What determines the changes in the terms of trade?

Salam and Hi,

I'm back. Just a little bit concerned about your understanding of the concept 'terms of trade'.

(Reference: Hashim Ali)
Fundamentally, you can define the terms of trade for a country as the rate at which a country exchanges its exports for imports.
Changes of ToT can be measured by the average prices of exports and the average prices of imports.
It can also be defined as the ratio of export prices to import prices.

So, if the country's export price is cheap relative to its imports, then more goods would have to be exported by the country in order to purchase a given quantity of import.
Terms of trade is said to worsen or become unfavourable.

Conversely, if the export price increases relative to its import price, terms of trade is said to have improved because the country would be able to purchase a given quantity of import with a smaller quantity of export.

Here's a little test for you.
For the following state whether changes will bring about a favourable or unfavourable terms of trade.

Note: Px --> price of exports; Pm --> price of import.

1. Px increases while Pm decreases.
2. Increases in Px are greater than increases in Pm.
3. The increase in Px is less than the increase in Pm.
4. Px remains constant while Pm decreases.
5. Px increases while Pm remains constant.
6. Px remains constant while Pm increases.
7. Px decreases while Pm increases.
8. Terms of trade = 110
9. Terms of trade = 98
10. Terms of trade = 100

OK...let's see the answers:

1. favourable
2. favourable
3. unfavourable
4. favourable
5. favourable
6. unfavourable
7. unfavourable
8. favourable
9. unfavourable
10. balanced

What's your score?

Now, how do we measure the terms of trade? Yes, in the theory of comparative advantage the terms of trade shows the exchange of goods with another good in terms of unit. By right, we measure it based on the following formula:

Price index or Average price of exports    x 100
Price index or Average price of imports

Example:

Given:

Year           X Price Index         M Price Index           Terms of trade

2006           100                              100                             100
2007           100                                90                             111.1
2008           110                                90                             122
2009             80                              120                               66
2010           110                              115                             95.6

Analysis:

1. When terms of trade is greater than 100 --> favourable
2. When terms of trade is less than 100 --> unfavourable
3. When terms of trade is equal to 100 --> balanced terms of trade

WHAT DETERMINES THE CHANGES IN THE TERMS OF TRADE OF A COUNTRY, THEN?

The fundamental factors for these changes  are the changes in the demand and supply conditions which determine the price of both exports and import.

1. increase in demand for imports causes increase in the price of imports thus leading to unfavourable terms
    of trade.
2. increase in the supply of imports causes the price of imports to decrease thus leading to favourable terms
    of trade.
3. increase in the demand for exports causes increase in the price of exports thus leading to favourable terms
    of trade.
4. increase in the supply of exports causes decrease in the price of exports thus leading to unfavourable terms
    of trade.

So, what are the factors that cause demand and supply to change?

Changes in demand conditions (can be for both exports and imports), ceteris paribus

1. Changes in population

    This will result in greater demand for food. Price of imported food will increase and will lead to
    unfavourable terms of trade. The exporting countries will then have favourable terms of trade.

2. Outbreak of wars
 
    Increase war in some countries like in the middle eastern countries will cause increase demand for weapons and food.  Price of food and weapons will become much higher. The importing countries will face unfavourable terms of trade while the exporting countries will experience favourable terms of trade.

3. Changes in tastes and preferences

   Increase in demand for manufactured goods from other countries will lead to increase in price of imported manufactured goods leading to an unfavourable terms of trade for the importing countries and favourable terms of trade for the exporting countries.

4. Important buyer withholds demand

   This will lead to unfavourable terms of trade for the exporting countries as they would have stockpiles of goods (surplus) causing the price to fall. Exporting countries will face unfavourable terms of trade then.

Changes in supply conditions, ceteris paribus

1. Research and Development

   This factor will lead to higher productivity and supply will increase leading to a fall in price. Terms of trade for the countries that supply the goods will face unfavourable terms of trade (as price of their exports gets lower).

2. Outbreak of wars

    This will cause a fall in the production of goods in the countries and lead to an increase in price. Export will become more expensive due to the shortage. Terms of trade will be favourable for the exporting countries.

3. Policy of self-sufficiency (autarky)

    This will lead to increase in supply for all products in the country leading to a price fall thus making terms of trade unfavourable.

IMPORTANT NOTE:

The results of these changes in terms of trade depend on how elastic or inelastic is the demand for exports or imports.
The impact of favourable terms of trade may not be positive all the way. Consider the following explanation:

If terms of trade is favourable:

1. Price of exports is relatively higher than the price of imports.
2. Exports will become more expensive than imports.
3. If the exports are inelastic relative to imports --> improvement in balance of trade. Why?
    The importing countries will still buy your exports --> increase in export revenue.
4. If the imports are inelastic relative to exports --> improvement in balance of trade. Why?
    The importing countries will reduce their spending on imports as price gets cheaper.
5. If exports are elastic relative to imports --> worsening in balance of trade. Why?
    The importing countries will switch to other countries products which are cheaper than your country's
    products. Your export revenue will fall.
6. If imports are elastic relative to exports --> worsening in balance of trade. Why?
    Now that the imports are cheaper, there will be an increase spending in imports.

Can you try to see the impact of unfavourable terms of trade?

NOTE:

The country whose terms of trade have worsened may not be able to to buy the exports of the country whose terms of trade have improved. If a country is highly dependent on its foreign trade which is subjected to frequent fluctuations (swings in the terms of trade), it may cause economic instability.

In actual fact, the effect of a change in terms of trade on the real national income of a country would depend on the causes of the change. A rise in the country's export price does not necessarily mean it is better off because the rise in price may have been caused by a fall in output. Export earnings may be lower than before although demand for exports tend to be inelastic. If export earnings fall, less imports could be bought. They still can enjoy improvement in terms of trade though as exports can still be greater than imports only lower.

On the other hand, a fall in a country's export price may not necessarily mean a worsening of the country's situation. The fall in price may be due to an improvement in technology in the export industry which will enable her to produce more but at a lower cost of production. Thus, national income will increase and the country will be better off.

Real-life situations are much much more complex. When you deal with terms of trade, please also consider other factors like exchange rate changes caused by factors like changes in tastes and preferences, inflation rate, interest rates, economic growth, real income and expectations. You can choose whatever factors you find can cause terms of trade to change. As long as you are consistent with your explanation, you are still on the right track.

Happy revising!!!