Subjects

Economics

Explore Economics
Search

The terms of trade measures the rate of exchange of one product for another when two countries trade.

David Ricardo's theory of comparative advantage explains that if countries specialise in the production of the good/service in which they have a comparative advantage, then all countries can move outside their PPF and gain from trade. How the gains from trade are distributed depends on the terms of trade.

We calculate the terms of trade as an index number using the following formula:

Terms of Trade Index (ToT) = 100 x Average export price index / Average import price index

If a country can buy more imports with a given quantity of exports, its terms of trade have improved.

For example, during the commodity price boom, many resource-exporting developing countries experienced increases in their terms of trade. In other words, for the same physical quantity of exports (copper, rubber, oil etc.) as before, they could buy more consumer and capital goods from abroad

If import prices rise faster than export prices, the terms of trade have deteriorated. A greater volume of exports has to be sold to finance a given amount of imported goods and services. Typically this leads to a fall in the standard of living because imports of food and technologies are more costly

The terms of trade fluctuate in line with changes in export and import prices. The exchange rate and the rate of inflation can both influence the direction of any change in the terms of trade

A key variable for many developing countries is the world price received for primary commodity exports e.g. the world export price for Brazilian coffee, raw sugar cane, iron ore and soybeans.

Significance of changes in the terms of trade
Featured
CPD courses

Teaching Behavioural Economics at A Level

This new course supports colleagues delivering the behavioural economics teaching content for the new AQA A Level Economics specification from September 2015.

Learn more ›

Teaching & learning products

Edexcel A2 Economics Worked Answers (2014)

Example A Grade answers to the Edexcel Unit 3 and Unit 4 exam papers sat in June 2014

£5.00

AQA Economics Year 1 (AS) Course Companion

Our AQA A Level Economics Year 1 (AS) Course Companion is the designed as a high quality and cost-effective replacement for expensive and overly complicated textbooks. The Course Companion maps precisely against the AQA specification and teaching content for Year 1 (AS) and provides students with comprehensive and concise coverage of what students really need to know and understand.

£100.00

Close

Economics