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International Economics. Terms of Trade

The terms of trade (TOT) is dependant upon supply and demand for the goods involved and is the ratio between two commodities. TOT is determined by the ratio presented by the two countries in return of the price that a country receives for its export commodity to the price it pays for its import commodity. A simple illustration of the TOT is represented by the example that if a country exports 100 dollars worth of product in exchange for 200 dollars worth of import then the country’s TOT would be 100/200 = 0.5. This way the TOT for the other country would be the reciprocal i.e., 2. Situations where this number is falling, the country’s TOT is on decline whereas the rising number presents a rise in TOT.

TOT can be viewed as the relative price of the ‘exportable’ commodities in terms of the ‘importable’ commodities, that is, the number of units of the latter obtainable for each unit of the former. It is through these relative prices that the relative benefits and cost involved in international trade are determined, but also in determining which commodities are exported and imported. Neoclassical economists believe that the terms of trade are determined by the production technologies involved, the scarcity of the factors of production, and the preferences of households or individuals (Deprez, 1995).

Here is an illustration that presents how TOT is determined. Consider two countries, A and B, which possess identical labour resources which they divide equally between the two primary products cloth and wheat. If A gets more efficient at producing wheat and B at cloth, this means that A specialises in wheat and B in cloth due to which A switches all its resources into wheat and B into cloth (Grimwade, 2000, p. 31). It is not necessary that as a result of specialisation, both countries would produce more of the two products with the same resources as before.

Therefore this does not mean that both countries will gain, provided they trade at the right terms of trade. This way we can analyse that the terms of trade are the rate at which cloth exchanges for wheat or vice versa. Specialisation would cause producers in each country to demand for a price for their goods which is better than the price which they could obtain domestically for trade to be worthwhile (Grimwade, 2000, p. 31).

There is a mechanism that links one country’s exports to other country’s imports which is complex and subtle, for it focuses on the foreign exchange market to illuminate what is going on. For example if the U.S starts reducing its tariff on Japanese goods one would expect U.S. demand for Japanese goods to increase. In this case, consumers in the U.S. will indirectly have to sell dollars on the foreign exchange market to purchase yen. This tends to depress the value of the dollar in terms of the yen or, conversely, to raise the value of the yen in terms of the dollar. This way the dollar value would be depreciated and would raise the price of Japanese goods in the U.S., dampening demand for those goods (Irwin, 1996, p. 6).

The flip arise when even though Japan did not change its tariff on U.S. goods, Japan starts purchasing more goods from the U.S. because the depreciated dollar tends to lower the yen price of U.S. goods. In other words, the TOT is influenced by the foreign exchange market which is one mechanism that links exports and imports to ensure that when a country unilaterally reduces its tariff its exports increase as well. While this is a highly simplistic example and can be subject to various qualifications in practice, it is nonetheless a useful thought experiment illustrating the influence of TOT. In most cases, one cannot directly observe the mechanism by which exports and imports are linked (Irwin, 1996, p. 6). Although the effect is not obvious or overt, it is still present and operative.

As far as TOT of a primary product exporting country is concerned, manufactured exports are valued for attributes that they are frequently believed to possess, beyond those of more traditional primary exports. Some of these attributes are also associated with other ‘non-traditional’ exports, and, particularly, with export diversification as a route toward greater stability of export earnings and the TOT (Helleiner, 1995, p. 5). In some countries, like Chile, policy focuses on the desirability of expanding ‘non-traditional exports’ rather than manufactured ones whereas in typical developing country circumstances, the former category is much larger than the latter.

Generally, both income elasticity and price elasticity of global demand are presumed higher for manufactures than for most traditional primary exports particularly from developing countries, therefore short-run supply elasticity takes place. Apart from the stabilizing effects of diversification that they may bring, the earnings from manufactured exports are also themselves usually more amenable to stable growth than those from primary products. Nonetheless there remain important uncertainties emanating from protectionist measures in principal markets; and the terms of trade for developing countries’ manufactures may deteriorate just as much as those for primary products (Sarkar and Singer, 1991).

Stabilization matters while reshaping TOT policies, for example in Colombia, a ‘crawling peg’ was introduced for the first time as early as 1967, in an effort to stabilize the real exchange rate. The real value of the currency thereafter tended to ‘track’ the terms of trade, creating increased incentives for manufactured and other non-traditional exports whenever coffee exports faltered, and conversely when they boomed.

Appropriate exchange rate policy, to achieve a domestic relative price of tradable that creates incentives for exports and export-oriented investments, undoubtedly continues to be critical to the future of manufacturing for export. Such exchange rate policy can only be sustained, however, if it is accompanied by fiscal, monetary and real wages policies that are fully consistent with it (Helleiner, 1995, p. 10).

Abiding by the trading policies with cooperation might involve only a limited, once-only activity, such as joining a trade mission from a given industry going to another country. Frequently organized by a government, this requires very limited group commitment with little real sense of cooperation. At the other extreme are more developed forms of cooperation, where high levels of cohesion exist, on a formalized, continuing basis.

In other cases cooperation for exporting purposes occurs on the basis of an arm’s length business relationship, as in a large turnkey project. The relationship between the principal and subcontractors often requires various forms of cooperation and is frequently cemented by a wide range of personal, social, and technical interactions (Rosson & Reid, 1987, p. 56). In some projects it is not uncommon for the eventual customer to stipulate a particular supplier as one of the subcontractors for one part of the total work, so that the cooperation is effectively imposed from outside.

In view of these apparently strong supportive reasons for export grouping it is perhaps surprising that there has not been a more sustained effort by individual firms or trade assistance agencies to bring them into operation. Clearly, the existence of such strong arguments is not a sufficient reason for the formation of export groups because in many cases the underlying rationale for grouping may have existed for some time, but it has not been translated into interest in or action toward any objective.

More important than actual numbers though is the composition of the group specifically the fit of the organizations and their products. To some extent the element of competition can be diverted when the group export operation is handled through a relatively independent party, for example, a trade association. A common external threat to the group’s members may also act to draw them together, overcoming a normal competitive tendency.

Primary products exporting countries’ preferential tariffs featured in the Anglo-American negotiations behind the GATT not only as a matter of principle but also around the specific issue of Imperial Preferences indeed, the negotiations almost broke down on this point. On the American side, easier access to the British, Canadian, and other Commonwealth markets was considered important as a counterweight to protectionist lobbies in selling a more liberal trade policy to the American public (Pomfret 1997, p. 73).

The trends in product composition differ across the seven industrial markets. In the United Kingdom the share of non-traditional products rose sharply, with the largest surge being in engineering goods. In the other markets the rise of non-traditional goods is relatively modest. Once again, the U.S. market stands out as the most dynamic, this time in terms of the shift from traditional to non-traditional products. As with the increased growth of manufactured imports from developing countries into the United States, the U.S. multinational corporations probably played an important role in the compositional shift for example, through the use of foreign assembly export platforms in electronic products.

If physical volumes of primary products are considered instead, the decline is more vivid. Further calculated by Martin Wolf, the physical volume of European Community imports of MFA products (including both textiles and apparel) from countries covered by agreements (excluding those with preferential treatment) grew by only 0.9 percent annually in 1976-81 (Cline, 1984, p. 64). Even when product upgrading is allowed for, however, growth of apparel imports has clearly been hurt by the tightening of the MFA.

Growth in the real value of imports of apparel fell from 8.1 percent annually in 1971-77 in the United States to -1.8 percent in 1978-81 (all sources) whereas in the European Community the decline was from 16.9 percent to 6 percent (from Hong Kong, Korea, and Taiwan). Followed by a similar drop in growth rate for imports of textiles into the European Community from the Far East, the United States’, however, textile imports have been declining in real terms for a full decade, reflecting not only early protection but also the process of capital-intensive modernization and increasing competitiveness of U.S. production.

Notwithstanding the uncertain outlook for protection in the world economy, the principal conclusion of the TOT is that primary product exporting nations appear to have considerable scope for continued expansion of their exports of manufactured goods at relatively rapid rates. But either a generalized move to extremely high growth rates for these exports (similar to the exceptional Korean performance in the 1960s and 1970s) or a concentration of exports in the most sensitive products would run the risk of a protective response from industrial countries.

The industrial country markets can absorb a relatively brisk growth of diversified manufactured exports from developing countries because the developing countries are experiencing intense pressure on their balance of payments, and steady growth of manufactured exports will be an important instrument for their continued economic growth (Cline, 1984, p. 34). Therefore in determining the TOT, export performance and economic growth matters and upholds consequences for the industrial as well as developing countries in terms of future markets and the capacity of developing countries to meet their obligations of payments on external debts.


Cline R. William, (1984) Exports of Manufactures from Developing Countries: Performance andPro spects for Market Access: The Brookings Institution: Washington, DC.

Deprez Johan, (1995) “Technology and the Terms of Trade: Considering Expectational, Structural, and Institutional Factors” In: Journal of Economic Issues: 29: 2.

Grimwade Nigel, (2000) International Trade: New Patterns of Trade, Production & Investment: Routledge: London.

Helleiner G. K., (1995) Manufacturing for Export in the Developing World: Problems and Possibilities: Routledge: New York.

Irwin A. Douglas, (1996) Three Simple Principles of Trade Policy, American Enterprise Institute for Public Policy Research: American Enterprise Institute: Washington, DC.

Pomfret Richard, (1997) The Economics of Regional Trading Arrangements: Clarendon Press: Oxford.

Rosson J. Philip & Reid D. Stanley, (1987) Managing Export Entry and Expansion: Concepts and Practice: Praeger Publishers: New York.

Sarkar, P. and Singer, H.W. (1991) “Manufactured Exports of Developing Countries and Their Terms of Trade Since 1965” In: World Development 19: 333-40.

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