Terms of trade
Terms of trade in international economics and international trade, is the ratio of the price of an export commodity(s) to the price of an import commodity(s). “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 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 less exports for the imports it receives.
In the simplified case of two countries and two commodities, terms of trade is defined as the ratio of the price a country must pay for its import commodity to the price it receives for its export commodity. In this simple case the imports of one country are the exports of the other country. For example, if a country exports 100 dollars worth of export product in exchange for 50 dollars worth of imported product, that country’s terms of trade are 100/50 = 2. The terms of trade for the other country must be the reciprocal (50/100 = .5). 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 percent (200% and 50% respectively). If a country’s terms of trade fall from say 100% to 70% (from 1.0 to .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 to 100% to make interpretation of the results easier.
In the more realistic case of many products exchanged between many countries, terms of trade can be calculated using a Laspeyre’s 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.
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 a county’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.
In the real world of over 200 nations trading hundreds of thousands of products, terms of trade calculations can get very complex. The possibility of errors is significant.
Two country model
Multi-commodity multi-country model
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
Other terms of trade calculations
Limitations
See Also:
Finding related topics
External sources
