Do terms of trade have to worsen for developing countries? How low-income elasticity of demand affects the terms of trade in a laboratory market, in combination with the effect of market power.

Abstract

A laboratory economy was created to test the influence of both market power and low income elasticity of demand on the terms of trade. The Prebisch-Singer "Theory of Unequal Exchange" predicts that terms of trade worsen for developing countries, due to low income elasticity of demand for their primary product exports. A model is presented to show that, ceteris paribus, the terms of trade improve with population growth and differential technological progress. The effect of market power on the terms of trade was analyzed by comparing a 'competitive' market, a primary commodity cartel, and an industrial monopoly. The competitive (price taker) model predicts declining prices in both markets and worsening terms of trade as production grows. The cartel model predicts higher prices of the primary product, which increase as income grows, lower prices of the manufactured product, and better and improving terms of trade. The monopoly model predicts lower prices for primary commodities, higher and increasing prices in the market for manufactured products, and lower and worsening terms of trade. Experimental results. Trading occurred in a multiple-unit double auction. Prices usually converge from above in both markets. Only sellers succeed in exploiting their market power, buyers fail to do so. In the competitive design, prices in both markets generally converge to the competitive equilibrium. The terms of trade worsen in all experiments as income grows (caused by the low income elasticity of demand), confirming the prediction of the Prebisch-Singer model. The commodity cartels increase primary export prices, but cannot stop the decline of prices when income increases. They cannot decrease prices of the manufactured product. Terms of trade for the cartels are usually better and do not always worsen. Earnings of industrialized countries facing the cartel are lower than competitive, but earnings of the cartel members are not significantly higher. The single industrial country fails to lower prices for primary products, but can charge higher prices for manufactured products. Terms of trade usually improve as income grows, contradicting both the competitive and the cartel model. When the monopoly faces a cartel, a substantial deadweight loss occurs.