The concept and calculation of terms of trade

Terms of trade refer to the ratio between the prices of a country's exports and the prices of its imports.

Formula for terms of trade index

$\text{Terms of trade index}=\frac{\text{index of average export prices}}{\text{index of average import prices}}\times 100$

Where:

• Index of average export prices = A measure of the average prices of goods sold abroad
• Index of average import prices = A measure of the average prices of goods bought from abroad

Worked example - Calculating terms of trade index

In a base year, a country's index of average export prices is 100 and its index of average import prices is also 100. In the following year, the export price index rises to 120 while the import price index increases to 110. Calculate the terms of trade index for the following year.

Step 1: Identify the values

• Index of average export prices = 120
• Index of average import prices = 110

Step 2: Apply the terms of trade index formula

$\text{Terms of trade index}=\frac{120}{110}\times 100$

Step 3: Calculate the terms of trade index

$\text{Terms of trade index}=\mathrm{1.0909...}\times 100=109.1$

Step 4: Interpretation

The index of 109.1 shows an improvement in terms of trade compared to the base year, meaning the country can afford more imports per unit of exports.

Effects of changes in terms of trade

Changes in terms of trade can make a country better or worse off economically, depending on whether the index rises or falls.

Consequences of a rise in terms of trade

• If export prices increase while import prices remain constant, the terms of trade index rises.
• This improvement means the country can purchase more imports with the same volume of exports.
• For example, if a nation exports a large amount of coffee and global coffee prices increase, its terms of trade index is likely to rise.

Consequences of a fall in terms of trade

• If a country's terms of trade index falls, it will effectively be worse off.
• For instance, during the recession in 2008-2010, the UK's terms of trade declined because import prices increased more rapidly than export prices.

Comparative advantage using production possibility frontiers

Comparative advantage occurs when a country can produce a good at a lower opportunity cost than another country. This concept can be illustrated using production possibility frontiers (PPF), which show the maximum combinations of two goods an economy can produce with fixed resources.

Key features of production possibility frontiers

A production possibility frontier (PPF) is a curve or straight line representing the maximum amounts of two goods an economy can produce with a fixed level of resources.

The gradient of the PPF indicates which country has the comparative advantage in each good.

For example, the steeper gradient of Country B's PPF shows it has the comparative advantage in wheat, whereas the gentler gradient of Country A's PPF shows it has the comparative advantage in coffee.

How specialisation and trade enable consumption beyond PPFs

Specialisation allows countries to focus on goods where they have a comparative advantage, and trade enables them to exchange surpluses. This combination lets economies consume more than they could produce alone, effectively moving beyond their individual PPFs.

By using specialisation and trade, countries can consume outside of their PPF. For example, if Country A produces 1500 wheat and 4500 coffee, and Country B produces 4000 wheat and no coffee. If Country B exports 2000 wheat to Country A, and Country A exports 1500 coffee to Country B, then Country A will consume at point P and Country B will consume at point Q – which are both beyond their respective PPFs.

Importance of trade for developed, developing, and emerging economies

International trade provides distinct advantages to economies at different stages of development, supporting growth, access to resources, and improved living standards.

Benefits for developed economies

• Imports are crucial to maintaining high standards of living in developed countries.
• Products will often be cheaper when bought from abroad, for example, due to increased competition and cheaper labour in developing countries.

Benefits for developing economies

• Developing countries can import goods they do not have the technology to produce themselves, which results in a higher standard of living.
• Trade also gives these countries access to new materials, meaning new industries will be created because they can produce new products. This will help to improve the economies of developing countries.

Benefits for emerging economies

• Emerging economies will experience some of the benefits of both developed and developing countries.
• For example, emerging economies will be able to purchase cheaper products from developing countries, and they will also benefit from importing products and services they do not have the technology to produce themselves.