Terms Of Trade

                         

INTERNATIONAL ECONOMICS

TERMS OF 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.