synonymous with terms of trade.

Policymakers must focus on avenues to make the economy thrive and ensure maximum utilisation of resources for the best returns. They must encourage manufacturers to set bases in their nations and to build up their products from raw form to finished products using progressive value-addition chains.

Ritesh Barot is a business and financial analyst