LDCs mostly specialize in producing and exporting primary commodities (because this is their comparative advantage), but this may cause declining terms of trade (ToT). The ToT are the price of a county’s exports relative to the price of its imports:
Recent empirical studies suggest that real primary product commodity prices have declined at an average annual rate of 0.6% since 1900. As the Prebisch-Singer hypothesis posits, primary commodity exporters suffer declining ToT due to the differences in the income elasticity of demand (YεD) between primary commodities and manufacture goods. Primary commodities have a low inelastic YεD (due to Engel’s law), whilst manufacture goods have a high elastic YεD. Thus, as world incomes rise, the demand (and hence price) of manufacture goods rise faster than that for primary commodities. The declining ToT causes primary commodity exporting LDCs’ current account to deepen into a deficit (as the value of manufacture imports rise contrasted to the value of primary exports falling) and consequently world income distribution skews further towards developed economies.
A way to overcome declining ToT is for LDCs to adopt an import substitution industrialization strategy to allow manufacture goods to be domestically produced and relieve the necessity and repercussions of exporting primary commodities.
However, declining terms of trade may not be a major constraint on development because: – LDCs could export primary commodities that have a high income elasticity of demand like diamonds. – An LDC could still develop by specializing in primary exports, for example Canada (timber and wheat). – Maybe commodity prices will rise if the world’s population grows fast enough and demand for food increases more rapidly than demand for manufacture goods.