Terms of Trade :-

The terms of trade of a nation are defined as the ratio of the price of its exports to the price of
its imports. Since in a two-nation world, the exports of a nation are the imports of its trade
partner, the terms of trade of the latter are equal to the inverse, or reciprocal, of the terms of
trade of the former.
In a world of many (rather than just two) traded commodities, the terms of trade of a nation
are given by the ratio of the price index of its exports to the price index of its imports. This
ratio is usually multiplied by 100 in order to express the terms of trade in percentages. These
terms of trade are often referred to as the commodity or net barter terms of trade to
distinguish them from various other measures of the terms of trade.
An improvement in a nation’s terms of trade is usually regarded as good for the nation in the
sense that the prices that the nation receives for its exports rise relative to the prices that it
pays for imports.
Illustration :-
If country 1 exports commodity X and imports commodity Y, its terms of trade are given by
Px/Py. If it exported and imported many commodities, Px would be the index of its export
prices, and Py would be the index of its import prices.

If country 2 exports commodity Y and imports commodity X, its terms of trade are given by
Py/Px. This is the inverse, or reciprocal, of l’s terms of trade and also equals 1 or 100 (in
percentages) in this case.

If through time the terms of trade of country 1 rose, say, from 100 to 120, this would mean
that country l’s export prices rose 20% in relation to its import prices. This would also mean
that country 2 is terms of trade have deteriorated from 100 to (100/120)100 = 83. We can
always set a nation’s terms of trade equal to 100 in the base period, so that changes in its
terms of trade over time can be measured in percentages.
Even if country l’s terms of trade improve over time, we cannot conclude that country 1 is
necessarily better of because of this, or that country 2 is necessarily worse off because of the
deterioration in its terms of trade.
Changes in a country’s terms of trade are the result of many forces at work both in that nation
and in the rest of the world, and we cannot determine their new effect on a nation’s welfare
by simply looking at the change in the country’s terms of trade.
The Concept of Terms of Trade:
Specialization and exchange benefit all the trading partners. Because of complete
specialization in the production of the commodities in which countries have comparative
advantages—as suggested by Ricardo, global production becomes larger. Now if every
country trades with each other, every country will gain from such exchanges.

However, such gain from specialization and exchange depends on the terms of trade (TOT).
It refers to the quantity of imports that exports buy. It is measured by the ratio of export price
to import price. It is the ratio at which a country can export or sell domestic goods for
imported goods.

Let PX be the price of export good and Pm be the price of import good. Thus the (barter or
commodity) TOT are defined as PX/Pm.
In the real world, where countries export and import a large number of goods, TOT are
computed as an index number:
T0T = index of export prices/index of import prices × 100
or, TOT = PX/Pm × 100

To calculate the index of export and import prices, we choose a base year and the current
period. A base period index of export and import price is 100. Thus, TOT for the base year is
100. Suppose, export price index rises to 120 and import price index rises to 110.
Thus, TOT rise to 109. This means that a unit of exports will buy 9 p.c. more imports than the
old TOT. TOT thus improves. A fall in the TOT, on the other hand, implies unfavourable
TOT in the sense that the country concerned will now use more exports to buy the same
quantity of imports.
On which factors the TOT depend? Answer to this question was unknown to Ricardo. In
other words, Ricardo could not locate the exact TOT at which trade takes place. This is
because of the fact that Ricardo concentrated on the cost or supply side of production and
ignored demand conditions.
Anyway, Ricardo suggested that the TOT would settle in-between two domestic cost ratios.
We explain first the Ricardian notion of TOT and then Mill’s concept of reciprocal demand.
Let us assume that the internal or domestic cost ratio in country A is 1 X for 1.5 Y, and, in
country B, it is 1 X for 2 Y. This domestic cost ratio suggests that country A has a
comparative advantage in X while country B has a comparative advantage in Y.
Thus, A and B will trade with each other. But what would be the TOT at which both will
trade? Ricardo argued that international TOT would lie somewhere between 1: 1.5 and 1: 2
and both the countries would stand to gain.
It was J. S. Mill who successfully determined the exact TOT by introducing the concept of
reciprocal demand. In other words, actual TOT depends on the relative prices of X and Y
after trade takes place. These relative prices will depend upon the strength and elasticity of
each country’s demand for the other country’s product or upon reciprocal demand.
If the TOT lie very close to 1: 1.5, then country A would gain very little and she would not
offer much X for export. However, at this TOT, country B would gain quite a large amount
since it would demand more X by offering less Y. Consequently, country B’s demand for
imports of X would exceed country A’s supply of exports of X, and so the price of X in terms
of Y would rise.
As the TOT rises to 1: 1.6; 1: 1.7, etc., country A offers more X to buy more Y, while country
B demands less Y to buy X. In this way, a particular TOT would prevail at which the value of
each country’s export equals its value of imports. In this way, reciprocal demand is equated
in the two countries at the international TOT.
Thus, TOT lies between the upper and lower limits of domestic cost ratios of two countries.
Equilibrium or international TOT brings equality between export and import. At the
equilibrium TOT, world output equals world consumption. But the gains to both the countries
need to be equal. However, more favourable the TOT to any country, greater is the welfare of
the country.
A tariff imposed on importables may bring TOT in favour of the tariff-imposing country.
However, if the tariff rate exceeds the optimum tariff rate, gains from trade may reduce even
though TOT may be favourable. Thus, a favourable TOT does not necessarily increase
welfare of a nation. Still then, TOT must not be adverse.

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 unfavourable to the country by 13%. In other words, the
country has to pay 13% more for a given amount of imports.

Determination of Terms of Trade and Offer Curves:

The theory of reciprocal demand has been explained graphically with the help of the concept
of offer curves developed by Edgeworth and Marshall. The offer curve of a country shows
the amounts of a commodity it offers at various prices for a given quantity of the commodity
produced by the other country.

To understand how offer curves are derived and how with their help determination of the
terms of trade is explained, we shall first explain how a country reaches its equilibrium
position about the amounts of goods to be produced and consumed.

For this purpose, modern economists usually employ the tools of production possibility curve
and the community indifference curves. The production possibility curve represents the
combinations of two commodities which a country, given its resources and technology, can
produce.

A community indifference curve shows the combinations of two goods which provide same
satisfaction to the community as a whole. A map of community indifference curves portrays
the tastes and demand pattern of a community for the two goods. A production possibility
curve TT’ and a set of community indifference curves IC1IC2 and IC3 of country A have been
drawn in Fig. 45.1.
The country reaches its equilibrium position with regard to production and consumption of
cloth and wheat at the point Q where the production possibility curve TT’ is tangent to the
highest possible indifference curve IC2 at which marginal rate of transformation of cloth for
wheat (MRTCW) equals marginal rate of substitution of cloth for wheat (MRS CW) as well as
the price ratio of the two commodities Pc/Pw as shown by the slope of the price line P1P1.
Thus, tangency point Q in Fig. 45.1 depicts the equilibrium position of country in the absence
of trade. Suppose country A enters into trade relation with country B and price of cloth rises
relative to wheat so that new price-ratio line becomes P2P2.
It will be observed from Fig. 45.1 that with price- ratio line P 2P2 production equilibrium of
country is at point M, its consumption equilibrium is at point R. This shows that with price-
ratio line PP2 country A will offer or export MN of cloth for RN imports of wheat.
Similarly, if price of cloth further rises relative to wheat, price-ratio line will become more
steep, then for the same quantity offered of export of cloth, the or import of wheat will
increase. With such information gathered from Fig. 45.1, we can derive offer curve of
country A in Fig. 45.2.

The tangent line in Fig. 45.1 shows the domestic price ratio of the two commodities and has a
negative slope. In the analysis of the offer curve, the price line is drawn with a positive slope
from the origin. This is because in the drawing of an offer curve we are interested only in
knowing the quantity of one commodity which can be exchanged for a certain quantity of
another commodity.

In other words, in the analysis of terms of trade what we are really interested is the absolute
slope of the curve, i.e., the price ratio. In Fig. 45.2 the positively sloping price line OP 1 from
the origin, which in absolute terms, has the same slope as P1P1 of Fig. 45.1 has been drawn. In
Fig. 45.2 at price ratio line O1P1 no trade occurs.
When price of cloth rises and price ratio line shifts to OP2 as will be from Fig. 45.2, country
A offers ON1 of cloth (exports) for RN1 of wheat (imports). (Note that at a given price ratio
how much quantity of a commodity, a country will offer for imports from the other country is
determined by production possibility curve and community’s indifference curves as
illustrated in Fig. 45.1).
Suppose the price of cloth further rises relatively to that of wheat causing the price line to
shift to the position OP3. It will be seen that with the price line OP 3, country A is willing to
offer for export ON2 quantity of cloth for SN2 of wheat.

Likewise, Fig. 45.2 portrays the exports and imports of the country A as price of cloth in
terms of wheat increases further and consequently price line shifts further above to OP 4 and
OP and the new offers of export of cloth for import of wheat are determined by equilibrium
points T and U. If points such as R, S, T and U representing the country A’s offers of cloth
for wheat are joined we get its offer curve.
It is important to note that the offer curve may be regarded as the supply curve in the
international trade as it shows amounts of cloth which the country A is willing to offer for
certain amounts of imports of wheat at various price ratios.

Another important point to be noted is that the offer curve cannot go below the price line OP,
which represents the domestic exchange ratio determined by the tangency point Q of pro-
duction possibility curve and community indifference curve of country A as shown in Fig.
45.1. This is because, as stated above, no country will be willing to export its product for the
quantity of the imported product which is smaller than that it can produce at home.

Likewise, we can derive the offer curve of country B. Figure 45.3 portrays the derivation of
the offer curve of country B. representing quantities of wheat which it is willing to exchange
for certain quantities of cloth from country A at various prices.
Note that so long as country B is importing a smaller quantity of cloth, it will be willing to
offer relatively more wheat for cloth. But as the quantity of imported cloth is increased, it
would be prepared to offer relatively less wheat for the given quantity of imports of cloth.

In Fig. 45.3 whose Y-axis represents wheat, the origin for indifference curves of country B
will be the North-West Comer Price lines. OP7, OP6, OP5, OP4 etc., express successively
higher price ratios of wheat for cloth. Price line OP 1 represents the domestic price ratio in
country B in the absence of trade. The points C, D, E, F, G which has been obtained from the
equilibrium or tangency points between the community indifference curves of country B and
the various price-ratio lines show the equilibrium offers of wheat by country B for cloth of
country A at various prices. By joining together points, C. D, E, F and G we obtain the offer
curve of country B indicating its demand for cloth of country A in terms of its own product
wheat.
It would be observed from Fig. 45.2 and 45.3 that offer curves OA and OB of the two
countries have been drawn with the same origin O (i.e., South-West Corner) as the basis.
These offer curves represent reciprocal demand of the two countries for each other’s product
in terms of their own product. The offer curves OA and OB of the two countries have been

brought together in Fig. 45.4.

The intersection of the offer curves of the two countries determines the equilibrium terms of
trade. It will be seen from Fig. 45.4 that the offer curves of two countries cross at point T. By
joining point T with the origin we get the price-ratio line OT whose slope represents the
equilibrium terms of trade which will be finally settled between the two countries.
At any other price-ratio line the offer of a product by country A in exchange for the product
of the other would not be equal to the reciprocal offer and demand of the other country B. For
instance, at price-ratio line OP1, country B would offer OM wheat for MH or ON of cloth
from country A (H lies on B’s offer curve corresponding to price-ratio line OP5).
But at this price-ratio line OP country A would demand much greater quantity of wheat UW
for OU of cloth as determined by point W at which the offer curve of country A intersects the
price ratio line OP. This will result in rise in price of wheat and the price-ratio line will shift
to the right until it reaches the equilibrium position OT or OP4.
On the other hand, if price ratio line lies to the right of Or (for instance, if it is OP,), then, as
will be observed from Fig. 45.4, it cuts the offer curve of country A at point L implying
thereby that the country A would offer OR of cloth in exchange for RL of wheat. However,
with terms of trade implied by the price ratio line OP 4, the country B would demand OZ of
cloth for ZS quantity of wheat as determined by point S.
It therefore follows that only at the terms of trade implied by the price ratio line OT (i.e.,
OP4) that the offer of a product by one country will be equal to its demand by the other. We
therefore conclude that the intersection of the offer curves of the two countries determines the
equilibrium terms of trade.
As explained above, the offer curves of the two countries are determined by their reciprocal
demand. Any change in the strength and elasticity of reciprocal demand would cause a
change in the offer curves and hence in the equilibrium terms of trade.

It is worthwhile to note that terms of trade must settle within the price lines OP 1 and
OP7 representing the domestic rates of exchange between the two commodities in the two
countries respectively as determined on the basis of production cost and s demand conditions
existing in them.
When the terms of trade are settled within these limits set by these price lines OP 1 and OP7,
both countries would gain from trade, though one may gain relatively more than the other
depending on the position of terms of trade line.
As explained above, the terms of trade cannot settle beyond these domestic prices ratio lines
because in case of terms of trade line lying beyond these price lines, it will be advantageous
for a country to produce both the goods (wheat and cloth) domestically rather than entering
into foreign trade.

Determination of Terms of Trade: Theory of Reciprocal Demand:

As seen above, the share of a country from the gain in international trade depends on the
terms of trade. The terms of trade at which the foreign trade would take place is determined
by reciprocal demand of each country for the product of the other countries.

The theory of reciprocal demand was put forward by JS. Mill and is thought to be still valid
and true even today. By reciprocal demand we mean the relative strength and elasticity of the
demand of the two trading countries for each other’s product.

Let us take two countries and B which on the basis of their comparative costs specialise in the
production of cloth and wheat respectively. Obviously, country would export cloth to country
B, and in exchange import wheat from it. Reciprocal demand means the strength and
elasticity of demand of country A for wheat of country B, and the intensity and elasticity of
country B’s demand for cloth from country A If the country has inelastic demand for wheat
of country B, she will be prepared to give more of cloth for a given amount of wheat. In this
case terms of trade will be unfavourable to it and consequently its share of gain from trade
will be relatively smaller.

On the contrary, if country A’s demand for import of wheat is elastic, it will be willing to
offer a smaller quantity of its cloth for a given quantity of the imports of wheat. In this case
terms of trade would be favourable to country A and its share of gain from trade will be
relatively larger. The equilibrium terms of trade would settle at a level at which its reciprocal
demand, that is, quantity of its exports which it will be willing to give for a given quantity of
its imports is equal to the reciprocal demand of the other country.

Note that the equilibrium terms of trade are determined by the intensity of reciprocal demand
of the two trading countries but they will lie in between the comparative costs (i.e., domestic
exchange ratios) of the two countries. This is because no country would be willing to trade at
a price which is lower than at which it can produce at home.

Let us return to the example of the two countries A and B which specialise in the production
of two commodities cloth and wheat respectively, and exchange them with each
other. Production conditions in the two countries are given below:
Table 45.1: Production of one man per week

It will be seen from above table that before trade production conditions in country B are such
that 12 bushels of wheat would be exchanged for 20 yards of cloth, in it, that is, the domestic
exchange ratio is 12: 20 (or 3: 5). On the other hand, in country A production conditions are
such that 4 bushels of wheat would be exchanged for 12, yards of cloth, that is, the domestic
exchange ratio is 4: 12 or 1: 3. Obviously, after trade, terms of trade will be settled within
these domestic exchange ratios of the two countries.

The domestic exchange ratios of the two countries set the limits beyond which terms of trade
would not settle after trade. It is evident that country B will be unwilling to offer more than
12 bushels of wheat for 20 yards of cloth since by sacrificing 12 bushels of wheat it can
produce 20 yards of cloth at home.
Likewise, country A would not accept less than 6.66 bushels of wheat for 20 yards of cloth,
for this is the domestic exchange rate cloth of wheat for(l :3) determined by production or
cost conditions at home in country A.

It is within these limits that terms of trade will be settled between the two countries as
determined by the strength of reciprocal demand of the trading countries. It also follows that
it is not mere demand but also the comparative production costs (i.e., the supply conditions)
that go to determine the terms of trade. Indeed, the law of reciprocal demand, if properly
understood, considers both the forces of demand and supply as determinants of the terms of
trade.