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.
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