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Terms of Trade (TOT) Definition

Terms of Trade (TOT) is defined as the ratio of a country’s import and export prices. The concept of terms of trade is important in economics as it throws light on the extent to which a nation can fund its imports based on the returns of its exports.

Key Takeaways

  • Terms of trade reflect the ratio of a country’s export and import prices and their relative relation.
  • The concept throws light on a nation’s ability to fund its imports based on the returns of its exports. For instance, if a nation’s export prices are more than its import prices, then it can purchase more imports at the same price.
  • Formula = (Index of Export Prices Index of Import Prices) x 100.
  • Different types of TOT are needed to be looked at to get a holistic view of a nation’s economic performance.

How Does Terms of Trade Work?

In simple words, the concept of TOT studies the import prices in relation to export prices to bring to light the monetary position of a country.

For instance, if a nation’s export prices are more than its import prices, then it can purchase more imports at the same price. In this case, TOT will tell us that for the same unit of exports, the country can purchase more imports.

Let us understand the concept in depth with a quick example.

(all units costing 1 USD)

Country A: 1000 tons of corn, (needs 300), 800 tons of wheat ( needs 1000)

700 surplus corn – 200 deficit wheat= 500 surplus remains

Country B:  100 tons of corn, (needs 700), 300 tons of wheat (needs 100)

600 deficit corn + 200 surplus wheat = – 400 deficit.

All prices being equal in our example, we see that the nation with a surplus stock is better suited to meet its needs. In other words, there is a positive cash flow, and more capital is produced from exports than imports.

Terms of Trade Formula

Now that we have a basic understanding let’s take a look at how it is calculated.

Terms of Trade Formula = (Index of Export Prices Index of Import Prices) x 100.

The basic formula for TOT calculations is

Basic terms of trade: (The price of exports the price of imports) x 100.

Let us understand this with an example.

Country A can export 700 tons of corn to Country B = $700 export price

Country A needs to import 200 tons of wheat from Country B= $200 import price

(700200=3.5) x 100 = 350.

With prices remaining constant at $1 per unit across both countries and for both products, the value for Country A’s terms of trade is 350/1, or 350.

Implications

  •  If the value of terms of trade is less than 100%, it is considered an unfavorable situation. When the value gets lower than 100 %, it could signify that the country is earning less money in exports and spending more on imports. It may seem like an alarming situation as it may indicate that the country is spending more money than it is making in exports-imports.
  • A positive TOT shows the value over 100%, reflecting that the country is earning more in exports than it is spending on imports.
  • The calculations of this ratio are not very simplistic, like 1:1 as multiple export and import figures are involved. Not to mention, the changes in the ratio could flow from many different reasons throwing a misleading picture. Many studies have been conducted repeatedly to understand the complex relationship between price volatility and this ratio.
  • Many socio-political causes in relations to economic can bring about a change in the ratio. For instance, import prices fall on account of over availability of the stock due to a self-sufficiency bill passed in the parliament.
  • So, while export prices remain the same, import prices drop. This can drastically push the ratio up even though there has not necessarily been an improvement in the exports. For this reason, different types of terms of trade are used for a holistic view of a country’s economic standing.

 

Types of Terms of Trade

Terms of Trade 1

#1 – Net Barter

It is calculated as the percentage ratio of the export unit value indexes to the import unit value indexes, measured relative to the base year 2000.

Also, referred to as commodity terms of trade, it was coined to better understand the overall view of the changes in a country’s trading.

#2 – Gross Barter

It is a ratio of total physical quantities of imports to the total physical quantities of a given country’s exports. It is measured by

TG = (QM/QX) × 100 where TG is Gross Barter TOT,

  • QM is Aggregate Quantity of Imports and
  • QX is the Aggregate Quantity of Exports.

A higher  TG can indicate that the country can import more units from abroad for the given units of exports. In our example from earlier, we easily see that Country A has a higher TG, relative to Country B as it can import more units.

#3 – Income TOT

It is the purchasing power, in terms of (described as) the price of imports, calculated as Pm, of the value (price times quantity) of a country’s exports: ITT = PxQx/Pm.

ITT can increase through an increase in export prices, a rise in the number of exports, and a decrease in imports’ prices. Overall, it is used as one of the measurements of the capacity to import.

#4 – Single Factorial TOT

It is found by multiplying the net barter with the productivity index in the domestic export sector. This is essentially the net barter terms of trade corrected for changes in the productivity of export goods.

#5 – Double Factorial TOT

This expresses the change in the productivity of both the domestic export industry and the export industries of the foreign countries selected.

It is found by TD = TC (ZX/ZM)

where

  • TD is the Double Factorial TOT,
  • TC is the Commodity TOT,
  • ZX is the productivity index in the domestic export sector,
  • ZM is the productivity index in the foreign countries’ export sector, or it is an import productivity index.

#6 – Real Cost TOT

It is the theory that states that an increase in export production drives resources away from other sectors of the economy to the export sector.

For example, if farm workers are being used to produce wheat to export to other countries, resources like the labor, extraction, processing, shipping personnel etc. are being pulled from the production to suffice wheat production. Those workers could also theoretically be used for community farming or processing other grains needed for domestic consumption.

The amount of resources allocated elsewhere or “utility” cost (also described as “sacrifices”) per unit of resources employed in the production of export goods is considered to be the real cost terms of trade. Therefore, it accounts for the opportunity cost of exporting a good into the overall picture of exports production.

It is calculated by Tr = Ts. Rx

Where,

  • TR = Real Cost TOT
  • RX = index of the amount of disutility suffered per unit of the resources utlilized in the production of exports goods.

Also explained as when the single factorial terms of trade are multiplied by an index of the relative average utility per unit of imported commodities.

#7 – Utility TOT

This measures the changes in the disutility of producing a unit of exports. It also measures the changes in the satisfactions arising imports and the indigenous products wasted to produce those exports. It is essentially the changes in the real cost tot in terms of the utilities wasted.

It is found by multiplying the real cost terms of trade with an index of the relative average utility of imports and domestic commodities wasted.

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