Terms of Trade - Meaning
How the gain from international trade would be shared by the participating countries
depends upon the terms of trade.
The terms of trade refer to the rate at which one country exchanges its goods for the
goods of other countries.
Thus, terms of trade determine the international values of commodities.
Obviously, the terms of trade depend upon the prices of exports a country and the
prices of its imports.
When the prices of exports of a country are higher as compared to those of its
imports, it would be able to obtain greater quantity of imports for a given amount of
In this case terms of trade are said to be favorable for the country as its share of gain
from trade would be relatively larger
Concepts of Terms of Trade
Net Barter Terms of Trade
The most widely used concept of the terms of trade is what has
been caned the net barker terms of trade
which refers to the relation between prices of exports and prices of
In symbolic terms: Tn = Px/Pm
Where Tn stands for net barter terms of trade.
Px stands for price of exports (x),
Pm stands for price of imports (m).
Gross Barter Terms of Trade
This concept of the gross terms of trade was introduced by F.W.
Taussig and in his view this is an improvement over the concept of
net barter terms of trade as it directly takes into account the volume
Accordingly, the gross barter terms of trade refer to the relation of the
volume of imports to the volume of exports.
Thus, Tg = Om/Qx
Where Tg = gross barter terms of trade,
Qm = quantity of imports
Qx = quantity of exports
Income Terms of Trade
In order to improve upon the net barter terms of trade G.S. Dorrance
developed the concept of income terms of trade which is obtained by
weighting net barter terms of trade by the volume of exports. Income
terms of trade therefore refer to the index of the value of exports
divided by the price of imports. Symbolically, income terms of trade
can be written as
Ty = Px.Qx/Pm
Where Ty = Income terms of trade
Px = Price of exports
Qx = Volume of exports
Pm= Price of imports
1. Reciprocal Demand
The reciprocal demand signifies the intensity of demand for the
product of one country by the other. If the demand for cloth,
exportable commodity of country A, is more intense (or inelastic) in
country B, the latter will offer more units of steel, its exportable
product, to import a given quantity of cloth. On the contrary, if the
demand for cloth in country B is less intense (elastic), then B will
offer smaller quantity of steel to import the given quantity of cloth.
When a country imposes tariffs on imports from the foreign
country, it implies a lesser willingness to absorb the foreign products.
It means the reciprocal demand in the tariff imposing country for
the foreign product has got reduced.
The tariffs or import duties are, therefore, likely to improve the
terms of trade for the tariff- imposing country.
The tariff will improve the terms of trade for the tariff-imposing
country, if the elasticity of offer curve of the other country is more
than unity but less than infinity.
If the foreign country B imposes retaliatory tariff of the equivalent
or relatively larger magnitude, the effect of imposition of tariff by the
first country A may get off-set or more than off-set.
3. Changes in Tastes
The terms of trade of a country may also be affected by the changes
in tastes. If tastes or preferences of the people in country A shift from
the product Y of country B to its own product X, the terms of trade
will become favorable to country A. In an opposite situation, the
terms of trade will turn against this country.
4. Changes in Factor Endowments
If there is an increase in the supply of labor in country A,
specializing in the production of labor-intensive commodity cloth,
while factor endowments in country B remain unchanged, the fall in
labor cost will lower the price of cloth. Consequently, more quantity
of cloth will be offered by country A for the same quantity of steel
resulting in the terms of trade becoming unfavorable to A. If labor
becomes scarcer in this country, the terms of trade are likely to
become favorable for it.
5. Changes in Technology
The terms of trade of a country get affected also by the changes in
techniques of production.
As there is technological improvement in the home country, say A,
there is rise in productivity and/or a fall in the cost of producing
exportable commodity, say cloth.
If the technological progress is labor-saving in this labor-intensive
export sector (cloth industry) there will be worsening of the terms of
trade as the offer curve of country A will shift to the right.
6. Economic Growth
The economic growth involves a rise in real national product or
income of a country over a long period.
As growth takes place, there is an expansion in the productive
capacity of the country. The increased productive capacity may result
from the increased supply of productive factors.
It is supposed that there are two countries A and B. The former is
the labor-abundant home country and cloth is its exportable product,
which is labor-intensive.
Steel, the capital-intensive commodity, is its importable product
from the foreign country B. The offer curves of two countries are
Devaluation is the reduction of the value of home currency in
relation to the value of foreign currency.
Since devaluation causes a lowering of export prices relative to
import prices, the terms of trade are supposed to get worsened after
devaluation of the home currency.
8. Balance of Payments Position
If a country is faced with a deficit in balance of trade and payments
and it has to adopt measures intended to restrict import and enlarge
exports such as internal deflation, devaluation, import and exchange
controls, the terms of trade are likely to get worsened.
On the opposite, a trade and payments surplus may be tackled
through the exchange appreciation and reflationary policies. As a
consequence, the terms of trade may get improved.
9. International Capital Flows
An increased flow of capital from abroad involves larger demand
for the products of the creditor country and consequent rise in the
prices of imported goods.
The rise in prices of imports relatively to the prices of exports
causes deterioration in the net barter terms of trade.
When the borrowing country makes repayments of outstanding
loans, there is outflow of capital. In order to get hold of required
foreign currencies for making repayments, there may be sale of
home-produced goods at rather low prices.
The fall in export prices relative to import prices will again result in
the deterioration in the net barter terms of trade.
10.Nature of Goods
If a country is producing and exporting only primary goods, and
importing manufactured goods, the terms of trade will be
11. Size of Population
An overpopulated country will have larger demand for imports. As a
result, the terms of trade will tend to be unfavorable in this case
relative to the under populated or optimally populated country
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