TERMS OF TRADE

Terms of trade refer to the rate at which the goods of one country are exchange for the goods of
another country. In other words, it is a measure of the purchasing power of exports of a country in
terms of its imports, and also expressed as the relationship between export prices and import prices of
goods. When the export prices of a country rise relatively to its import prices, its terms of trade are said
to have improved. The country gains from trade if it can have a larger quantity of imports in exchange
for a given quantity of exports. Better still, when its import prices rise relatively to its export’s price, its
terms of trade are said to have worsened. The country’s gain from trade is reduced because it can have
a smaller quantity of imports in exchange for a given quantity of exports than before.

1a. Commodity or Net Barter Terms of Trade: The commodity or net barter terms of trade is the ratio
between the price of a country’s export goods and import goods. Symbolically, it can be expressed as:

TC = PX/PM

Here TC = commodity terms of trade or net barter terms of trade, P X = export price, PM = import price.
(the subscript indicates the base and end period)
If the net barter terms of trade are to be applied to more than one export and import commodities and
the changes in terms of trade over a given period are to be computed, the index numbers of export and
import (measures price of changes in goods or services purchased from abroad and sold to foreign
buyers) prices rather than prices of individual commodities are taken into account. In such situations,
the net barter terms of trade can be measured as below:

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It means there is deterioration in country’s terms of trade by 20 percent between 2010 and 2015.
Criticism
(i) Problems in the Construction of Index Numbers: construction of index numbers has several
problems related to the choice of commodities, obtaining of price quotations, choice of base year, use of
appropriate weights and the method for computing index numbers. (ii) Neglect of Qualitative Changes
in output in the two trading countries during a given period. Therefore, the net barter terms of trade
cannot measure exactly the changes in welfare due to foreign trade in general and terms of trade in
particular. (iii) Misleading: the net barter terms of trade can sometimes result in misleading conclusions.
(iv) Inappropriate for Explaining Distribution of Gains from Trade: the distribution of gains from trade
cannot be rightly decided on the basis of changes just in the net barter terms of trade. (v) Faulty Index
of Gain from Trade: if balance of payments includes also the capital transactions and unilateral
transfers, the gain from trade cannot be determined through the ratio of export and import prices. (vi)
Period of Time: there is the possibility of some major changes in the structure of production and
demand in the countries such that comparisons on the basis of export and import prices are rendered
irrelevant. (vii) Neglect of Factors Affecting Prices: There is absolute neglect of the factors, which cause
variation in these prices. The export and import prices are affected by changes in productivity, costs,
wages, general business conditions and reciprocal demand in the trading countries. (viii) Capacity to
Import: The improvement or worsening of the commodity terms of trade cannot give any definite
conclusion about the capacity of a country to import.
1b. Gross Barter Terms of Trade: The gross barter terms of trade is the ratio between the quantities of a
country’s imports and exports. Symbolically, Tg = Qm/Qx, where Tg stands for the gross terms of trade,
Qm for quantities of Imports and Qx for quantities of exports. The higher the ratio between quantities of
import and export, the better the gross term of trade. To measure changes in the gross barter terms of
trade over a period, the index number of the quantities of imports and exports in base period (usually
yearly) and the end period are related to each other. The formula is as follows:

Here QM1 and QM0 are the quantity indices of imports in the current year (1) and base year (0)
respectively. QX1 and QX0 are the quantity indices of exports in the current year (1) and base year (0)
respectively.

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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:

The above illustration shows that the gross barter terms of trade have improved for the given country by
20.00 percent over this period.
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

When there is a deficit or surplus in trade balance, the gross barter and net barter terms of trade will
differ from each other (TC <> TG).
This concept has been criticized on the following grounds:
(i) Aggregation of Goods, Services and Capital Transactions: The lumping together of the non-
homogeneous quantities was both unreal and impractical. It was because of this reason that this
concept of terms of trade came to be rejected at the hands of economists like Jacob Viner and Haberler.
(ii) Faulty Index of Welfare: If there are such changes in tastes and habits of a people that even a
smaller quantity of imports yields greater satisfaction, the community may derive greater welfare
despite an unfavourable gross barter terms of trade. (iii) Neglect of Productivity: The increased factor
productivity still indicates the gain from the point of view of the exporting country. The impact of
improvement in productivity has been overlooked in this measure of terms of trade. (iv) Neglect of
Qualitative Changes: The gross barter terms of trade ratio undoubtedly takes into account the physical

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quantities of imports and exports but ignores the fact that there might have been qualitative
improvements in production in the exporting and importing countries. (v) Neglect of Capital
Movements: The international capital movements have quite important influence on the balance of
payments and general economic condition of a country. This vital factor, however, has not found proper
expression in the measurement of gross barter terms of trade
2. Income Terms of Trade: G.S Dorrance has improved upon the concept of the net barter terms of
trade by formulating the concept of the income terms of trade. This index takes into account the volume
of exports of a country and its export and import prices (the net barter terms of trade). It shows a
country’s changing import capacity in relation to changes in its exports. Thus, the income terms of trade
is the net barter terms of trade of a country multiplied by its export volume index.
These can be stated as:

In this case, there has been deterioration in the income terms of trade by 10 percent between 2010 and
2015.
As income terms of trade fall from 100 to 99, the commodity terms of trade (TC) = (PX/PM) × 100 =
(123/164) × 100 = 75 in 2015, signifying a deterioration in T C compared with the base year of 2010. In
the first illustration, where T1 rises to 132 in 2015, there is an improvement in the commodity terms of
trade in that year

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A rise in the income terms of trade implies that a country can import more goods in exchange of its
exports and vice-versa. It is also possible that the income terms of trade of a country show an
improvement but the commodity terms of trade get deteriorated. On the opposite, there can also be a
possibility that income terms of trade have deteriorated, although the commodity terms of trade have
improved between two periods.
According to Jacob Viner, the income terms of trade reflect the ‘capacity to import’ of a country. If P X,
PM, QM and QX represent the absolute magnitudes of price of export, price of import, quantity imported
and quantity exported respectively, the equality between total receipts from exports and total payments
due to imports can be expressed as below:

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.
This concept of terms of trade has great relevance for the less developed countries.
Criticisms:
(i) Not an Accurate Measure of Gain from Trade: This concept cannot give an exact measure of the gain
from trade. (ii) Not a Measure of Total Import Capacity: The income terms of trade measure only the
export- based import capacity of a country and not its total import capacity which depends also upon its
foreign exchange receipts. (iii) Cannot Replace the Commodity Terms of Trade: It is sometimes believed
that the income terms of trade are superior to the commodity terms of trade. In view of contradictory
conclusions given by the two indices, the former alone is clearly inadequate. It can supplement but by
no means replace the commodity terms of trade or net barter terms of trade. (iv) Misleading Indicator
of Welfare Gain: The income terms of trade may prove to be a faulty and misleading indicator of
direction of change of the welfare of a country.

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3. Single Factorial Terms of Trade and Double Factoral Terms of Trade

Single Factorial Terms of Trade: The concept of income terms of trade attempted — a correction in the
net barter terms of trade for changes in the volume of exports. Jacob Viner made another modification
over the net barter or commodity terms of trade. He corrected the commodity terms of trade for
changes in factor productivity in the production of export goods.
Single Factoral Terms of Trade is determined by multiplying the commodity terms of trade with the
productivity index in the domestic export sector. The single factoral terms of trade imply a ratio of the
export price index and import price index adjusted for changes in the productivity of factors used in the
production of export goods.
It can be stated as:

From the above illustration, it is clear that change in the export productivity index can have highly
significant effect on the terms of trade of a country. If the increase in productivity in the export sector
causes such a substantial decline in costs that export prices have declined by a marked extent, it is

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possible that the commodity terms of trade become unfavourable even when the single factoral terms
of trade have improved.
Criticisms:
(i) Difficulty in the Measurement of Productivity (ii) Not a Reliable Index of Gain from Trade (iii) Increase
in Global Inequalities (iv) Neglect of Increase in Productivity in Foreign Countries
Double Factorial 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)

Here TD is the double factoral terms of trade, T C is the commodity terms of trade, Z X is the productivity
index in domestic export sector and Z M is the productivity index in the export sector of the foreign
countries or it is import productivity index.

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 [T C =
(PX/PM) × 100 (170/160) × 100 = 106.25]. The single factoral terms of trade show a much substantial
improvement in terms of trade by 87 percent [T S = (PX/PM) . ZX = (170/160) × 176 = 187].
A relatively smaller improvement in the double factoral terms of trade by 37.5 percent is on account of
the fact that the increase in import productivity index has some neutralizing impact. If the import
productivity index were greater (say, Z M = 204) than the export productivity index, the double factoral

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terms of trade could even become unfavourable (84.62 percent) despite favourable commodity and
single factoral terms of trade.
Criticisms: (i) Measurement of Productivity (ii) Misplaced Emphasis (iii) Faulty Concept (iv) Difficulty in
the Determination of Gains from Trade (v) Neglect of Real Costs
4. Real Cost Terms of Trade and Utility Terms of Trade.
The real cost terms of trade: Viner has also developed a terms of trade index to measure the real gain
from international trade. He calls it the real cost terms of trade index. This index is calculated by
multiplying the single factoral terms of trade with the reciprocal of an index of the amount of disutility
per unit of productive resources used in producing export commodities. It can be expressed as: Tr = T s .
Rx
Where TR = real cost terms of trade and R X = index of the amount of disutility suffered per unit of
resources employed in producing exports goods.

If the commodity terms of trade (T C = PX/PM) have got worsened, the deterioration in T C may be offset by
the corresponding increase in the export productivity index (Z X) and the single factoral terms of trade
may remain stable, provided there is no change in the real cost (R X) of producing export commodities.
Given the single factoral terms of trade, the increase in R X will cause the worsening of the real cost terms
of trade (TR) and vice-versa.
Criticisms: The main grounds on which it is criticised are as follows:
(i) Subjective Concept: The disutility or real cost involved in the additional production of export goods is
a highly subjective concept which cannot be measured in precise quantitative terms. (ii) Neglect of Real
Cost of Diverting Domestically Consumed Goods to Exports: failed to take into account the real cost
involved in diverting the goods being used for domestic consumption to supplement exports for paying
the imports. (iii) Neglect of Real Cost of Producing Import- Substitutes: This concept neglects the real
cost involved in the production of import-substitutes within the country because the domestic
production of import-substitutes can have significant effect on quantity imported (Q M) as well as the
price of imported goods (PM).
With the object of removing this deficiency, Jacob Viner introduced still another concept of utility terms
of trade: The utility terms of trade index measures “changes in the disutility of producing a unit of
exports and changes in the relative satisfactions yielded by imports and the domestic products foregone

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as the result of export production.” In other words, it is an index of the relative utility of imports and
domestic commodities forgone to produce exports. 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.