Specialisation and exchange benefit all the trading partners. Because of complete specialisation in the production of the commodities in which countries have comparative advantages as suggested by Ricardo, global production becomes larger.
Now, if every country trades with each other, every country will gain from such exchange.
However, such gain from specialisation and exchange depends on the terms of trade (TOT). 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 is defined as PX/Pm.
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In the real world, where countries export and import a large number of goods, TOT are computed as an index number:
To calculate index of export and import prices, we choose base year and the current period. A base period index of export and import price is 100. Thus, TOT for the base year is 100. Suppose, export price index rises to 120 and import price index rises to 110. Thus,
TOT rises to 109. This means that a unit of export will buy 9 p.c. more imports than the old TOT. TOT thus improves. A fall in TOT, on the other hand, implies unfavourable TOT in the sense that the country concerned will now use more exports to buy the same quantity of imports.
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On which factors TOT depends? Answer to this question was unknown to Ricardo. In other words, Ricardo could not locate the exact TOT at which trade takes place. This is because of the fact that Ricardo concentrated on the cost or supply side of production and ignored demand conditions. Anyway, Ricardo suggested that the TOT would settle in-between two domestic cost ratios. We explain first the Ricardian notion of TOT and then Mill’s concept of reciprocal demand.
Let us assume that the internal or domestic cost ratio in country A is 1 X for 1.5 Y and in country B is 1 X for 2 Y. This domestic cost ratio suggests that country A has a comparative advantage in X while country B has a comparative advantage in Y. Thus, A and B will trade with each other. But, what would be the TOT at which both will trade? Ricardo argued that international TOT would lie somewhere between 1: 1.5 and 1: 2 and both the countries would stand to gain.
It was J. S. Mill who successfully determined the exact TOT by introducing the concept of reciprocal demand. In other words, actual TOT depends on the relative prices of X and Y after trade takes place. These relative prices will depend upon the strength and elasticity of each country’s demand for another country’s product or upon reciprocal demand.
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If TOT lie very close to 1:1.5, then country A would gain very little and she would not offer much X for export. However, at this TOT, country B would gain quite a large amount since it would demand more X by offering less Y. Consequently, country B’s demand for imports of X would exceed country A’s supply of exports of X and the price of X in terms of Y would then rise.
As the TOT rises to 1: 1.6; 1: 1.7, etc. country A offers more X to buy more Y, while country B demands less Y to buy X. In this way, a particular TOT would prevail at which the value of each country’s export equals its value of imports. In this way, reciprocal demand is equated in the two countries at the international TOT.
Thus, TOT lies between the upper and lower limits of domestic cost ratios of two countries. Equilibrium or international TOT brings equality between export and import. At the equilibrium TOT, world output equals world consumption. But the gains to both the countries need to be equal.
However, more favourable the TOT to any country, greater is the welfare of the country. A tariff imposed on importables may bring TOT in favour of the tariff-imposing country. However, if the tariff rate exceeds the optimum tariff rate, gains from trade may reduce even though TOT may be favourable. Thus, a favourable TOT does not necessarily increase welfare of a nation. Still then, TOT must not be adverse.