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Home Theory of International Trade Terms of Trade

Terms of Trade:

 

Definition/Meaning and Explanation:

 

By terms of trade, is meant terms or rates at which the products of one country are exchanged for the products of the other. It is known to us that every country has got its own money. The currency of one country is not legal tender in the other country. So every country has to export commodities in order to import goods.

 

"The rate at which given volume of exports Is exchanged for a given quantity of imports is called the commodity terms of trade".

 

The rate of exchange or the term of exchange depends upon the elasticities of the demand of each country for the products of the other.

 

For instance, if Pakistan's demand for Indian's wheat is much more intense than Indian's demand for Pakistan's cotton, the terms of trade will be more favorable to India than to Pakistan. This is because Pakistan's demand for India's wheat is highly inelastic while India's demand for Pakistan's cotton is highly elastic.

 

The country which is more eager to sell or purchase stands at disadvantage in the bargain. In the words of Taussing:

 

"That country gains more from international trade whose exports are more in demand and which itself has little demand for the things it imports, i.e., for the exports of the other countries, that country gains least which has the most insistent demand for the products of the other country".

 

That terms of trade are measured by the ratio of import prices to export prices. The terms of trade will be favorable to a country when the export prices are high relatively to import prices. This is because the products of one unit of domestic resources will exchange against the product of more than one unit of foreign exchange. If, on the other hand, the prices of its imports rise relatively to the prices of its exports, the terms of trade will be unfavorable to the country.

 

Equation/Formula:

 

The terms of trade can be expressed in the form of equation as such:

 

Terms of Trade = Price of Imports and Volume of Imports

                                                                Price of Exports and Volume of Exports

 

The terms of trade are of economic significance to a country. If they are favorable to a country, it will be gaining more from international trade and if they are unfavorable, the loss will be occurring to it. When the country's goods are in high demand from abroad, i.e., when its terms of trade are favorable, the level of money income increases. Conversely, when the terms of trade are unfavorable, the level of money income falls.

Measurement of Change in Terms of Trade:

 

The changes in terms of trade can be measured by the use of an import and export index number. We here take only standardized goods which have internal market and give them weight according to their importance in the international transactions. A certain year is taken as base year and the average of the countries import and export prices of the base year is called 100. We then work out the index of subsequent year. These indices then show as to how the commodity terms of trade move between two countries. The ratio of exchange in export prices to the change in import prices is put in the form of an equation as under:

 

Commodity Terms of Trade = Change in Export Prices

                                                                                      Change in Import Price

Algebraically, it can be expressed:

 

Te = Px1 Pm1

                                                                             Pxo   Pmo

 

Here:

 

Te Represents commodity terms of trade.

 

Px1 Represents export price index for the required year.

 

Px Represents exports price index of the base year.

 

Pm1 Represents indices of prices of the required year.

 

Pm Represents indices of prices for the base year.

 

We now apply the above formula by taking a specific example. We take the indices of export and import prices for the year 1982 as 100. We assume also that the export prices index for the year 1982 is 330 and import prices index 380. The ratio of change in export prices to the change in import prices will be:

 

Te = 300 380

                                                                              100    100

 

Te = 330 x 300

                                                                              100    380

 

Te = 0.87

                                                         

The above example shows that the prices of imports have increased more than the exports prices. The terms of trade are unfavorable to the country by 13%. In other words, the country has to pay 13% more for a given amount of imports.

 

Income Terms of Trade:

 

It is the desire of every country that it should earn the maximum of income out of international exchange by taking permanent favorable terms of trade. In order to secure maximum gain, the country will try to increase the volume and value of exports and reduce the volume of imports and buy it also from the cheapest market. If the country is having a monopoly in the supply of a commodity and the demand for products is inelastic, then it can fetch more income. Incase the terms of trade move

against the country, then there will be drain of national income, the commodity terms of trade depend upon the following factors:

 

(i) Ratio of import prices to export prices.

 

(ii) The volume and value of exports and imports.

 

(iii) The condition attached to export and import such as insurance charges, supply of machinery and shipping, etc.

 

If the terms of trade are favorable which may be due to monopolistic supply or inelastic demand or cheap and better kind of exports, etc., the terms of trade will be favorable and the national income will rise. In case of terms of trade are unfavorable over a period of time, the national income will fall.

Relevant Articles:

Home Trade and International Trade
Foreign Trade and National Income
Origin and Purpose of International Trade
Theory of Comparative Cost
Gains From International Trade
Modern Theory of International Trade
Terms of Trade
Advantages and Disadvantages of International Trade
 

Principles and Theories of Micro Economics
Definition and Explanation of Economics
Theory of Consumer Behavior
Indifference Curve Analysis of Consumer's Equilibrium
Theory of Demand
Theory of Supply
Elasticity of Demand
Elasticity of Supply
Equilibrium of Demand and Supply
Economic Resources
Scale of Production
Laws of Returns
Production Function
Cost Analysis
Various Revenue Concepts
Price and output Determination Under Perfect Competition
Price and Output Determination Under Monopoly
Price and Output Determination Under Monopolistic/Imperfect Competition
Theory of Factor Pricing OR Theory of Distribution
Rent
Wages
Interest
Profits
Principles and Theories of Macro Economics
National Income and Its Measurement
Principles of Public Finance
Public Revenue and Taxation
National Debt and Income Determination
Fiscal Policy
Determinants of the Level of National Income and Employment
Determination of National Income
Theories of Employment
Theory of International Trade
Balance of Payments
Commercial Policy
Development and Planning Economics
Introduction to Development Economics
Features of Developing Countries
Economic Development and Economic Growth
Theories of Under Development
Theories of Economic Growth
Agriculture and Economic Development
Monetary Economics and Public Finance
History of Money

 

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