THE GAIN S FROM TRADE

1. MEA NING
The gains from trade refer to net benefits or increases in goods that a country obtains by trading
\Vith other countrie s. It also means the increase in the consump tion of a country resulting from
exchang e of goods and specialis ation in producti on through internati onal trade.
The theory of gains from trade was at the core of the classical theory of internati onal trade.
Accordin g to Adanz Smith 1, the gains from trade resulted from the advantag es of division of
labotu and specialis ation both at the national and international level. They were due to the exist-
ence of absolute differences in costs, that is, each country would specialise in the producti on of that
commod ity which it could produce more cheaply than other countries and import those com-
modities which it could produce dearly. Thus international specialisation would increase world
output and benefit all the trading countries.
For Ricnrdo, extensio n of internati onal trade very powerfully contribu ted 'to iDcrease the mass of
commod ities, and therefore , the sum of enjoyments ... obtaining the imported goods through
trade instead of domestic producti on.' J.S. Mill analysed the gains from internati onal trade in
terms of his theory of reciprocal demand which depends upon the terms of trade. In n1oden1
analysis, the gains from internati onal trade refer to the gains from exchange and the gains from
specialisation based on the general equilibri um analysis.
MEAS UREM ENT OF GAINS FROM TRADE
Econom ists have adopted various methods to measure the gains from internat ional trade which
are explaine d as under:
1. The Classica l Method . Jacob Viner 2 points out that the classical econom ists followed three
diffe~ent methods or criteria for measuri ng the gains from internat ional trade: (1) differenc es in
compara tive costs; (2) increase in the level of national income; and (3) the terms of trade. But
they often intermix ed these methods without specifyin g them clearly. We disct1ss them as un-
der.
P'1cardo's Approach. To take Ricardo' s approac h first a country will export those commod ities in
~,ruch its compara tive product ion costs are less, and will import those commod ities in ¥lhlch its
compara tive product ion costs are high. "The country thus econom ises in the use of its resources
bta ning for a given amount thereof a larger total income than if it attempt ed to produce e, er)·
·ng tself. ''
Prof. RonaJd Findlay in his Trade and Specialisation (1970) has explaine d Ricardo 's approach to
the ga n from internat ional trade in tern1s of Fig. 1. In the pre-trad e situation , AB is the produc-
bon po 1biHty curve of a country which produce s two corrunod ities X and), gi, en the quantit\
of labour input. On AB, the country is in equilibr ium at point E. After it enters into trade, its
internat ional price ratio is given by the slope of the line CB. Suppose tl1at it is in equilibrLttm at
point Fon the line CB. I( the quantiti es of X and ) represen ted b) the co1nbination at Fare to be
 THP. GI\INS FROM TRADE : 121
r11)titH- X'd 1l1Ullni l1l,il!\ lht· \I\11111
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1
lit 1l l'\H':,. h. t'l 1)\ l\ I(' t'h'1' I h}ssihd
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'P lrnm 1\H lo /\ 1/! 1• I he );ains fr1>m trade will thus be
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.I "
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1

A 1l3 1 ls pr~ler,,bh.' k1 lh,H on CH. ~

rrt' 1 R1.,n,1ld Finctl.,y h.is n1odifi0d the Ricardo measure of 0 8 0 B,
X-Commodity
the f-•rn:s f~L)In lr.1de using the community indifference
(lll "-~ l 1. lt th 1..' l:1 bour input is increased sufficiently lo 1
FIG.
push tlw prodnc hon possibility curve lo A B instead of to A B the point G on the Cf curve will
l . i' . :i
m,, . . .e_~.,c' mt tVH. ual as better as he is at() the
I (l I I'
free trade point F. The gains from trade would,
thcreh) ft', he equal to B8 0 /OB instead of the larger BB /OB. This measur e satisfie
1 s Malthu s's
critil:ism of Ricardo.
,\ Wl' ~ A pproac!i • J.S. Mill analysed the gains as well as the distribution of the gains from interna-
tional tradP in tenns of his theory of reciprocal demand. Accroding to Mill, it is recipro
cal de-
mand Lhat determ .ines terms of trade which, in. turn, determine the distribution of gains
from
trade of each cotmtry. The term 'terms of trade' refers to the barter terms of trade between the
two countri es i.e., the ratio of the quantity of imports for a given quantity of exports of a cotmtry
.
To take an example, in cotmtry A, 2 units of labour produc e 10 units of X and 10 units of Y, while
in country B the same labour produces 6X and 8Y. The domestic exchange ratio (or domest
ic
terms of trade) in cotmtry A is lX =1Y, and in country B, lX =l.33Y. This means that one unit
of
X can be exchanged with one unit of Yin country A or 1.33 units of Yin country B. Thus the
terms of trade betwee n the two countries will lie between lX or 1Y or 1.33 Y.
However, the actual exchange ratio will depend upon reciprocal demand , i.e., "the relative
strength and elasticity of demand of the two trading countries for each other's product in terms
of their own product." If A's demand for commodity Yis more intense (inelastic), then the terms
of trade will be nearer lX = 1Y. The terms of trade will move in favour of Band against country
A. B will gain more and A less. On the other hand, if A's demand for commodity Y is less
intense
(more elastic), then the terms of trade will be nearer lX = 1.33Y. The terms of trade will move
in
favour of A and against B. A will gain more and Bless.
The distribution of gains from trade is explained in terms of the :O
Marshall-Edgeworth offer curves in Fig. 2. OA is the offer curve of
,R T
country A, and OB of country B. OP and OQ are the domestic con-~
stant cost ralios of producing X and Yin country A and B respec-~
lively. These rays are, in fact, the limits within which the terms of~
trade between the two countries lie. However, the actual terms of8
i
trade are settled at Ethe point of intcr~section of OA and OB. The>-
line OT represents equilibrium terms of trade ,,t E. _ . .
The cost ratio within country A is KS units of Y :.OK umts ot X. But
'~
it gets KE units of Y through trade. S£ units ~f Y is, therefor~, its X•Commodity
gain. The cost ratio within country Bis KR units of Y: OK umts of FIG. 2
: INl l·l~N A l'H}N \I It '(lN( )l\1H
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lt•vd.
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Fig. ~ C'\p
1nily 1111 liff(•1t•11u. 111 VC'
1 f'p.
(he sup ply sr(k" dlld ( ·1 11 is the l.:Ol llm1
c·co1111,ny I he clo, t<I ,-,,
rt•p resc nlin g the dcm,111d ~icf,, of tll''
wn by poi, ,t I. whc1 fl
eco nom y (llll lr,1ch•) equ ilibr ium is sho
t ,md bolh ('tjL1tl 'I
the J\B c1nd C/0cm ves ,1re tnnAen! lo <?,Kh olhc
th(' dom esti c term s ll( lr,1d c or commod
i1y price- r·,1110 (lirw ) ti. p
free) lr,1dc, the in- 1;- A
Wit h the intr odu dio n l'lf intc rn:i tion ;il (or
1ernJlionc1I pric e rt1tio (te, m~ of trc1dc)
will be d1ffcrcnl irom 8 t--~ ---" """ -
J(; shown JS P, ;ind ~
the dom esli c pric e r;1tio (te1m~ of trade). ft
is slee per than the domestic price r.1ti
o P. It me,,n~ t]iat the 8
lion to corn moc l- >-
pric e of com mod ity X has increased in rel,1 K'- - - - - - •• -
l1onal price line r,,
ity Yin the worJd mttrket. At the mten1d
rnunity indif-
the consumers move to point Con a hig·hcr com o
e. This move- 8
ference curve Cl, from point Eon the C/0 curv X-C omm odity
r. or co usu mp-
men t from E to C measures the gahz from exclimrg FIG. 3
lion gain wit h no change in production. and
ld market, pro duc ers incr eas e its production
Since the price of X has increased in tJ,e wor N
decrease that of Y. This leads to movement
along the transformation cur ve from point C to
al N the
re a new inte rna tion al pric e line P is tang ent to the AB cur ve. Jn oth er wor ds,
whe 2
of tran sfor mat ion in pro duc tion equ als the inte rna tion al price ratio. The new world
marginal rate rriol
e it is parallel to Pr At N the coun lry exports
terms of trad e ratio P2 is the sam e as P1 bec aus
X in exc han ge for KC, imp orts of Y.
of incr ease d spe cial isat ion in the pro duc tion of X, there is a shift in con sum ptio n from
As a resu lt
e, where consumers con sum e larger quanti·
point Co n the C/ 1 cur ve to point C1 on the C/2 curv produc·
to C1 mea sur es the gain from specialisation in
ties of both X and Y. This mo vem ent from C
prod uction gain . At C, the mar gin al rate of sub stitution and the international price ratio are
lion or
gain s from inte rnat iona J trad e are max imi sed at poi nts N and C berause the
equal. Hence the ump·
and the mar gin al rate of substitution\n coris
mar gin al rate of tran sfor mat ion in pro duc tion of the
o P . The total gai n from free trad e is the sum
tion are equ al to the inte rna tion al pric e rati 2
n ~d pro duc tion gain s and is sho wn as imp rov eme nt in welfare from Cl0 to Cir
con sum ptio
0nal Inco me. Thi s ana lysi s also exp lain s the increase in the real income and hence
Increase m Nat1 me thart tbe
gains from trade. Point No n the pric e line P2 corresponds to a higher real inco
the
Eat the price line P. This is bec ause at the new price line p,2 there are production
pre-trade point
e.
and consumption gain s to the cou ntry afte r trad
9. STA TIC AN D DY NA MIC GA INS FRO M
TRA DE
The gain s from trad e are divi ded into static and
dyna mic gain s which are d8Jcussed as under :M

STA ffCG AIN S

The following are the sta
1,-of
ll!lldt&omthead
nafioaal levell GI~
llonoadle
Its.good,
country med!dl•
produce at a ~~
 THE GAINS FROM TRADE : 129

cost n~sullint.; from ol~t,,~ning the irnpol'ted goods through trade instead of domestic produc-
li1Jn. " Thus trade ma:\'.nn1ses production.
2. Incre~se in \,Vclfar~. /\s c1 resull of international division of labour and specialisation, the
production of goods increases in the trading country. As a result, the consumption of goods
inLrcase~ and so does the welfare of the people. As pointed out by Ricardo, "The extention of
intcrn,,ttr,n,,t trc1de very powerfully contributes to increase the mass of commodities and, there-
fore , the sun1 of enjoyments."
3. Increase in Nat~onal Income. When a country gains from international specialisation and
exch 0 nge of goods m trade, there is increase in its national income. This, in turn, raises its level of
output and growth rate of the economy.
4. Vent for Surplus. The gain from trade also arises from the existence of idle land, labour, and
other resources in a country before it enters into international trade. With its opening (vent) to
worl~ markets, its. r~sources are used to produce a surplus of goods which would otherwise
remam unsold. This 1s Adam Smith's vent for surplus gain from trade.
DYNAMIC GAINS

The following are the dynamic gains from trade:

1. Efficient Employment of Resources. The direct dynamic gains from foreign trade is that com-
parative advantage leads to a more efficient employment of the productive resources of the
world.
2. Widens the Market. The major indirect dynamic gain from trade is that it widens the size of
the market. By enlarging the size of the market and scope of specialisation, international trade
makes a greater use of machines, encourages inventions and innovations, raises labour produc-
tivity, lowers costs and leads to faster growth.
3. Development of Other Activities. When a country starts producing goods for export and
importing goods for domestic consumption, other economic activities also develop. There is
expansion of infrastructure facilities in power, and building highways, bridges, fly-overs, etc.
Shopping and housing complexes are built along with industrial centres. The primary sector
develops into business sector for export of raw materials and for domestic use. Tertiary sector
expands in the form of banks, communications, insurance, etc.
4. Increase in Investments. Foreign trade encourages the setting up of new units for assembling
and production of variety of goods. Supplementary and ancilliary units are established. Produc-
tion for exports leads to backward and forward linkages in developing other activities referred
to above. All these increase autonomous and induced investments in the country.
 TH E TER MS OF TR AD E

The terms of trade refer to the rate at which the good s of one coun try
exch ange fo~ the goodsc
anoth er country. It is a meas ure of the purch asing powe r of expo rts
?fa coun ~y m te:rns ot l~
impo rts, and is expre ssed as the relation betw een expo rt price s and
impo rt pnce s of its goods.
When the expo rt prices of a coun try rise relatively to its impo rts price
s, its term s of trade are sa1r.1
to have impro ved. The coun try gains from trade becau se it can have
a large r quan tity of imports
in excha nge for a given quan tity of exports. On the other hand ,
when its impo rts prices ri&:
relati vely to its expo rt prices, its terms of trade are said to have wors
ened . The coun try's gains
from trade is reduc ed becau se it can have a smaller quan tity of impo
rts in exch ange for a given
quan tity of expo rts than before.
Jacob Vine r1 and G.M. Meie r2 have discu ssed many types of term s of
trade whic h we ta:ke up one
by one.

1. COM MOD ITY OR NET BAR TER TER MS OF TRA DE

The comm odity or net barte r terms of trade is the ratio betw een the
price of a coun try's expo\
good s and impo rt good s. Symbolically, it can be expre ssed as
Tc=P x/Pm
where Tc stand s for the comm odity terms of trade , P for price, the subsc
ript- x for expo rts and
for imports.
To meas ure chan ges in the commodity terms of trade over a perio d,
the ratio of the change in
export prices to the chan ge in impo rt prices is taken. Then the form ula
for the commodity terms
of trade i.s

~ Px 1
c= Px
0
I Pm 1
Pm
0
where the subscripts 0 and 1 indicate the base and end periods.
Taking 1971 as the base ye,u and expressing India's both export prices and
import prices as 100,
if we find that by the end of 1981 its index of export prices had fallen
to 90 and the index of
impo rt prices had risen to 110. The terms of trade had changed as follo
ws:
 THE TERMS OF TRADE : 131

90 110
Tc=--/- =SI.S2
100 100
ll implies th<ll lndii!'s lerms of trade declined by about 18 per cent in 1981 as compared with
! 971, thcl·eby showing worsening of its terms of trade.
If the ind I?:\ of c:-.port prices had risen to 180 and that of import prices to 150, then the terms of
trade would be 120. This implies an improvemen t in the terms of trade by 20 per cent in 1981
over 1971.
The concept of the commodity or net barter terms of trade has been used by economists to meas-
ure the gain from internationa l trade. The terms of trade, as determined by the offer curves in the
Mill-r-.1.1rshall analysis, are related to the commodity terms of trade.
ITS LIMITATIO NS

Despite its use as a device for measuring the direction of movement of the gains from trade, this
concept has important limitations .
. . , )problems of Index Numbers. Usual problems associated with index number in terms of cov-
erage, base year and method of calculation arise.
q;Z'. Change in Quality of Product. The commodity terms of trade are based on the index numbers
of export and import prices. But they do not take into account changes taking place in the quality
and composition of goods entering into trade between two countries. At best, a commodity
terms of trade index shows changes in the relative prices of goods exported and imported in the
base year. Thus the net barter terms of trade fail to account for large change in the quality of
goods that are taking place in the world, as also new goods that are constantly entering in inter-
national trade.
~ roblem of Selection of Period. Problem arises in selecting the period over which the terms of
trade are studied and compared. If the period is too short, no meaningful change may be found
between the base date and the present. On the other hand, if the period is too long, the structure
of the country's trade might have changed and the export and import commodity content may
not be comparable between the two dates.
~ auses of Changes in Prices. Another serious difficulty in the commodity terms of trade is
that it simply shows changes in export and import prices and not how such prices change. As a
matter of fact, there is much qualitative difference when a change in the commodity terms of
trade index is caused by a change in export prices relative to import prices as a result of changes
in demand for exports abroad, and ways or productivity at home. For instance, the commodity
terms of trade index may change by a rise in export prices relative to import prices due to strong
demand for exports abroad and wage inflation at home. The commodity terms of trade index
does not take into account the effects of such factors.
~ eglect of Import Capacity. The concept of the commodity terms of trade throws no light on
the "capacHy to import" of a country. Suppose there is a fall in the commodity terms of trade in
India. ft means that a given quantity of Indian exports will buy a smaller quantity of imports
than before. Along with this trend, the volume of Indian exports also rises, may be as a conse-
quence of the faJJ in the prices of exports. Operating simultaneou sly, these two trends mc1y keep
Indja's capacity lo import unchanged or even improve it. Thus the commodity terms of trade
fails to take into c'lccounl a country's capacity to import.
. .
GROSS BARTER TERMS OF TRADE
The gross barter terms of trade is the ratio between the quantities of a country's imports an?
exports. Symbolically, Tg = Qm/Qx, where Tg stands for the gross terms of trade, Qm ~~r qua~ti-
ties of Imports and Qx for quantities of exports. The higher the ratio between quantlties of im-
ports and exports, the better the gross terms of trade. A larger quantity of imports can be had for
the same volume of exports.
To measure changes in the gross barter terms of trade over a period, the index number of the
quantities of imports and exports in base period and the end period are related to each other.
The formula for this is :

Tg= Qm1
Qmo
I Qx1
Qxo
Taking 1971 as the base year and expressing India's both quantities of imports and exports as
100, if we find that the index of quantity imports had risen to 160 and that of quantity exports to
120 in 1981, then the gross barter of trade had changed as follows:

T; =160;120 = 133.33
g !00 100
It implies tihat there was an improvement in the gross barter terms of trade of India b, 33 per
cent jn J981 as compared with 1971. J

If the quantity of import index had risen by 130 and that of quantity exports by 180, then the
gross barter terms of trade wouJd be 72.22.

Ti - l 30 / I 80 - 72.22
g 1oc, I 00
This impHes deterioration in the tcrrns of trade by 18 per cent in 1981 1971
When the net barter tcr m of h adc (7 ) eou,1I the (l'ross l)arter tn f tro, edr . . T ·th a'-
' ~, n · L,
1

'""rn1s o a e ( s), e countt') I1 •

 THE TERMS OF TRADE : 133

balance of_ trade equilibrium. ll shows that total receipts from exports of goods equal total pay-
ments for 1mporl goods.
NLJmerically:
Px x Qx = PmxQm
Px Qm
or =
Pm Qx
or Tc = Tg
Irs CRITICISMS

The concept of gross barter terms of trade has been criticised by economists on the foilowing
grounds:
1. Aggregating Goods, Services and Capital Transactions. The concept of gross barter terms of
trade has been criticised for lumping together all types of goods and capital payments and re-
ceipts as one category in the index numbers of exports and imports. No units are applicable
equally to rice and to steel, or to export (or import) of capital and the payment (or receipt) of a
grant. It is therefore, not possible to distinguish between the various types of transactions which
are lumped together in the index. Haberler, Viner and other economists have, therefore, dis-
missed this concept as unreal and impracticable as a statistical measure.
2. Ignores Factor Productivity. This concept ignores the effect of improvemen t in factor produc-
tivity on the terms of trade of a country. A country may have unfavourabl e gross barter terms of
trade due to increase in factor productivity in the export sector. This increased factor productiv-
ity, in turn, reflects the gain for the exporting country.
3. Neglects Balance of Payments. The concept of gross barter terms of trade relates to the trade
balance and ign9res the influence of international capital receipts and payments of a tracling
country.
4. Ignores Improveme nts in Production. This concept measures the terms of trade in terms of
physical quantities of exports and imports but ignores qualitative improvemen ts in the produc-
tion of exportable and importable goods.
5. Not True Index of Welfare. An improvemen t in gross barter terms of trade is regarded as an
index of a higher level of welfare from trade. For the country exchanges more importable goods
for its exportable goods. But this may not be true if tastes, preferences and habits of the people
change so that the country needs less importables which yield greater satisfaction to the people.
It will lead to unfavourab le gross barter terms of trade but improve welfare.
Conclusion. Due to the above noted limitations, Viner uses only the concept of net barter terms
of trade while other writers use only the export-impo rt price ratio as the commodity terms of
trade. So this concept has been discarded by economists.

3. lh'COME TERMS OF TRADE

Dorrance 4 has improved upon the concept of the net barter terms of trade by formulating t~e
concept of the income terms of trade. This index takes into accmmt the volume of exports ot a
country and its export and import prices (the net barter terms of trade). It shows a country's
changing import capacity in relation to ch<1nges in its exports. Thus, the income terms of trade is
the net barter terms of trade of a country multiplied by its export volume index. It can be ex-
pressed as
A
IN ER.NATIONAL t C'ONOMIC ~
>
' of I xporr I c,
c , I xporl Quan Li ty
~:x;..:.:-...;_- -
(·.- Tc _ Px)
. - ----
\ lnd1.:x ot lmpo1 CPrices P11,
t1, r the commodity terms of trade and Qx the
~ l '' me m., I "'" of tr,l c, 1 exPoi 1

I' 'dino the index o( the value of exports by an index f

1 l11." tin~ mckx l'.I\ c ,v,l,. M • "5 o
r • 11s it the "Export Gain tram Trade Index.
l ,, ._ ll' l:)
- . _ 1 ,r b,1c.c , enr, if
- 0 ,lnd Q.x = 80 in 1981, then

160
,., : that there is improvement in the income terms of trade by 60 per cent in 1981 a
ared with 1971.
1os1 Px = 80, Pm= 160 and Qx == 120,
en,
= so )( 120 == 60
60
t mpl es that the income terms of trade have deteriorated by 40 per cent in 1981 as compared
\~ th 1971.
A rise in the index of income terms of trade implies that a country can import more goods in
exchange for its exports. A country's income terms of trade may im~rove but it~ commodi~
erms of trade may deteriorate. Taking the import prices to be constant, tf export pnces fail, there
w be an increase in the sales and value of exports. Thus while the income terms of trade might
ha\ e improved, the commodity terms of trade might have deteriorated.
The income terms of trade is called the capacity to import. In the long-run, the total value oI
exports of a country must equal to its total value of imports, i.e., Px.Qx = Pm.Qm or Px. Qx/Pm :
Qm Thus Pr.Qx/Pm determines Qm which is the total volume that a country can import. The
capacity to import of a country may increase if other things remain the same (i) the price ol
exports (Px) rises, or (ii) the price of imports (Pm) falls, or (iii) the volume of its exports (Qx) rises.
Thus the concept of the income terms of trade is of much practical value for developing coun·
havmg low capacity to import.
ITS CRITICISMS

~ ncept of income _terms of trade has been criticised on the following counts:
1 faiJ.5 to Measure Gam or Loss from Trade. The index of income terms of trade fails to me~·
ly the gain or Joss fr~~ internationa_I trade. When the capacity to import of a conn
, t imply means tha~ 1t 1s also exporting more than before. In fact, exports include _the
.:-,.r,~_:_,·.~•-«"Hr of a country which can be used domestically to improve the living standard o' ~
2 ~ot Related to Total Capacity to Import. The income terms of trade inctt~x is rcL1ted tti the
b J Ity lo 1mpo, t and not to the total capacity to import of ~1 countn which ,1ls
nd u 1 {c rr,gn x hangc rci.:c1pts. For example, if the income tenns of tr'1de index of n coun·
l nor fed I ul it km·1gn exchange receipts have risen, its capacity to in1port has i1ctll·
r d, fiV n though 1hr ind(>X shows detenor,llion.
J. Inferior to Commodity 1 em,s of Trade. Since the index of inconle tern'\S of trade is based 011
 nm TtRMS OF TRADE : 135
rommoditv terms of 1r·:1d•" "n.,
• ... " u 1caus to contrndict
,J
•
.,
terms of trndc is u~u.1lly usc(i 11- 1 f ' ory resu1ts, t h e concept of the commodity
.., • pre crencc to th , ·
the ~.,in from internalion.ll trade. e mcome terms of trade concept for measuring

4. S1NGLE FACTORAL TERMS OF TRADE

The concept of commodity terms of trade doe . . .
port industries. Prof. Viner had snot take acc~unt of productivity changes m ex-
allows changes in the d . developed the concept of smgle factoral terms of trade which
terms of trade index b o~estic export sec_to_r. It is calculated by multiplying the commodity
Yan mdex of productivity changes in domestic export industries It can be
e:\presse d. as: · ·

F Px.Fx ( Px)
r _ r
's - 'c. x :: Pm ·: Tc= Pm
where Ts. is . the commodity terms of trade, and Fx is the
the dsingle fact oral terms of trade, Tc 1s
·ty.
pro d uc ti v1 m ex of export industries.
It ·
. shows. that a country's factoral terms of tr ad e rmprove as prod uctivity ·
· · rmproves · 1·ts export
m
rnd u stnes._ If the productivity of a country's e~orts industries increases, its factoral terms of
tr~de ma! rmprove even though its commodity terms of trade may deteriorate. Fo~ example, the
pnces of its expo~ts may !all relatively to its import prices as a result of increase in the productiv-
1ty of th e export mdustn~s of a country. The commodity terms of trade will deteriorate but its
factoral terms of trade will show an improvement.
Its Limitations. This index _is not free from certain limitations. It is difficult to obtain the neces-
sary data to compute a productivity index. Further, the single factoral terms of trade do not take
into account the potential domestic cost of production of imports industries in the other country.
To overcome this weakness, Viner formulated the double factoral terms of trade.

5. DOUBLE FACTORAL TERMS OF TRADE

The double factoral terms of trade take into account productivity changes both in the domestic
export sector and the foreign export sector producing the country's imports. The index measur-
ing the double factoral terms of trade can be expressed as

Td Fx = Px . Fx
= Tc. Pxj
( ·: Tc= Pm
Fm Fm Fm
where Td is the double factoral terms of trade, Px/Pm is the commodity terms of trade., Fx is the
export productivity index, and Fm is the import productivity index.
It helps in measuring the change in the rate of exchange of a country as a result of the change in
the productive efficiency of domestic factors manufacturing exports and that of foreign factors
manufacturing imports for that country. A rise in the index of ctouble factoral terms of trade of a
country means thnt the productive efficiency of the factors producing exports has increased
relatively to the factors producing imports in the other country.
Its Criticisms
1. Not Possible to Construct a Double factoral Terms of Trade Index. In practice, however, it is
not possible to calculate an index oJ double foctornl terms of trade of a country. Prof. Devons6
made some calculations of changes in the single factoral terms of trade of England between
1948-53. But it has not been possible to construct ,l double factoral terms of trade index of any
country because it involves men~uring and comparrg productivity changes in the import in·
136 U'\1ERNATIONAL ECONOMICS

duslries of the other cmmlr) ,, ith that of the domeslic export indu 5 lries. .
2. Required Qu,mtit) of Productive F~ctors not Important. Moreover, th e Important thin_ . .
the qu.mhty of commoditit'S 1h,,t can be imported with a given quantity of _e~orts rather 1~
• ot prodlh tn • c factors rcqwre · a for c·gn
· ,d tn country to produce Us imports • a~
J
th(' qu mht, 1

3. No Difference Between the Double Fadoral Terms of Trade ~ nd th e Commodity Tenn5 of

Tradr. A.~ ·u n, if thl'rt' :m~ constant returns to scale in manufactunng ;md no tnmsport costs arp
nn ohed thelf'~ is 110 diJference between the double factoral terms of trr1de and the cornrnod·1-.·
lly
tern,, of tr.1dc or a count,)'- . .
4 Single factorai Terms of Trade is more Relevant Concept. Accordmg to Kindleberger, ''."f~
~ n~le factor\,! terms of lrc1de is c1 much _more relevant concept than th~ double factora1. We are
nten~stcd in \Vhat our factor can earn m go~d~, not what factor se1:17ices can _command in tht,
~n ices of foreign fiKtors. Related to product1v1ty abroarl moreover, 1s a question of the qualiti
of Llw goous 1mported .,,~ y
,.l •

. REAL Cosr TER11s OF TRADE

Viner has also developed a terms of trade index to measure the real gain from international
trade. He caUs it the real cost terms to trade index. This index is calculated by multiplying the
single factoral terms of trade with the reciprocal of an index of the amount of clisutility per unit
of productive resources used in producing export commodities. It can be expressed as:

Tr= Ts.Rx= ;; .Fx.Rx (·: Ts=::. Fx)

1

where Tr is the real cost terms of trade, Ts is the single factoral terms oftrade and Rx is the index
of the amount of disutility per unit of productive resources used in producing export commodi-
ties.

ITS CRITICISMS

A fo\·ourable real cost terms of trade index (Tr) shows that the amount of imports received is
greater in terms of the real cost involved in producing export commodities. But this index fails to
measure the real cost involved in the form of goods produced for export which could be used for
domestic consumption to pay for imports. To overcome this problem. Viner develops the index
of utility terms of trade.

7. UTILITY TERMS OF TRADE

The utility terms of trade index measures changes· in the disutility of producing a unit of ex·
11

ports and changes in the relative satisfactions yielded by imports, and the domestic products
foregone as the result of export production." In other words, it is an index of the relative utilit)
. f imports and domestic commodities forgone to produce exports. The utility terms of tr~dt
mdex JS calculated by mulliplying the real cost terms of trade index with an index of the rel.1tt\~
average utility of imports nnd of domestic commodities foregone. If we denote the ,wer~ge u'.il-
ll) by fl and the dome~tic commodities whose consumption is foregone to use resources tor

export production by 11, then "

Um
l la
/Um
1
Ll<i
0
, where II is the index of relative utility of imports
I o
 THE TERMS OF TRADE · 137
11 s
' ltc,lU) foregone commodities. Thus, the utility terms of trade index can be expressed

Pl
- . Fx.Rx.u
P111

c l ,e ~eal tern,s of ~ad~ index and utility terms of trade index involve the 1neasureme t 0
l I t) in term~ of pain, irksomeness and sacrifice, they are elusive concepts. As a matter of
l t is not poss1ble to measure disutility (for utility) in concrete terms.
r cisms
ence like the single and double factoral terms of trade concepts, the concepts of real and utility
terms of trade are of little practical use. They are only of academic interest. That is ~vhy the
concepts of the commodity terms of trade and of income terms of trade have been used m meas-
uring the gains from international trade in developed as well as developing countries.
3.2.3. lrn,p ort anc e of Terms of Trade : ains
ms of trad e are vital-im por tan ce in det ermining the gains in which a country obt
Ter
tion al trad e. The se term s of trad e not only have a bearing on the quantum of
from interna
tional
trade between the nations. As the interna
international trade but also the quality of
ction of
n countries and they also define the dire
trade is a continuous relationship betwee e
s ext ern al rela tion s as well. The sign ificance or the importance of term s of trad
a country
can be explained as follows:
:
1) Eco nom ic We lfar e and Terms of Trade y as
nt bearing on the welfare of the econom
A country 's terms of trade has a significa
ntry in the con tem por ary world ca~ rem ain in isolation and it is forced to trade
no cou
ted
be ensured that the terms of trad e negotia
with other countries. However, it should
y. Economic growth achieved within the
are to the maximum benefit of the econom
will
tion and productivity through efficiency
country throu,gh expansion in real produc
incr eas e wel fare and living stan dar ds in the country at terms of trad e constantly
fail to
s of trade which is an indicator of gains from
deteriorate. That is, if the commodity term
immiserising effect on the economy.
trade are adverse then it would cause an
me nt :
2) Ter ms of Tra de and Bal anc e of Pay
e and the bal anc e of pay me nt situ atio n of any country is inextricably inter
Terms of trad
nce
an important component of the total bala
related as the effect of terms of trade is
nts situ atio .
n· If the term s of trad e ·are adverse, it will also adversely affect the
of pay me
balance of payment situation.
Inte rna tion al Tra de :
3) Terms of Trade and the Vol um e of
e in term s of net bar ter or com mo dity terms of trade has an important
Terms of trad
ulative effect of the commodity terms and
bearing on the volume of trade and the cum
s det erm ine the net imp rov em ent in the economic welfare of the country
price term
e
terms of trade and the price terms of trad
due to international trade. The commodity
ong st the ms elve s a com ple me nta ry effect on each other in determining the
have am
ntries.
complexion of the trade between the cou
de :
4) Terms of Tra de - Fac tor ial Terms of Tra
mously with the commodity terms of
Terms of trade which is understood synony
bea ring on the fac tori al term s of trade as well as the mobility of factors
trade has a
 Gains from Trade
of production. Be it material labour, capital or organisation from countries where they
are in abundance to countries, where they are scarce and there is greater demand in
consonance with the factor prices between countries. As the economies get integrated
due to growing international trade even the labour tends to move fast and far from the
places where the wages are low to economies which are ready to pay more.
5) International Economic Growth - a Product of Reasonable Terms of Trade :
Reasonable and scientifically developed terms of trade which are sensitive to the
ground realities of international trade would bring •in an equilibrium in the international
economy as a whole and the growing wealth and incomes of the world are equitab\y
redistributed having regard to the area, population and the gross productive potential
. .

of the countries.
10. SU!vHviARY OF FACTORS AFFECTING TERMS OF TRADE**

The terms of trade (TOT) of a country are influenced by a number of factors which are ex-
plained below:
1. Reciprocal_ Demand and Supply. The TOT of a country depends upon reciprocal demand
and ~upply, z.e. the strength and elasticity of each country's demand and supply of exports
~d imp?rts. Whe~ the demand for exports of a country is less elastic as compared to its
imports, its TOT will be favourable. For its exports will fetch a higher price than its imports.
On the other hand, if the demand for its imports is less elastic than its exports, its TOT will be
unfavourable because it will have to pay a higher price for its imports.
If the supply of its exports is more elastic than its imports, its TOT will be unfavourable because
it can increase or decrease the supply of its exports in keeping with international market
conditions. The opposite will be the case when the supply of exports is less elastic. So the TOT
will be favourable.
2. Change in Demand. The TOT are also influenced by the size of demand for exports and
imports of a country. Other factors remaining the same, if the demand for exports increases, it
will raise the prices of exportables as against the prices of importables. The TOT will be favour-
able. On the other hand, if the demand for importables increases, their prices will rise as against
the prices of importables, thereby worsening the TOT exportable.
3. Changes in Factor Endowments. The TOT of a country are influenced by changes in its factor
endowments. With given tastes and technology, if the increase in factor supply is related to
export industries, it will lead to the production of more of export goods and less of import goods.
As a result, the TOT will worsen because exports of more goods will bid down their prices in
world markets. Conversely, if the growth of factors produces more of import-competing goods,
the TOT will improve. For the demand for imports goods will fall which will bid down their
relative prices in world markets.
4. Changes in Technology. Technological changes also affect the TOT of a country. If the techno-
logical changes lead to the production of more ·export goods, their supply will increase, prices
will fall relative to its imports. It will export more than it imports. Therefore, its TOT ,---till be
unfavourable. On the contrary, if it leads to the production of more import-competing goods, its
volume of world trade will be less and its TOT will improve.
5. Change in Tastes. Changes in tastes of the people of a country influence its TOT with another
country. If the tastes for the products of another country increase, it leads to increase in the
demand for the imported goods. Consequently, the TOT will become unfavourable, and trice
versa.
6. Economic Growth. Another factor is economic growth which increases the country's pro-
ductive capacity, welfare and income, given the tastes and technology. Economic growth
affects TOT in two ways. The first is the demand effects which increases the demand for imports
as a result of increase in per capita income with economic growth. The second is the supply
effect which increases the supply of exportables and import-competing goods. It is the net
effect of these two effects which ultimately determines the TOT of a country. If the demand
· INTERNATIONAL ECONOMICS

effect is more powerful than the supply effect and the volume of trade i~creases through
impnrts, its TOT will be unfavourable. On the other hand, if the supply effect. 15 1:1ore powerful
than the demand effect, and the country's trade volume increases through nse in exports ant{
import-competing goods, its TOT will improve.
7. Tariffs. An import tariff improves the TOT of the tariff-impo sing country. As a_result of the
imposition of tariff duties, imports will be reduced in relation to exports and its TOT Wili
improve.
8. Quotas. Fixation of quotas also reduces imports and thus improves the TOT of the country.
fixing quotas. . .
9. Devaluatio n. By devaluation is meant a reduction of the value of domestic currency m terms
of the foreign currencies. Devaluatio n makes imports costlier and exports cheaper in foreign
markets. Thus it reduces imports and increases exports and makes the TOT favourable for the
devaluing country. But the elasticities of demand and supply of exports and imports deter-
mine deterioratio n or improveme nt in its terms of trade. If both the foreign demand for exports
and home demand for iinports are highly inelastic to price movements , devaluatio n leads to an
improveme nt in the terms of trade, and vice versa.
10. Market Conditions. A country which has got monopoly or oligopoly in the goods which
it exports in the world market, but its import market is competitive , its TOT will be favourable.
For it will sell its goods at a high price in the world market. If a few countries are oligopolistic
and form a cartel, such as oil producing countries, they can raise the price of oil by reducing its
supply. So their TOT will improve.
11. Import Substitutes. If the country produces import-sub stitute goods in sufficient quantities,
its import demand for such goods will be low. As a result, it will import less and its TOT will be
favourable, and vice versa.
12. Internation al Capital Flows. An inflow of capital from abroad in the form of capital and
other goods reduces the demand for home products and exportables . As a result the prices of
exportables faH relaHve to importables , thereby worsening the TOT of the country. On the other
hand, when there is an outflow of capital to repay the debt in the form of larger exports their
prices fall which again make the TOT unfavourab le for the country. '
13. Balance of Payments. Deficit in BOP brings improveme nt in TOT because the exchange rate
faUs. On the other hand, a surplus in BOP worsens the TOT by raising the exchange rate of the
currency.
14. Inflation and Deflation. Inflation worsens the TOT because with the rise in domestic prices
the demand for imports goes up and for export declines. On the other hand, deflation improves
the TOT because the prices of domestic goods fall, the demand for exports increases and for
imports falls.
 z .
3.2.Ef. Causes of Unfavourable Terms of Trade to Developing Countries:
Normally, underdeveloped countries are. exporting primary goods and importing
manufactured goods. In this case, terms of trade of underdeveloped countries are not in
favour of the country. All underdeveloped countries do not stand on the same leveL
1) Predominance of Agricultural / Primary Goods:
Most of LDCs are predominantly agriculture countries. Some of them are producing
primary goods. It is the opinion of many economists that terms of trade have over time
deteriorated for underdeveloped countries. The explanation of this deterioration has
been held to be in respect of primary producing countries inelastic supply conditions.
These countries respond to the reduced prices by producing more and offering more
abroad· and an inelastic demand for raw materials and food in developed countries.
Less developed countries are the producers of primary products and the developed
countries are of industrial products.
2) lnelasticity of Supply of Primary Products:
Foreign trade possesses great importance for less developed countries. International
trade has made tremendous contributions to the development of less developed
countries. According to Myrdal, international trade operates with a fundamental bias
in favour of the richer and progressive regions and in disfavour of the less developed
countries. By exporting industrial products at cheaper rates to less developed
 countries, they have displaced the small-scale industry and handicrafts of the latter.
This has tended to less developed countries to export primary products. The demand
for primary products being inelastic in the export marketl suffer from excessive price
fluctuations. So the less developed countries are unable to take the advantage of
either a fall or a rise in the world prices of their exports. The importing countries take
an advantage of the cheapening of their products because of the inelastic market for
their expofts. ·
3) International Demonstration Effect:
It has been observed that the operation of international demonstration effect through
foreign trade has adversely affected capital formation in less developed countries.
According to Prebisch, there has been deterioration in terms of trade of less developed
countries. It implies that there has been an international transfer of income from the
poor to rich countries and that the gain from international trade has gone more to the
developed countries. Because of foreign trade, the real income level and capacity for
development of less developed countries is hampered.
4) Limited Range of exportable Primary Goods:
1

In the first instance, every less developed country is dependent upon a very narrow
1
range of export of primary products. Such countries produce only a part of the world s
total export of minerals and agricultural products. The reason for the deterioration of
terms of trade of underdeveloped countries has not been the declining world demand
for their primary products but inflationary pressures trading to high costs and prices
and airge external deficit which acts as a drag on their exports.