Terms of trade

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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 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.

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[edit] 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 percent (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 to[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 (simplified)= Exports divided by Imports

[edit] Protectionism

[edit] Advantages of Protectionism

Protectionism occurs when one country reduces the level of its imports because of:

  • Infant industries. If sunrise firms producing new-technology goods (eg computers) are to survive against established foreign producers then temporary tariffs or quotas may be needed.
  • Unfair competition. Foreign firms may receive subsidies or other government benefits. They may be dumping (selling goods abroad at below cost price to capture a market).
  • Balance of payments. Reducing imports improves the balance of trade.
  • Strategic industries. To protect the manufacture of essential goods.
  • Declining industries. To protect declining industries from creating further structural unemployment.

[edit] 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.

{{p_x^c\, q_x^0}\over{p_x^0\, q_x^0}} \left/ {{p_m^c\, q_m^0}\over{p_m^0\, q_m^0}}\right.

Where

p_x^c=price of exports in the current period
q_x^0= quantity of exports in the base period
p_x^0= price of exports in the base period
p_m^c= price of imports in the current period
q_m^0= quantity of imports in the base period
p_m^0= price of imports in the base period

[edit] 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.

[edit] 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.

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.

[edit] See also

[edit] References

  • Bhagwati, J. (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.