relevance of terms of trade

1. TERMS OF TRADE
Prepared by
Dr. Ruchi Sharma

2. MEANING OF TERMS OF TRADE
In economics, terms of trade (TOT) refer to the relationship between how much
money a country pays for its imports and how much it brings in from exports.
When the price of a country's exports
increases over the price of its imports, economists say
that the terms of trade has moved in a positive direction.
The TOT is expressed as a ratio of import prices to export prices.

3. FORMULAE
 Terms of Trade (TOT) = Index of Export Prices / Index of
Import Prices X 100
 Index of export prices =115
 An index of import prices =107
TOT = 115 / 107 X 100 = 107.5

4. • An increase in the terms of trade means that the value of
exports is increasing relative to the value of imports.
• The country can afford to buy more imports with the revenue
from its exports.
• For example, decrease in the price of oil (improves) the
terms of trade for the oil-importing country like India and
lowers it for the exporting countries.

7. NET BARTER TERMS OF TRADE
• Also called commodity terms of trade
• Net barter, terms of trade (N) is the ratio of the price index of
the country’s exports (Px), to the price index of its imports
(Pm), multiplied by 100 (to express the terms of trade in
percentages).

8. • N = (Px/Pm) 100
• For example, if we take 2010 as the base year , and we find
that by the end of 2012, the nation’s Px fell by 5% (to 95),
while its Pm rose by 10% (to 110), then this country’s
commodity terms of trade declined to
• N = (95/110) 100 = 86.36
• This means that between the net barter terms of trade have
become unfavourable. As against nation’s export in 2010, the
exports in 2012 get 14% less imports.

9. CRITICISM OF NET BARTER TERMS OF
TRADE
• Problem in construction of index numbers
• Neglect of qualitative changes
• Misleading
• Faulty index of gains from trade
• Short period of time
• Neglect of factors affecting prices

10. GROSS BARTER TERMS OF TRADE
• The gross barter term of trade is a ratio of total physical
quantities of imports to the total physical quantities of
exports of a given country.
• Given the above definition, the gross barter terms of
trade in case of particular commodities can be
measured at a point of time through the formula given
below:
• TG = (QM/QX) × 100

11. CONTINUED…
• Higher the magnitude of TG over 100, better are the gross barter terms
of trade. It implies that the country can import larger quantities from
abroad for the given quantities exported to other countries and vice
versa if TG is less than 100.

12. • If the balance of trade of a country is in a state of balance and the total receipts from
export of goods are exactly equal to the payments for import of goods, the net barter
terms of trade will be equal to the gross barter terms of trade.
• Total Receipts from Exports = Total Payments for Imports

13. Given the quantity indices of imports and exports as 100 each in the base year 2010 and
184 and 230 respectively in the current year 2015, the gross barter terms of trade have
turned unfavourable for the given country-

14. CRITICISM OF GROSS BARTER TERMS OF
TRADE
• Aggregation of Goods, Services and Capital Transactions
• Faulty Index ofWelfare
• Neglect of Productivity
• Neglect of Qualitative Changes
• Neglect of Capital Movements

15. INCOME TERMS OF TRADE
• This concept is an improvement upon the net barter terms of
trade.
• It takes into account the indices of export and import prices
and quantity index of exports.
• The income terms of trade are determined by the product of
net barter terms of trade and the quantity index of exports.

17. •A rise in the income terms of trade implies that
a country can import more goods in exchange
of its exports and vice-versa.

18. • The capacity to import of a
country will increase if there is:
(i)A rise in export prices,
(ii) A rise in quantity exported, and
(iii) A fall in the prices of imports
and vice versa.

19. • This concept of terms of trade has great relevance for the less developed countries.
In these countries, the capacity to import is low on account of lower export prices
and quantities of goods exported, while the prices of imports are relatively higher.

20. CRITICISM OF INCOME TERMS OF TRADE
• Not an Accurate Measure of Gain from Trade
• Not a Measure of Total Import Capacity
• Cannot Replace the Commodity Terms of Trade
• Misleading Indicator ofWelfare Gain

21. SINGLE FACTORAL TERMS OF TRADE
• S = (Px/Pm) Zx where Zx is a productivity index in the country’s export sector.
Thus, S measures the amount of imports the nation gets per unit of domestic factors of
production included in its exports.

22. SINGLE FACTORIAL TERMS OF TRADE

23. SINGLE FACTORIAL TERMS OF TRADE
•

24. CRITICISM OF SINGLE FACTORIAL TERMS
OF TRADE
• Difficulty in the Measurement of Productivity
• Not a Reliable Index of Gain from Trade
• Increase in Global Inequalities
• Neglect of Increase in Productivity in Foreign Countries

25. DOUBLE FACTORAL TERMS OF TRADE
• The concept of double factoral terms of trade, formulated by
Jacob Viner takes into account the change in factor
productivity both in the domestic export industries and
export industries of the foreign countries.
• This concept can be expressed as:
• TD = TC . (ZX/ZM)

26. Thus the double factoral terms of trade show an improvement by 37.50 percent over the given
period.
• In this illustration, the commodity terms of trade indicate an improvement by only 6.25
percent.170/160*100=106.25
• The single factoral terms of trade show a much substantial improvement in terms of trade by
87 percent [TS = (PX/PM) . ZX = (170/160) × 176 = 187].

27. CRITICISM OF DOUBLE FACTORAL TERMS
OF TRADE
• Measurement of Productivity
• Misplaced Emphasis
• Faulty Concept
• Difficulty in the Determination of Gains from Trade
• Neglect of Real Costs

28. THE REAL COST TERMS OF TRADE
• The increased production of export good requires
the diversion of productive resources from other
sectors to the export sector.
• The amount of utility lost or sacrificed per unit of
resources employed in the production of export
good constitutes the real cost of producing exports.

29. THE REAL COST TERMS OF TRADE
• The real cost terms of trade can be measured by multiplying the single factoral terms
of trade by the index of the amount of disutility (pain, sacrifice etc.,) per unit of the
resources employed in producing export goods.
• Tr = Ts . Rx
Given the single factoral terms of trade, the increase in RX will cause the worsening of the real
cost terms of trade (TR) and vice-versa.

30. CRITICISM OF THE REAL COST TERMS OF
TRADE
• Subjective Concept
• Neglect of Real Cost of Diverting Domestically Consumed Goods to Exports
• Neglect of Real Cost of Producing Import- Substitutes

31. THE UTILITY TERMS OF TRADE
• The utility terms of trade index is calculated by multiplying the real cost terms of
trade index with an index of the relative average utility of imports and of domestic
commodities foregone.
• If we denote the average utility by u and the domestic commodities whose
consumption is foregone to use resources for export production by a,
• Then u = Um1/Ua1 / Um0/Ua0 where u is the index of relative utility of imports and
domestically foregone commodities.
• Tr = Ts . Rx .u

32. CRITICISM OF THE REAL TERMS OF TRADE
• Since the real terms of trade index involves the
measurement of disutility in terms of pain and
sacrifice, this is an elusive concept. As a matter of
fact, it is not possible to measure disutility (for utility)
in concrete terms.

33. • Hence like the single and double factoral terms of
trade concepts, the concepts of real and utility terms
of trade are of little practical use. They are only of
academic interest. That is why the concepts of the
commodity terms of trade and of income terms of
trade have been used in measuring the gains from
international trade in developed as well as
developing countries.

34. FACTORS INFLUENCING TERMS OF TRADE
1.Reciprocal Demand:The terms of trade of a country depend upon
reciprocal demand, i.e. the strength and elasticity of each country's demand for the
other country's product.
• Example: 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.

35. FACTORS INFLUENCING TERMS OF TRADE
2.Changes in Factor Endowments: If there is an increase in
the supply of labour in country A, specialising in the production
of labour-intensive commodity cloth, while factor endowments
in country B remain unchanged, the fall in labour 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 unfavourable to A.

36. FACTORS INFLUENCING TERMS OF TRADE
3.Changes in Technology: 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 labour- saving in this
labour- intensive export sector (cloth industry) there will be worsening of the terms of
trade
4.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 favourable to country A.

37. FACTORS INFLUENCING TERMS OF TRADE
5.Effect of Economic Development on terms of trade
6.Tariff: The tariffs or import duties improve the terms of trade for the tariff-
imposing country
7.Devaluation
8.Availability of substitutes

38. PRINCIPLE OF RECIPROCAL DEMAND
• The actual ratio at which commodities are transacted
between two countries depends crucially upon the
strength and elasticity of each country’s demand for
the product of the other or the reciprocal demand.

39. ASSUMPTIONS OF THE THEORY
i) The trade takes place between two countries, A and B.
(ii) The trade is in two commodities, X andY.
(iii) In both the countries, the production is governed by constant return to scale.
iv) The trade between two countries is governed by the principle of comparative costs.
(v) The pattern of demand is similar in two countries.
(vi) There are perfectly competitive conditions in the market.
(vii) There is no restriction on trade and government follows a policy of laissez faire.

40. ASSUMPTIONS OF THE THEORY
viii) There is full employment of resources in both the countries.
(ix) There is an absence of transport costs.
(x) The exports of each country are sufficient to pay for its imports.

41. EXPLANATION
• India and Nepal are entering into trade
• Cost ratio of rice and wheat in India =1:1
• Cost ratio of rice and wheat in Nepal is 1 unit of rice =2units of wheat
• India has absolute advantage in production of both but greater comparative
advantage in production of rice.
• Nepal produces wheat and India produces rice.

42. India’s demand for wheat
LESS ELASTIC
Will be ready to accept little
more than 1 unit of wheat(1.1 or
1.2) in exchange of 1 unit of
rice
MORE ELASTIC
Will be ready to accept little less
than 2 units of wheat(1.8 or 1.9)
in exchange of 1 unit of rice
Cost ratio =1:1

43. Nepal’s demand for Rice
LESS ELASTIC
Will be ready to accept little
more than 1 unit(1.1 or 1.2) of
rice in exchange of 2 units of
wheat
MORE ELASTIC
Will be ready to accept little less
than 2 units of rice (1.8 or 1.9) in
exchange of 2 units of wheat
Cost ratio =1 unit of rice :2 units of wheat

44. SCHEDULE OF TRADE PROPENSITY OF
INDIA

45. OFFER CURVE OF INDIA

46. Nepal expects more and more units of rice in exchange of wheat .So upward
sloping offer curve at increasing rate.

47. DETERMINATION OF ACTUAL TERMS OF
TRADE

48. CRITICISMS TO MILL’S THEORY OF RECIPROCAL
DEMAND:
• (i) The theory is based on unrealistic assumptions, such as perfect competition and
full employment.
• ii) Actual trade is not restricted to two country, two commodity model.
• (iii) Mill concentrates on the elasticity of demand, thus neglecting the impact of
elasticity of supply. According to the modem economists, terms of trade are generally
influenced by- (a) elasticity of demand for exports, (b) elasticity of demand for
imports, (c) elasticity of supply exports, and (d) elasticity of supply of imports.

49. CONTINUED…
• (iv) Graham has criticised the reciprocal demand aspect of Mill’s theory. It has
exaggerated the role of reciprocal demand and neglected the comparative cost
conditions in determining the terms of trade.
• (v) Jacob Viner has criticised the theory as imperfect and inadequate.
• (vi) Shadwell has criticised the theory by saying that in this theory the exchange
ratio is fixed at a point where the value of imports and exports are in equilibrium as a
mere truism. It does not throw any light on the determinants of terms of trade.