Trade patterns and the terms of trade describe different aspects of international exchange.
Must know
- Trade patterns identify partners and products.
- Terms of trade compare export and import price indices.
- An improvement means more imports can be bought per unit of exports.
Must know definitions
Trade creation: lower-cost imports from a member replace higher-cost domestic production after trade barriers fall.
Trade diversion: preferential barriers cause imports to switch from a lower-cost non-member to a higher-cost member.
Trading bloc: a group of countries that agree to reduce trade barriers between participating members.
Terms of trade: the price of a country's exports relative to the price of its imports, calculated as (index of export prices / index of import prices) × 100.
Prebisch-Singer hypothesis: the theory that developing countries dependent on commodity exports tend to experience a long-run deterioration in their terms of trade, as commodity prices fall relative to manufactured goods prices.
Must know relationship: Terms of trade = export price index / import price index × 100.
Interpretation: an index above 100 means export prices have risen relative to import prices since the common base period. It does not mean exports exceed imports or that the trade balance must improve.
Explain and apply
Mechanism in brief: Higher export prices raise purchasing power per unit sold. Whether total export revenue rises depends on export volumes and demand responsiveness; higher production costs can reduce competitiveness despite the improved index.
Distinguish: An improvement is not automatically a welfare gain; terms of trade are not the trade balance.
Use the extract: Separate price indices from trade values and quantities; identify why export prices changed relative to import prices.
Patterns and volume of world trade
Factors influencing patterns of trade between countries and causes of changes in these patterns
A pattern of trade describes which goods and services a country exports and imports, and with which trading partners. Patterns of trade are not fixed — they shift over time as the factors below change, reshaping who trades what with whom.
Impact of emerging economies
Explanation: industrialisation and participation in international supply chains can change countries’ shares of manufactured exports. A falling share does not necessarily mean falling exports in absolute terms. Compare the same measure over a stated period: a country’s share of manufacturing output is different from its share of manufactured exports. A shift towards services can also alter the composition of trade without eliminating manufacturing exports.
Changes in comparative advantage
Explanation: As relative opportunity costs shift (e.g. through capital investment, education, or technology), countries' comparative advantages change, altering what they specialise in and trade — China's shift from low-cost manufacturing towards higher-value goods is one example
Growth in trading blocs and bilateral trading agreements
Explanation: removing barriers can increase trade within a bloc. Identify whether lower-cost imports replace domestic production (trade creation) or higher-cost member imports replace cheaper non-member imports (trade diversion); extra intra-bloc trade alone does not establish either.
Changes in relative exchange rates
Explanation: A depreciation tends to make exports cheaper in foreign currency and imports dearer in domestic currency, subject to pricing and pass-through. This may change trade volumes and partners; the response depends on elasticities, capacity and other trading conditions.
Changes in protectionism between countries
Explanation: Tariffs, quotas and other trade barriers reduce trade with the countries they target and can redirect trade towards less-restricted partners; conversely, trade liberalisation opens up new trade relationships
Trade creation occurs when lower-cost imports from a partner replace higher-cost domestic production after barriers fall. Trade diversion occurs when preferences cause imports to switch from a lower-cost non-member to a higher-cost member. These are distinct effects; more intra-bloc trade alone does not tell us which has occurred.
Trade patterns should be illustrated with a named measure, dates and a source. Distinguish a bilateral goods balance from a country’s overall current-account balance; a change in one does not establish the same trend in the other.
Changes in trade flows between countries, and the reasons for these changes
Changes in trade flows between countries arise from the same underlying factors as in part (a) — shifting comparative advantage, trading bloc membership, exchange rate movements and protectionism — combined with the broader state of the global economy.
- For example, a global recession reduces trade volumes across the board as incomes and demand fall (income elasticity of demand for traded goods is often high), while a period of strong global growth tends to expand trade flows generally, on top of any structural shifts caused by the factors above.
3. Terms of trade
Understanding and calculation of the terms of trade
The terms of trade measure the price of a country's exports relative to the price of its imports, using price indices for exports and imports:
Terms of trade = (index of export prices / index of import prices) × 100
A value above 100 means the terms of trade have improved since the base year (exports have become relatively more expensive compared to imports); a value below 100 means they have worsened/deteriorated (exports have become relatively cheaper compared to imports).
Worked example. Suppose a country's export price index rises by 15% while its import price index rises by 20% over the same period:
- Terms of trade = (115 / 120) × 100 = 95.83.
- Since 95.83 is below 100, the terms of trade have worsened — the country must now export a greater volume of goods to earn enough to pay for the same volume of imports, even though both export and import prices rose in absolute terms.
Factors influencing a country's terms of trade
| Factor | Explanation |
|---|---|
| Relative inflation rates | Higher domestic inflation than trading partners pushes export prices up faster than import prices → terms of trade tend to improve, though at the cost of competitiveness |
| Relative productivity rates | Faster productivity growth lowers unit costs and allows export prices to rise more slowly (or even fall) relative to competitors, which tends to worsen the terms of trade even as it improves competitiveness |
| Relative labour costs | Rising domestic wage costs (relative to trading partners) push up export prices → terms of trade tend to improve, but exports become less price-competitive |
| The exchange rate | With domestic-currency export prices unchanged, appreciation can lower import prices in that same currency and improve the index. Price pass-through and invoicing determine the actual result; depreciation need not produce an exact reverse. |
| The prices of imports and exports | Directly determine the ratio itself — e.g. a rise in the world price of oil worsens the terms of trade for an oil-importing country but improves it for an oil-exporting country |
Export PED affects how export quantities and revenue respond to a price change. It does not alter the definition of the terms of trade: the index can improve even when export revenue falls.
- The Prebisch–Singer hypothesis proposes that primary commodity prices may decline relative to manufactured-goods prices over the long run, worsening the terms of trade of economies dependent on commodity exports. This is not a prediction for every commodity or period. Supply conditions, demand growth, market power and commodity-price cycles matter; assess the export and import price indices for the country and period in question.
This tendency is formalised in the Prebisch-Singer hypothesis, which argues that developing countries reliant on commodity exports tend to see their terms of trade fall over time, because commodity prices fall relative to the price of manufactured goods (the goods they import).
- Global competition and changes in production methods can lower the prices of some manufactured goods. If a country’s import prices fall relative to its export prices, its terms of trade improve. A services-exporting economy could benefit through this channel, but the result depends on its actual trade basket and relative prices. It should not be assumed that globalisation automatically improves the UK’s terms of trade.
A large importing country may improve its terms of trade if a trade restriction reduces the world price received by foreign suppliers. A small country taking world prices as given has no such gain. Retaliation and domestic welfare losses may outweigh any improvement. Higher import demand affects the index only if it changes relative prices, not merely import volumes.
Use one currency basis: if export prices in domestic currency stay unchanged and appreciation lowers domestic-currency import prices, the terms of trade improve. The result depends on invoicing and price pass-through; appreciation alone does not guarantee it.
The impact of changes in a country's terms of trade on export revenues, living standards and the balance of trade
| Improving terms of trade | Worsening terms of trade |
|---|---|
| Fewer exports need to be sold to buy the same volume of imports → can raise living standards, as import purchasing power ↑ | More exports must be sold to buy the same volume of imports → tends to lower living standards |
| If the improvement comes from lower import prices, imported inputs may become cheaper and ease cost-push pressure. A higher export-price index alone does not establish this. | If the deterioration comes from higher import prices, imported inputs may become dearer and add cost-push pressure. A lower export-price index alone does not establish this. |
| If own export prices rise relative to competing exporters’ prices, price competitiveness may weaken. An improvement caused only by lower import prices does not imply this; trade revenues also depend on quantities and elasticities. | If own export prices fall relative to competing exporters’ prices, price competitiveness may improve. A deterioration caused only by higher import prices does not imply this; trade revenues also depend on quantities and elasticities. |
| Lower imported-capital prices can support investment and productivity. An improved terms-of-trade ratio alone does not show that these prices fell. | Higher imported-capital prices can constrain investment and productivity. A worse terms-of-trade ratio alone does not show that these prices rose. |
| Debt service may become easier if foreign-currency export earnings rise or repayment costs fall. An improved terms-of-trade index alone does not establish this. | Debt service may become harder if foreign-currency export earnings fall or repayment costs rise. A worse index alone does not establish this. |
The overall effect of a change in the terms of trade is therefore ambiguous and depends on the cause of the change: a common slip in exams is to assume an improving terms of trade is always "good" — but an improvement driven purely by cost-push export price rises is more likely to erode competitiveness and worsen the balance of trade, output and employment, whereas an improvement driven by strong export demand (rather than just rising export prices) need not harm competitiveness.
Identify why relative prices changed. Stronger export demand may improve both revenue and the terms of trade, while cost-driven price rises may reduce sales; the index alone cannot establish a welfare improvement.
Rapid recap
Terms of trade = export price index/import price index × 100. An improvement means greater import purchasing power per unit exported, not necessarily a better trade balance.
Related chapters: Unit 4 chapter 2 (p. 10) · Unit 4 chapter 8 (p. 42)