Terms of trade

This article may require cleanup to meet Wikipedia's quality standards. Please improve this article if you can. (October 2009)

In international economics and international trade, terms of trade or TOT is the relative prices of a country's export to import. "Terms of trade" are sometimes used as a proxy for the relative social welfare of a country, but this heuristic is technically questionable and should be used with extreme caution. An improvement in a nation's terms of trade (the increase of the ratio) is good for that country in the sense that it has to pay less for the products it imports. That is, it has to give up fewer exports for the imports it receives.

The term

"Terms of trade" takes a plural form. However, it is a single number that represents the ratio of the relative prices.

Two country model CIE economics

In the simplified case of two countries and two commodities, terms of trade is defined as the ratio of the price a country receives for its export commodity to the price it pays for its import commodity. In this simple case the imports of one country are the exports of the other country. For example, if a country exports 50 dollars worth of product in exchange for 100 dollars worth of imported product, that country's terms of trade are 50/100 = 0.5. The terms of trade for the other country must be the reciprocal (100/50 = 2). When this number is falling, the country is said to have "deteriorating terms of trade". If multiplied by 100, these calculations can be expressed as a percentage (50% and 200% respectively). If a country's terms of trade fall from say 100% to 70% (from 1.0 to 0.7), it has experienced a 30% deterioration in its terms of trade. When doing longitudinal (time series) calculations, it is common to set the base year^{[citation needed]} to make interpretation of the results easier.

In basic Microeconomics, the terms of trade are usually set in the interval between the opportunity costs for the production of a given good of two countries.

Terms of trade is the ratio of a country's export price index to its import price index, multiplied by 100

Multi-commodity multi-country model

In the more realistic case of many products exchanged between many countries, terms of trade can be calculated using a Laspeyres index. In this case, a nation's terms of trade is the ratio of the Laspeyre price index of exports to the Laspeyre price index of imports. The Laspeyre export index is the current value of the base period exports divided by the base period value of the base period exports. Similarly, the Laspeyres import index is the current value of the base period imports divided by the base period value of the base period imports.

Where

price of exports in the current period

quantity of exports in the base period

price of exports in the base period

price of imports in the current period

quantity of imports in the base period

price of imports in the base period

Basically: Export Price Over Import price times 100 If the percentage is over 100% then your economy is doing well (Capital Accumulation) If the percentage is under 100% then your economy is not going well (More money going out then coming in)

Other terms-of-trade calculations

1. The net barter terms of trade is the ratio (expressed as a percentage) of relative export and import prices when volume is held constant.
2. The gross barter terms of trade is the ratio (expressed as a percent) of a quantity index of exports to a quantity index of inputs.
3. The income terms of trade is the ratio (expressed as a percent) of the value of exports to the price of imports.
4. The single factorial terms of trade is the net barter terms of trade adjusted for changes in the productivity of exports.
5. The double factorial terms of trade adjusts for both the productivity of exports and the productivity of imports.

Limitations

Terms of trade should not be used as synonymous with social welfare, or even Pareto economic welfare. Terms of trade calculations do not tell us about the volume of the countries' exports, only relative changes between countries. To understand how a country's social utility changes, it is necessary to consider changes in the volume of trade, changes in productivity and resource allocation, and changes in capital flows.

The price of exports from a country can be heavily influenced by the value of its currency, which can in turn be heavily influenced by the interest rate in that country. If the value of currency of a particular country is increased due to an increase in interest rate one can expect the terms of trade to improve. However this may not necessarily mean an improved standard of living for the country since an increase in the price of exports perceived by other nations will result in a lower volume of exports. As a result, exporters in the country may actually be struggling to sell their goods in the international market even though they are enjoying a (supposedly) high price. An example of this is the high export price suffered by New Zealand exporters since mid-2000 as a result of the historical mandate given to the Reserve Bank of New Zealand to control inflation.

In the real world of over 200 nations trading hundreds of thousands of products, terms of trade calculations can get very complex. Thus, the possibility of errors is significant.

See also

• International trade
• Offer curve
• Singer-Prebisch thesis

References

• Jagdish Bhagwati(1959) Growth terms of trade and comparative advantage, Economia Internazionale, 1959.
• Dorrance, J. (1948) The income terms of trade, Review of Economic Studies, 1948-49.
• Krueger, A. and Sonnenschein, H. (1967) The terms of trade, the gains from trade, and price divergence, International Economic Review, vol 8-1, February, 1967, pp. 121-127.
• Harry Bloch and David Sapsford, “Whither the Terms of Trade? An Elaboration of the Prebisch-Singer Hypothesis,” Cambridge Journal of Economics, 24 (2000): 461-481.
• James M. Cypher and James L. Dietz, “Static and Dynamic Comparative Advantage: A Multi-Period Analysis with Declining Terms of Trade,” Journal of Economic Issues, 32 (June 1998): 305-314.
• E.R. Grilli and M.C. Yang, “Primary Commodity Prices, Manufactured Good Prices, and Terms of Trade of Developing Countries,” World Bank Economic Review, 2 (1988): 1-48.