UNIVERSITY OF LUCKNOW, LUCKNOW

FACULTY OF LAW

LL.B (5 Years Integrated) (2024-2029)

Subject : Economics II

Assignment on

Topic : Terms of Trade

Submitted by: Submitted to:

Name: Aafiya Khan Dr. Kulsoom Raza
Roll no. : 2410013015156
Class Sr. No. : 71
Section : B
 ACKNOWLEDGEMENT

The success and outcome of this project required a lot of guidance and
assistance from many people and I am extremely privileged to have got this all
along the completion of my project. All that I have done is only due to such
supervision and assistance and I would not forget to thank them all. I respect
and thank Dr. Kulsoom Raza ma’am for providing me an opportunity to do the
project work and giving us all support and guidance, which made me complete
the project duly. I am thankful to and fortunate enough to get constant
encouragement and guidance from all teaching staff which helped me in
successfully completing our project work.
 INDEX

Serial No. Topic Page no.

1 Introduction : Meaning and Definition 1-3

2 Concept and Measurements

I) Net Barter or Commodity Terms of
Trade
II) Gross Barter Terms of Trade
4-10
III) Income Terms of Trade
IV) Single Factorial Terms of Trade
V) Double Factorial Terms of Trade
VI) Real Cost Terms of Trade
VII) Utility Terms of Trade

7 Conclusion 11

8 Bibliography 12
 INTRODUCTION

In today's interconnected world, no country can produce everything it needs on its own.
Countries rely on trade with one another to obtain goods and services that they cannot
efficiently produce domestically. This exchange of imports and exports helps nations access a
wider variety of products, improve living standards, and boost economic growth.

However, the balance between what a country exports and what it imports plays a very
important role in determining the health of its economy.

When a country imports more than it exports, it can lead to economic challenges such as
increased debt, weakened currency, and dependency on foreign markets. On the other hand, if
exports are higher, it can strengthen the economy and improve national income.

This balance is measured through a concept known as Terms of Trade (TOT).

Terms of Trade refers to the ratio between the prices of a country’s exports and the prices
of its imports. It shows how much import goods a country can purchase for a given quantity
of its exports. A favorable terms of trade means a country can buy more imports for the same
amount of exports, while an unfavorable ratio means the country gets less in return for what it
sells abroad.

MEANING AND DEFINITION

The concept of Terms of Trade plays a crucial role in understanding how countries exchange
goods in the global economy.

According to the well-known economist Jacob Viner,

"Terms of Trade refer to the ratio of export prices to import prices."

In simple terms, this means the terms of trade show how much a country earns from its
exports compared to what it spends on imports.

In a world where only two nations are trading, the goods exported by one country become the
imports of the other. As a result, the terms of trade for one country are simply the inverse, or
reciprocal, of its trading partner’s terms of trade.

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When more than two countries are involved, and a variety of commodities are traded, the
terms of trade are measured using price indexes -- specifically, the ratio of the export price
index to the import price index. This ratio is typically multiplied by 100 to express the terms

of trade as a percentage.

This basic form is often referred to as the commodity terms of trade or net barter terms of
trade, to distinguish it from other, more advanced measures.

An improvement in a nation’s terms of trade is generally seen as beneficial, as it means the

country is receiving higher prices for its exports compared to what it pays for its imports. In
other words, the country can afford more imports for the same quantity of exports.

Different economists have introduced several approaches to define and measure terms of
trade.

As highlighted by G.M. Meier, these concepts can be classified into three main categories:

(i) those that relate to ratio of exchange between commodities - the Commodity and Income
terms of trade

(ii) those that relate to interchange between productive resources - the Single and Double
factorial terms of trade

(iii) those that interpret the gains Terms of Trade and Developing Countries from trade in
terms of utility analysis - the Real cost and Utility terms of trade.

It refers to the quantity of imports that exports buy. It is measured by the ratio of export price
to import price. It is the ratio at which a country can export or sell domestic goods for
imported goods.

Let Px be the price of export good and Pm be the price of import good.

Thus, the Barter or Commodity TOT are defined as Px/Pm.

In the real world, where countries export and import a large number of goods, TOT are
computed as an index number:

T0T = (index of export prices/index of import prices) × 100

or,

TOT = (Px/Pm) × 100

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Illustration :

Let’s say, Country 1 sells (exports) a product called Commodity X and buys (imports) a
product called Commodity Y.

The terms of trade for Country 1 are calculated by dividing the price of X by the price of Y

= (Px/Py)

Now, if Country 1 trades many different products instead of just one, the prices are measured
using an export price index (for all the products it sells) and an import price index (for all
the products it buys).

The same formula applies:

Terms of Trade = Export Price Index / Import Price Index.

On the other hand, if Country 2 is selling Commodity Y and buying Commodity X, its terms of
trade will be the opposite:

= Py/Px.

This is the inverse of Country 1’s terms of trade.

If one country’s terms of trade go up, the other’s usually go down.

For example, if Country 1’s terms of trade rise from 100 to 120, this shows its export prices
have increased by 20% compared to import prices. At the same time, Country 2’s terms of
trade will fall to (100/120)100 = 83 because when one improves, the other weakens in a
direct trade relationship.

Usually, economists set the base year’s terms of trade at 100 so that it’s easy to see
percentage changes over time.

However, Even if country l’s terms of trade improve over time, we cannot conclude that
country 1 is necessarily better off because of this, or that country 2 is necessarily worse off
because of the deterioration in its terms of trade.

Changes in a country’s terms of trade are the result of many forces at work both in that nation
and in the rest of the world, and we cannot determine their new effect on a nation’s welfare
by simply looking at the change in the country’s terms of trade. Simply looking at the terms
of trade number doesn’t give the full picture of a country’s well-being.

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 CONCEPT AND MEASUREMENTS OF TERMS OF TRADE

1. Net Barter or Commodity Terms of trade:

The idea of Net Barter Terms of Trade was first introduced by F.W. Taussig in 1927. Later,
economist Jacob Viner referred to the same concept as Commodity Terms of Trade in 1935.

The basic definition is simple: it is the ratio of the price of exports to the price of imports.

To make this ratio easier to read and compare, it is usually multiplied by 100 so it can be
shown as a percentage.

The formula for Commodity or Net Barter Terms of Trade is:

N = (Px / Pm) × 100

Where:

N = Commodity or Net Barter Terms of Trade

Px = Price of exports

Pm = Price of imports

When a country trades a variety of goods and wants to track changes over time, economists
use price indexes instead of individual prices.

The terms of trade are then calculated using the following formula:

N = (Px₁ / Px₀) ÷ (Pm₁ / Pm₀) × 100

Where:

Px₁ = Export price index in the current year

Px₀ = Export price index in the base year

Pm₁ = Import price index in the current year

Pm₀ = Import price index in the base year

If the value of N increases over time, it means the country can either:

 Get more imports for the same quantity of exports, or

 Export less and still afford the same amount of imports.

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Usually, when the terms of trade improve, it is seen as a sign that the country's economic
welfare has improved, because it earns more from exports and pays less for imports. This
allows the country to benefit from higher export prices while spending less on foreign goods.

But in reality, this isn’t always the case. If the demand for a country’s exports is very elastic
(meaning buyers are sensitive to price changes), a rise in export prices might cause a sharp
drop in the quantity of goods sold, leading to lower total export earnings.

Similarly, if the demand for imports is elastic, a fall in import prices might tempt the country
to import much more, which could cause a big increase in total import spending.

So even if the terms of trade look favorable, the country's overall welfare might actually fall
if export earnings decrease and import spending rises too much.

Because of this, economist Haberler suggested that instead of trying to maximize the terms of
trade, a country should aim to optimize them - meaning the best possible balance, where
export earnings are at their highest and import costs are at their lowest.

This point of optimization is where a country can benefit the most from its trade, both in
terms of income and spending.

2. Gross Barter Terms of Trade:

The Gross Barter Terms of Trade (G) refers to the ratio of import volume to export volume.

It may be expressed as:

G = (Qm/Qx) × 100

Where,

G = Gross Barter Terms of Trade

Qm= the physical quantity of imports

Qx = the physical quantity of exports

In case of many commodities and comparison between two periods, the gross barter terms of
trade refers to the ratio of indices of quantities imported to quantities exported.

It is expressed as:

G = (Qm₁ / Qm₀) ÷ (Qx₁ / Qx₀) × 100

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Where,

Qm1 = the quantity index of imports in current period

Qmo = the quantity index of imports in base year

Qx1 = the quantity index of exports in current year

Qxo = the quantity index of exports in base year

A rise in G is regarded as favourable changes as more imports are received for given volume
of exports.

As mentioned earlier, Taussig introduced the idea of Gross Barter Terms of Trade as an
improvement over the Net Barter Terms of Trade. However, this concept also has its own
limitations.

One major drawback is that it does not take into account the effects of changes in
productivity, the quality of goods, or the overall composition of a country’s foreign trade.

In addition, there has been debate about whether unilateral payments (such as gifts, foreign
aid, or remittances) should be included in the calculation of terms of trade. Economists like
Meir (1970) and Haberler (1968) argued that it is better to treat such unilateral transactions
separately rather than including them in the terms of trade index.

3. Income Terms of Trade:

S. Dorrance introduced the concept of Income Terms of Trade in 1948 to improve on the Net
Barter Terms of Trade. This new measure adjusts the commodity terms of trade to account for
changes in the volume of exports.

The formula is:

I = N × Qx

Where:

I = Income terms of trade

N = Commodity terms of trade

Qx = Export volume index for a specific period of time

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When “I” rises, it means the country can import more goods by selling its exports. In other
words, the country’s ability to import based on its exports has increased.

This concept is especially useful for developing countries, which often struggle with low
export prices, small export volumes, and higher import prices. The Income Terms of Trade
help highlight the changes in a country’s capacity to import based on its exports.

However, this measure doesn’t give a complete picture of the gains from trade.

For example, if a country can increase its ability to import by depleting its real resources (like
natural resources), it may harm the country's long-term growth potential and its ability to
improve living standards

Also, the Income Terms of Trade don’t account for a country’s full import capacity, as factors
like capital inflows, receipts from services, and unilateral payments also play a role.
Therefore, a country might have worsened income terms of trade but still experience an
increase in foreign exchange reserves, which could mean a larger ability to import despite the
negative terms of trade.

4. Single Factorial Terms of Trade (S):

Jacob Viner (1948) introduced the concept of Single Factorial Terms of Trade (S) to refine
the Net Barter Terms of Trade by adjusting for changes in the productivity of factors used in
the production of export goods.

This is calculated by multiplying the commodity terms of trade by the productivity index of
the export sector.

The formula is:

S = N × Zx

Where:

S = Single Factorial Terms of Trade

N = Net Barter Terms of Trade

Zx = Productivity index of export industries

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An improvement in S means that the productivity of the export industry has increased.
However, while S may improve, N could deteriorate if the increase in productivity reduces
the export price while the price of imports remains unchanged.

This measure is considered more accurate and scientific than commodity terms of trade,
especially for developing countries, where growth often involves the use of more efficient
production techniques.

However, there are criticisms like:

Obtaining the necessary data to calculate the productivity index is difficult.

Measuring productivity is challenging because it depends on factors like

psychological and technical elements, which are hard to quantify.

Additionally, productivity varies not only between industries but also from one plant
to another, complicating the calculation of the productivity index over time.

Furthermore, the Single Factorial Terms of Trade does not consider changes in productivity
in other countries and how that might impact the terms of trade. To overcome these
limitations, Viner later introduced the concept of Double Factorial Terms of Trade.

5. Double Factorial Terms of Trade (D):

Double factorial terms of trade (D) take into account the changes in productivity both in the
domestic export sector and the foreign export sector producing the country's imports.

It can be expressed as:

D = N × Zx/Zm

Where,

D = the double factorial terms of trade

N = the net barter terms of trade

Zx = the export productivity index

Zm = the import productivity index

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A rise in D is favourable movement because it implies that one unit of home factors of
production embodied in exports can now be exchanged for more unit of foreign factors
embodied in imports.

In other words, the productive efficiency of the factors producing export has increased
relatively to the factors producing imports in the other country.

The factorial terms of trade both single and double are of little practical significance because
it is difficult to measure statistically changes in productivity of factors of production.

6. Real Cost Terms of Trade (R):

The increased production of export goods requires the diversion of productive resources from
other sectors to the export sector. The amount of utility lost or sacrificed per-unit of resources
employed in the production of export goods constitute the real cost of producing exports.
Imports on the other hand represent gain of utility.

Jacob Viner introduced the concept of Real Cost Terms of Trade (R) to measure the gains
from trade in terms of utility. The basic idea is that producing more export goods requires
shifting productive resources from other sectors to the export sector. The real cost of
producing these exports is the utility lost per unit of resources used in their production. On
the other hand, imports are seen as a gain in utility.

To measure the Real Cost Terms of Trade, Viner suggested multiplying the Single Factorial
Terms of Trade by an index that reflects the amount of disutility (or sacrifice) per unit of
resources used in producing export goods.

The formula is:

R = N × Fx × Rx

Where:

R = Real Cost Terms of Trade

Fx = Index of productivity in export industries

Rx = Index of the disutility (or cost) incurred for each unit of resources used in the export
sector

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If R increases, it means that a country is getting more imports relative to the real cost
involved in producing its export goods. However, this concept has some limitations. The
disutility or real cost of producing more exports is difficult to measure precisely because it's a
subjective concept and hard to quantify in exact terms.

Additionally, while this measure focuses on the real cost of producing exports, it doesn’t
consider the cost of diverting resources from goods used for domestic consumption to
produce exports in exchange for imports. It also doesn’t account for the real costs involved in
producing substitutes for imports within the country.

7. Utility Terms of Trade (U):

Jacob Viner introduced the concept of Utility Terms of Trade (U), which refines the Real
Cost Terms of Trade by correcting for the relative desirability of imports and the domestic
goods that are sacrificed when resources are diverted to produce more export goods.

This index, according to Viner, adjusts for the utility lost due to this resource reallocation.
The Utility Terms of Trade can be expressed as:

U = N × Fx × Rx × Um

Where:

U = Utility Terms of Trade

N = Net Barter or Commodity Terms of Trade

Fx = Index of productivity efficiency in export industries

Rx = Index of disutility (the cost) incurred per unit of productive resources in the export
sector

Um = Index of the relative utility of imports and domestic goods that are forgone

An increase in U indicates that a country gains more in utility from imports than the utility
lost from the domestic goods it must sacrifice to produce more exports.

However, this measure has been criticized for its reliance on subjective and non-quantifiable
concepts of utility. These are difficult to measure in a precise, objective manner, which limits
the practical usefulness of the Utility Terms of Trade.

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 CONCLUSION

In conclusion, despite the various criticisms and limitations associated with the different
measures of terms of trade, the Net, Gross, and Income Terms of Trade remain the most
widely used in economic discussions and analyses, especially since the early 1950s.

The primary reason for their widespread application is their simplicity in both calculation
and interpretation. These measures are particularly useful for historical analysis, offering a
practical approach to understanding trade relations and their impacts over time. They provide
a clear and accessible way to measure the exchange of goods between countries, making
them popular tools for economists and policymakers alike.

In contrast, concepts such as the Double Factorial Terms of Trade, offer a more refined
approach by accounting for changes in productivity. However, they face significant
challenges in their application. These concepts require detailed data on the productivity of
various sectors within an economy, as well as across different countries. Unfortunately, such
data is often not readily available or is difficult to obtain, especially over extended periods.
Moreover, even when productivity data is available, measuring changes in productivity
consistently remains a complex task due to various factors, such as technological
advancements, labor efficiency, and other intangible elements that can affect productivity.
These difficulties further complicate the use of more advanced terms of trade measures,
making them less practical for general application compared to the simpler and more widely
accepted terms of trade.

Ultimately, while the Net, Gross, and Income Terms of Trade provide a useful and accessible
framework for understanding international trade dynamics, the more refined concepts
highlight the importance of considering productivity and other factors in a country's trade
relations.

Nonetheless, the challenges in obtaining accurate and consistent data for these advanced
measures limit their broader use in real-world economic analysis.

As such, the more straightforward measures continue to dominate the discourse on terms of
trade, even though they may not capture all of the complexities of global trade relationships.

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 BIBLIOGRAPHY

 Datt, R. (2006) Indian Economy, S. Chand & Company Ltd.

 Ahluwalia, I. J. (2011) Economic Reforms in India: Challenges and Prospects, Oxford

University Press.

 Ghosh, B. N. (2009) Economic Theory and Indian Economy, Kalyani Publishers.

 Jain, S. P. (2014) Indian Economy: A Comprehensive Analysis, Atlantic Publishers &

Distributors.

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