International Economics - Terms of trade, International Economics

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Terms of trade

The theory of comparative advantage in its original and modified form proves that I r countries specialise in the production of the commodity in which they have comparative advantage and trade their produce with the other countries (i.e., they export what they produce and import what they do not), they will gain from for­eign trade. But the gain from trade may not remain constant-it may change over time. The change in the gains from foreign trade to the trading countries depends on the terms of trade. The terms of trade is defined as the quantity of domestic goods that must be given in exchange of one unit of imported goods.

A number of measures of terms of trade have been suggested by the econo­mists, e.g., Mill, Marshall, Taussig, Ohlin, Haberler, Viner and Kind leberger. The multiplicity of measures (or formulae) of terms of trade only indicates the lack of unanimity among the economists on the measures of terms of trade. Moreover, we discuss here the various concepts of terms of trade.

1.      Net Barter Terms of Trade

The net barter terms of trade (T_n) is the most common concept of terms of trade. It has been defined by Taussig and Viner as,

T_n = X_p/M_p

where X_p and M_p are prices of exports and imports, respectively. By comparing the X_P/M_P in two different periods, one can find the trends in terms of trade. A rise in the ratio X_P/M_p means that a given volume of exports is being exchanged for a larger volume of imports than in the past comparable period. Such changes how­ever do not tell us why relative prices of exports and imports have changed and what has changed the physical volume of exports and imports.

2.      The Gross Terms of Trade

The other concept of terms of trade is gross barter terms of trade. Taussig and Viner have defined the gross terms of trade as M_q/X_q i.e., the ratio of quantity of imports (M_q) to quantity of exports (X_q). 

When trade between two countries is balanced, the net barter terms of trade is equal to the gross barter terms of trade, i.e., when trade is balanced then

                   X_p.X_q = M_p.X_q         

This can be interpreted for a country as:

(i)      If M_p and M_q are constant and X_p increases, terms of trade turns favourable since a smaller X will be required to balance the trade.

(ii)     If M_p and M_q are constant and X_p decreases, terms of trade become unfauourable, since a larger X_q will be required to balance the trade.

(iii)    If X_p and X_q remains constant and M -increases, terms of trade become unfavourabe, since larger imports will be required to balance the trade.

(iv)    If X_p and X_q remains constant, and M decreases, it is favourable development In the terms of trade.  

Kindleberger has, however, commented that gross barter terms of trade are least informative "since they reflect less price movements than the change in the balance of payments, and even capital movement:' He suggests that when refer­ence to 'terms of trade , is made without qualification, it should be taken for the net barter of trade, i.e., X_p/ M_p.

3.      Income Terms of Trade

Income terms of trade is an improvement on the net barter terms of trade, A se­rious limitation of net barter terms of trade is that its application is limited only to the conditions of perfectly competitive system of international price system. Otherwise, if export prices are held coristant, the volume of exports will fall. It will, no doubt, reflect a favourable term of trade but at the cost of export earnings.

To overcome this anomaly, another concept of terms of trade, i.e., the income terms of trade, has been suggested. It is obtained by weighting the net barter terms of trade by X_q. The income terms of trade is defined as 

               X_q (X_p/M_p)               

 4.      Single-Factor Terms of Trade

Yet another concept of terms of trade suggested to remove another major de­fect of net barter terms of trade (X_p /M_p) is Single-factor terms of trade. Kind leberger calls it another 'monstrous piece of jargon'. However, the usefulness of single factor terms of trade lies in that it removes one of the major defects of the net barter terms of trade (X_p/M_q). The net barter terms of trade does not take into account the change in efficiency and, hence, ignores its effects on the welfare of the country to the extent it is based on foreign trade. For example, if export prices fall by 10 per cent on account of a fall in cost of production by 15 per cent due to improvement in the efficiency, the exporting country is still better off. Therefore, an adjustment in X_p/M_q should be made to account for improved efficiency. This adjustment factor is provided by the-single-factor terms of trade. The formula for single-factor terms of trade is given as

X_p. E_x/M_p 

where E_x denotes the improved efficiency in the export sector, measured over a suitable base year.

5.      Double-Factor Terms of Trade

The single-factor terms of trade is further modified to include the improved efficiency of factors in the country from which it imports. The concept of double­ factor terms of trade is defined as:

X_p.E_x / M_p. E_m

The single-factor terms of trade is considered to be superior to the double fac­tor terms of trade for the purpose of single country. But in the analysis of overall gains from trade to the trading partners, the double factor terms of trade is consid­ered to be preferable. 

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