PART II: AGRICULTURAL POLICY AND AGRICULTURAL MARKETS
2 The concept and measurement of 'terms of trade'
In textbooks on agricultural economics, price parity is measured using a price ratio that measures the purchasing power of a unit of agricultural output in terms of other goods and services.
The concept of price parity and the related concepts of income parity or a 'fair' exchange of goods and services have a long history in the agricultural policy of many countries.2 Therefore, it comes as no surprise that these concepts have been the focus of much attention in economics.
The economic concept behind the notion of parity is the terms of trade (ToT) (H EN-RICHSMEYER & WITZKE, 1991, p. 185). Parity and ToT are very closely related. Essentially, main-taining price parity is equivalent to mainmain-taining constant ToT, and those who complain about price disparity in Ukrainian agriculture are complaining about declining agricultural ToT. In the follow-ing, we discuss several different ToT indices and their implications.
1 These Laws are "On Prices and Pricing" (art. 3); "On the Priority of Social Development in Rural Communities and the Agroindustrial Complex in the National Economy" (art. 1); and "On a Collective Agricultural Enterprise" (art. 15).
2 See HANAU (1952) and SEROVA (1999).
2.1 Commodity terms of trade
The simplest and the most widespread ToT index is the so-called Commodity Terms of Trade (CToT). The CToT of a given sector is defined as the ratio of that sector's output price index to an index of its input prices:
I O
I I
P
CToT = P (1)
where
IO
P = price index for the industry's output, and
II
P = price index for the means of pro-duction and other resources employed by the industry (HENRICHSMEYER & WITZKE, 1991).
The CToT is easy to compute and the required statistical data is easily available in many countries. This accounts for its frequent use in empirical studies. The CToT simply shows how much faster (CToT increasing) or how much slower (CToT decreasing) agricultural output prices are increasing compared with the prices of input commodities used for the purpose of agricultural production.3
However, the CToT is far from being perfect. Its fall or rise does not automatically entail a deterioration or improvement in the purchasing power of the investigated industry because it does not account for quantity changes that might be counteracting price changes. For instance, a decline in an industry's CToT could be coupled with increased sales of that industry's output, and the com-bined effect of falling prices and increasing output could very well be to increase overall proceeds (HENRICHSMEYER & WITZKE, 1991, p. 185). Similarly, the CToT does not account for changes in productivity. It could be that as the CToT falls, for example, producers are learning to produce more units of output per unit of input, leading to a net increase in profits.
Thus, two important conclusions can be drawn with regard to the CToT index: a) the CToT is, by definition, identical to the notion of price parity as it is most commonly used in political dis-cussions, and b) the CToT measures the purchasing power of a unit of an industry's output, not the purchasing power of that industry itself. The CToT is only an indirect indicator of the latter.
2.2 Income terms of trade
The shortcomings of the CToT are partially overcome by the Income Terms of Trade (IToT) concept. An industry's IToT is equal to its CToT multiplied by an index of that industry's output.
I O O O I O
I Q I Q I I
P I I P
P x
IToT P ×
=
= (2)
whereIQO = an index of the industry's output of finished goods, and all other symbols are as in (1).
The IToT measures changes in the amount of inputs that an industry can purchase using its total revenue (the numerator in equation (2)). Therefore, as opposed to CToT, the IToT is a direct indicator of the dynamics of an industry's purchasing power. However, the IToT still suffers from the weaknesses that it does not take productivity changes into account. For example, in order to make output grow it could be that the industry has used proportionately more inputs, leading to a net reduction in profitability even as the IToT increases.
3 Generally, a base year is set equal to 100, so a CToT greater (less) than 100 indicates that the purchasing power of a unit of output measured in units of input has increased (decreased) since the base year.
2.3 Factoral terms of trade
In order to make a more realistic assessment of the dynamics of the purchasing power and competitiveness of an industry, the CToT index can be multiplied by a productivity index or ratio of productivity indices, leading to the so-called Factoral Terms of Trade (FToT) concept. Both Dou-ble Factoral Terms of Trade (DFToT) and Single Factoral Terms of Trade (SFToT) can be con-sidered.
The DFToT index equals the product of the CToT and a ratio of productivity indices between the industry in question and the industries that manufacture the inputs consumed by this industry:
I O I I x P DFToT P
I O
a
= a (3)
whereaO = an index of the productivity of the investigated industry,aI = an index of the productivity of the manufacture of inputs consumed by the investigated industry, and all other sym-bols are as in equation (1).
Given the difficulties involved in collecting statistical data on the productivity of input manufacture, it is often much simpler to make use of the SFToT, which only takes into account the productivity index of the investigated industry (HENRICHSMEYER & WITZKE, 1991):
O I I x P SFToT P
I
O a
= (4)
Productivity measures how effectively an industry is making use of its inputs such as land, animals, labour, material and technical resources and finance. Changes in productivity can make it possible for farms to absorb the impact of falling CToT without suffering corresponding reductions in profitability. As a stylised example, while it may require 10 times more wheat (output) to pur-chase one tractor (input) today than it did 50 years ago (declining CToT), this would be compen-sated (overcompencompen-sated) by the fact that it is possible to produce 10 or 12 times as much wheat with one tractor today than was the case 50 years ago.
Indeed, as is discussed below, changes in productivity are actually a driving force behind changes in CToT over time. Productivity growth goes hand in hand with progress in science and technology, which is a critical factor in long-term agricultural growth (LELE & MELLOR, 1989;
CORNELIS & VAN DER MEER, 1989).
2.4 An illustrative comparison of the different terms of trade indices and their implications
The results of computing different ToT indices can be illustrated by the following example (see table 1):
It is assumed that all indices equal 1 in the base period t = 0. By t = 1, the prices of outputs in the industry in question have grown with respect to this base period by 10% (PIo = 1.1), while the prices of inputs consumed by this industry have grown by 20% (PIo = 1.2). Since it is also assumed that output and productivity remain unchanged between t = 0 and t = 1, we see that all 3 ToT indices are identical in t = 1 and that the industry's purchasing power has fallen by 8% relative to t = 0.
It is assumed that by t = 2 output prices have declined with respect to the base period by 5%, while input prices have grown by 20% (i.e. the former have declined since t = 1 while the latter have remained constant). It is also assumed that over the same period output has grown by 22%, while input use has fallen by 8% so that the productivity index has increased to (roughly) 1.3.
Table 1: A comparative illustration of different terms of trade concepts Period Index values with respect to
the base period ToT index
t = 0
1 1 1
1
=
=
=
=
O Q
I I
O I O
I P P
a
1 1 1=
= CToT
1 1 1
1 =
= x IToT
1 1 1
1 =
= x SFToT
t = 1
1 1
2 . 1
1 . 1
=
=
=
=
O QO
II IO
I P P
a
92 . 2 0 . 1
1 . 1 =
= CToT
92 . 0 2 1
. 1
1 .
1 =
= x IToT
92 . 0 2 1
. 1
11 =
= x SFToT
t = 2
3 . 1
22 . 1
2 . 1
95 . 0
=
=
=
=
O QO
I I IO
I P P
a
79 . 2 0 . 1
95 .
0 =
= CToT
97 . 0 22 . 2 1 . 1
95 .
0 =
= x
IToT
03 . 1 3 . 2 1 . 1
95 .
0 =
= x
SFToT
Source: Own presentation.
Based on the CToT index (the price parity index) one might conclude that the industry as a whole is worse off in t = 2 since the CToT parameter in this period (0.79) is considerably lower than in t = 1. A look at the other indices (IToT and SFToT) indicates that this conclusion is wrong. In fact, when increases in output and productivity are taken into account it becomes clear that the pur-chasing power and the profitability of the industry have increased in comparison to t = 0.