Question

The international terms of trade (tot) influence the extent to which a country gains from trade. Explain what is meant by terms of trade, and how do changes in the terms of trade affect the ‘welfare’ effects of trade.

Answer 1

Terms of trade is the ratio of export prices to import prices of a country. It is a measure of how much a nation can import in terms of its export. In other words it is the rate at which one country exchanges its goods (export) for the goods of other countries (import).

Terms of Trade= Export prices/Import prices= Px/Pm.

Terms of trade shows one country’s relative competitiveness in the international market. If export price rise relative to the import prices, there is an improvement in the terms of trade. A given unit of export brings relatively more units of import. The improvement in the terms of trade improves the relative competitiveness of the country in international trade.

If import prices rise relative to the export prices, the country’s terms of trade is said to be deteriorated. In this case a given amount of export brings relatively less amount of import. This reduces the country’s relative Competitiveness in the international trade. An improvement in terms of trade increases the living standard of the people whereas deterioration decreases the living standard of the citizens.

The welfare from trade depends upon the relative prices of import and export. An improvement in the terms of trade increases the consumer’s welfare in the economy. The import prices will be lower than the export price. On the other hand deterioration in the terms of trade increase the prices of imported items. Thus there will be a reduction in consumer’s welfare.