Terms of Trade, Example, Concepts, Critical Evaluation

Terms of Trade refer to the ratio of export prices to import prices. It represents the amount of goods and services that a country can import per unit of export. In other words, it measures the purchasing power of a country’s exports in relation to its imports.

The terms of trade are calculated by dividing the price of a country’s exports by the price of its imports. If the terms of trade are improving, it means that the price of exports is increasing at a faster rate than the price of imports. This would enable a country to buy more imports with the same amount of exports. On the other hand, if the terms of trade are deteriorating, it means that the price of imports is increasing at a faster rate than the price of exports. This would lead to a decline in the purchasing power of exports.

The terms of trade have significant implications for a country’s economy. If a country’s terms of trade are improving, it can boost the country’s export earnings and help to reduce its trade deficit. On the other hand, if the terms of trade are deteriorating, it can make it more difficult for the country to pay for its imports and can lead to a worsening of its trade balance.

Therefore, a country’s government and policymakers closely monitor the terms of trade to understand the country’s economic performance and to make informed decisions about trade policies and exchange rate management.

Formula with Example:

The formula for calculating the terms of trade is:

Terms of Trade = (Export Price Index / Import Price Index) x 100

Where Export Price Index is the weighted average price of a basket of goods that a country exports, and Import Price Index is the weighted average price of a basket of goods that a country imports.

For example, let’s assume that Country A exports three goods: wheat, steel, and cotton, and imports two goods: oil and machinery. The table below shows the prices of these goods in two different years:

Using this data, we can calculate the export price index and the import price index for both years as follows:

Now, using the formula, we can calculate the terms of trade for both years:

Terms of Trade (2019) = ($225 / $264) x 100 = 85.23

Terms of Trade (2020) = ($250 / $272) x 100 = 91.91

These results show that the terms of trade for Country A improved from 2019 to 2020. This means that the country was able to purchase more imports for each unit of exports in 2020 compared to 2019.

Concepts of Terms of Trade

Terms of Trade is an important concept in international trade and economics. The key concepts related to terms of trade are:

• Export price index: The export price index is the weighted average of the prices of goods that a country exports. It is calculated by assigning weights to the prices of different goods according to their share in the country’s total exports.
• Import price index: The import price index is the weighted average of the prices of goods that a country imports. It is calculated by assigning weights to the prices of different goods according to their share in the country’s total imports.
• Terms of trade index: The terms of trade index is the ratio of the export price index to the import price index. It indicates the amount of goods and services that a country can import per unit of export.
• Favorable terms of trade: If the terms of trade improve, it means that the country can buy more imports with the same amount of exports. This is considered a favorable terms of trade, and it is beneficial to the country.
• Unfavorable terms of trade: If the terms of trade deteriorate, it means that the country can buy fewer imports with the same amount of exports. This is considered an unfavorable terms of trade, and it can be detrimental to the country.
• Impact on balance of trade: The terms of trade can have a significant impact on a country’s balance of trade. A favorable terms of trade can increase a country’s export earnings and improve its balance of trade, while an unfavorable terms of trade can lead to a decline in the country’s export earnings and worsen its balance of trade.
• Impact on economic growth: The terms of trade can also affect a country’s economic growth. A favorable terms of trade can lead to an increase in a country’s purchasing power, which can stimulate economic growth. On the other hand, an unfavorable terms of trade can lead to a decline in a country’s purchasing power, which can slow down economic growth.

Net Barter Terms of Trade explanation with formula and example

The Net Barter Terms of Trade (NBTT) is a concept used to measure the relative prices of a country’s exports and imports, taking into account changes in the volume of trade. It measures the ratio of the price of a country’s exports to the price of its imports, adjusted for changes in the relative volumes of exports and imports. The formula for calculating the NBTT is:

NBTT = (Export Price Index / Import Price Index) x (Volume of Imports / Volume of Exports)

Where:

• Export Price Index is the price index of a country’s exports, calculated as the weighted average price of exports.
• Import Price Index is the price index of a country’s imports, calculated as the weighted average price of imports.
• Volume of Exports is the quantity of exports in a given period.
• Volume of Imports is the quantity of imports in a given period.

For example, let’s say Country A exports 100 units of goods at a price of $10 per unit and imports 50 units of goods at a price of $15 per unit. In the next period, Country A exports 120 units of goods at a price of $12 per unit and imports 60 units of goods at a price of $20 per unit. We can calculate the NBTT for both periods as follows:

For the first period:

• Export Price Index = [(100 x $10) / (100 x $10)] x 100 = 100
• Import Price Index = [(50 x $15) / (100 x $10)] x 100 = 75
• Volume of Exports = 100
• Volume of Imports = 50
• NBTT = (100 / 75) x (50 / 100) = 0.67

For the second period:

• Export Price Index = [(120 x $12) / (100 x $10)] x 100 = 144
• Import Price Index = [(60 x $20) / (100 x $10)] x 100 = 120
• Volume of Exports = 120
• Volume of Imports = 60
• NBTT = (144 / 120) x (60 / 120) = 1.2

The results show that the NBTT has increased from 0.67 to 1.2 between the two periods, indicating an improvement in Country A’s terms of trade. This means that Country A can now purchase more imports for each unit of exports.

Gross Barter Terms of Trade explanation with formula and example

Gross Barter Terms of Trade (GBTT) is a concept used to measure the relative prices of a country’s exports and imports. It is the ratio of the price index of a country’s exports to the price index of its imports. The formula for calculating the GBTT is:

GBTT = (Export Price Index / Import Price Index) x 100

Where:

• Export Price Index is the price index of a country’s exports, calculated as the weighted average price of exports.
• Import Price Index is the price index of a country’s imports, calculated as the weighted average price of imports.

For example, let’s say Country A exports 100 units of goods at a price of $10 per unit and imports 50 units of goods at a price of $15 per unit. In the next period, Country A exports 120 units of goods at a price of $12 per unit and imports 60 units of goods at a price of $20 per unit. We can calculate the GBTT for both periods as follows:

For the first period:

• Export Price Index = [(100 x $10) / (100 x $10)] x 100 = 100
• Import Price Index = [(50 x $15) / (100 x $10)] x 100 = 75
• GBTT = (100 / 75) x 100 = 133.33

For the second period:

• Export Price Index = [(120 x $12) / (100 x $10)] x 100 = 144
• Import Price Index = [(60 x $20) / (100 x $10)] x 100 = 120
• GBTT = (144 / 120) x 100 = 120

The results show that the GBTT has decreased from 133.33 to 120 between the two periods, indicating a deterioration in Country A’s terms of trade. This means that Country A can purchase fewer imports for each unit of exports.

Income Terms of Trade (ITOT) is a measure that takes into account changes in a country’s income as well as changes in its terms of trade. It reflects the purchasing power of a country’s exports in terms of its imports. The formula for calculating the ITOT is:

ITOT = (Export Volume Index x Export Price Index) / (Import Volume Index x Import Price Index) x 100

Where:

• Export Volume Index is the index of a country’s export volume, calculated as the ratio of the quantity of exports in the current period to the quantity of exports in the base period.
• Export Price Index is the index of a country’s export prices, calculated as the ratio of the average export price in the current period to the average export price in the base period.
• Import Volume Index is the index of a country’s import volume, calculated as the ratio of the quantity of imports in the current period to the quantity of imports in the base period.
• Import Price Index is the index of a country’s import prices, calculated as the ratio of the average import price in the current period to the average import price in the base period.

For example, let’s say Country A exported 100 units of goods at a price of $10 per unit and imported 50 units of goods at a price of $15 per unit in the base period. In the current period, Country A exported 120 units of goods at a price of $12 per unit and imported 60 units of goods at a price of $20 per unit. We can calculate the ITOT as follows:

• Export Volume Index = (120 / 100) x 100 = 120
• Export Price Index = ($12 / $10) x 100 = 120
• Import Volume Index = (60 / 50) x 100 = 120
• Import Price Index = ($20 / $15) x 100 = 133.33

ITOT = (120 x 120) / (120 x 133.33) x 100 = 90

The result shows that the ITOT has decreased from 100 to 90, indicating a deterioration in Country A’s purchasing power. This means that the country can purchase fewer imports for each unit of exports, taking into account changes in both the prices and quantities of traded goods.

Theory of Reciprocal Demand with example

The Theory of Reciprocal Demand is an economic theory that explains how the terms of trade are determined in international trade between two countries. According to this theory, the terms of trade between two countries depend on the relative demand for each other’s products. Specifically, a country’s terms of trade will improve if it can increase the demand for its exports relative to its imports.

For example, let’s consider a hypothetical scenario where Country A produces wheat and Country B produces cotton. Both countries engage in trade, with Country A exporting wheat to Country B, and Country B exporting cotton to Country A.

If the demand for wheat in Country B is relatively high compared to the demand for cotton in Country A, then Country A would have an advantage in the trade relationship. This is because Country B would be willing to pay a higher price for wheat, and Country A would be able to demand a lower price for cotton. In this scenario, the terms of trade would be favorable for Country A.

However, if the demand for cotton in Country A is relatively high compared to the demand for wheat in Country B, then Country B would have an advantage in the trade relationship. This is because Country A would be willing to pay a higher price for cotton, and Country B would be able to demand a lower price for wheat. In this scenario, the terms of trade would be favorable for Country B.

Therefore, the Theory of Reciprocal Demand suggests that a country’s terms of trade will depend on the relative demand for its exports compared to its imports. Countries that are able to increase the demand for their exports relative to their imports will improve their terms of trade, while countries that are not able to do so will experience a deterioration in their terms of trade.

Critical Evaluation of the Reciprocal Demand Theory

The Reciprocal Demand Theory is one of the oldest and most widely recognized theories of international trade. While the theory provides a simple explanation of how the terms of trade are determined, there are some criticisms that have been leveled against it. Some of the critical evaluations of the theory include:

• Neglects supply-side factors: The Reciprocal Demand Theory only focuses on the demand side of the market and ignores supply-side factors such as production costs and technological advancements. The theory assumes that countries have a fixed supply of goods and that the terms of trade are determined solely by the relative demand for each other’s products. In reality, the production costs and technological advancements play a crucial role in the determination of the terms of trade.
• Does not account for non-price factors: The Reciprocal Demand Theory assumes that the terms of trade are based solely on price differences. However, there are many non-price factors such as quality, brand, and reliability that can influence the demand for a country’s exports. Therefore, the theory overlooks the importance of these non-price factors in determining the terms of trade.
• Does not explain persistent trade imbalances: The theory assumes that the terms of trade will eventually adjust to balance trade between countries. However, persistent trade imbalances have been observed in many cases, which cannot be explained by the theory alone.
• Ignores the role of government: The theory does not consider the role of government policies such as tariffs, subsidies, and trade agreements, which can significantly affect a country’s terms of trade. Government policies can distort the market and result in trade imbalances that cannot be explained by the theory.
• Limited applicability: The Reciprocal Demand Theory may not be applicable to all countries and industries. Some industries may be dominated by a few large producers, making it difficult for smaller countries to increase the demand for their exports.

Determination of Terms of Trade and Offer Curves

The determination of terms of trade and offer curves is a crucial aspect of international trade theory. The terms of trade represent the rate at which two countries exchange goods and services with each other. Offer curves, on the other hand, depict the different combinations of goods that a country is willing to export or import at various terms of trade.

The determination of terms of trade and offer curves can be explained using the following steps:

• Consider two countries, Country A and Country B, that engage in trade with each other. Each country produces two goods, X and Y.
• Assume that the production possibilities of Country A and Country B are as follows:

Country A: Produces 10X and 5Y

Country B: Produces 5X and 10Y

• Assume that the preferences of Country A and Country B are as follows:

Country A: Prefers more of good X and is willing to trade away some of good Y for X.

Country B: Prefers more of good Y and is willing to trade away some of good X for Y.

• Draw the offer curves for Country A and Country B. The offer curve for Country A shows the different combinations of goods that Country A is willing to export or import at various terms of trade. The offer curve for Country B shows the different combinations of goods that Country B is willing to export or import at various terms of trade.
• The point of intersection of the offer curves represents the terms of trade between the two countries. At this point, the rate at which the two countries exchange goods and services with each other is mutually beneficial.
• Changes in preferences, technology, and production possibilities can shift the offer curves, leading to changes in the terms of trade.

The determination of terms of trade and offer curves helps in understanding the gains from trade between two countries. It also helps in analyzing the effects of trade policies such as tariffs, quotas, and subsidies on the terms of trade and welfare of the countries.

Effect of Tariff on Terms of Trade

A tariff is a tax levied by a government on imported goods. Tariffs can have a significant impact on the terms of trade between countries. The effect of tariffs on terms of trade can be explained as follows:

• Increase in Price of Imported Goods: Tariffs increase the price of imported goods, making them more expensive for consumers in the importing country. This reduces the demand for imported goods, which can lead to a decrease in the volume of trade between the two countries.
• Increase in Domestic Production: Tariffs provide protection to domestic producers by making imported goods more expensive. This can lead to an increase in domestic production of the same goods, as domestic producers become more competitive due to the tariff protection. This can lead to an increase in exports of the protected goods from the importing country.
• Change in Relative Prices: Tariffs can lead to a change in relative prices between the two countries. If the importing country imposes a tariff on the imported goods, the terms of trade will shift in favor of the importing country. The exporting country will have to export more goods to maintain the same level of imports, which can result in a decrease in the terms of trade for the exporting country.
• Retaliation by Exporting Country: If the exporting country perceives the tariff as unfair, it may retaliate by imposing a tariff on the importing country’s exports. This can lead to a trade war between the two countries, with both countries imposing tariffs on each other’s exports. This can result in a decrease in trade volume and a deterioration in the terms of trade for both countries.