Terms of Trade, Meaning and Types

The terms of trade refer to the rate at which one country exchanges its goods for the goods of other countries. Thus, terms of trade determine the international values of commodities. Obviously, the terms of trade depend upon the prices of exports a country and the prices of its imports.

When the prices of exports of a country are higher as compared to those of its imports, it would be able to obtain greater quantity of imports for a given amount of its exports. In this case terms of trade are said to be favourable for the country as its share of gain from trade would be relatively larger.

On the contrary, if the prices of its exports are relatively lower than those of its imports, it would get smaller quantity of imported goods for a given quantity of its exports. There­fore, in this case, terms of trade are said to be unfavourable to the country as its share of gain from trade would be relatively smaller. In what follows we first explain the various concepts of the terms of trade and then explain how they are determined.

Types

1. Commodity or Net Barter Terms of Trade:

If one good is considered export good and the other good is supposed import good then “the ratio between prices of exports to price of imports is given the name of net barter terms of trade”. If we include so many goods then the ratio of price index of exports to price index of imports is called net barer terms of trade.

2. Income Terms of Trade:

The income terms of trade allow the capacity to import of a country on the basis of imports.

3. Single Factor Terms of Trade:

Single factor terms of trade show the number of imports which can be obtained against the domestic factor employed in export sector.

4. Double Factor Terms of Trade:

Such terms of trade measures that how much of factors used in export sector could be substituted against how much of factors employed in import sector.

5. Utility Terms of Trade:

The utility terms of trade are presented to explain welfare changes. The utility terms of trade indicate the total amount of gain from trade, as excess of total utility which is obtained from imports over the total sacrifice of utility in surrender of export.

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

Concepts of Terms of Trade:

Net Barter Terms of Trade:

The most widely used concept of the terms of trade is what has been caned the net barker terms of trade which refers to the relation between prices of exports and prices of imports. In symbolic terms:

T_n = P_x/P_m

Were

T_n stands for net barter terms of trade.

P_x stands for price of exports (x),

P_m stands for price of imports (m).

When we want to know the changes in net barter tends of trade over a period of time, we prepare the price index numbers of exports and imports by choosing a certain appropriate base year and obtain the following ratio:

Px₁/ Pm₁ : Px₀/ Pm₀

Px„ Pm„

where Px_o and Pm₀ stand for price index numbers of exports and imports in the base year re­spectively, and Px₁) and Pm₁) denote price index numbers of exports and imports respectively in the current year.

Since the prices of both exports and imports in the base year are taken as 100, the terms of trade in the base year would be equal to one

Px₀/ Pm₀ = 100/100 = 1

Gross Barter Terms of Trade:

This concept of the gross terms of trade was introduced by F.W. Taussig and in his view this is an improvement over the concept of net barter terms of trade as it directly takes into account the volume of trade. Accordingly, the gross barter terms of trade refer to the relation of the volume of imports to the volume of exports. Thus,

T_g = Om/Qx

Where

Tg = gross barter terms of trade, Qm = quantity of imports

Qx = quantity of exports

Income Terms of Trade:

In order to improve upon the net barter terms of trade G.S. Dorrance developed the concept of income terms of trade which is obtained by weighting net barter terms of trade by the volume of exports. Income terms of trade therefore refer to the index of the value of exports divided by the price of imports. Symbolically, income terms of trade can be written as

Ty = Px.Qx/Pm

Were,

T_y = Income terms of trade

P_x = Price of exports

Q_x = Volume of exports

P_m= Price of imports