Terms of Trade

What Is Terms of Trade?

The terms of trade are the rate at which one good is exchanged for another between trading partners, or more broadly the ratio of a country's export prices to its import prices. In the classic two-country model, the terms of trade determine how the gains from trade are split between the two nations. For trade to be mutually beneficial in the standard model, the agreed terms of trade must fall between the two countries' opportunity costs of producing the good. If the exchange rate of goods lands outside that range, one country would be better off simply producing the good itself rather than importing it, and trade would not occur.

Why It Matters

The terms of trade decide who captures more of the surplus that specialization creates. Suppose one country can make a unit of cloth by giving up two units of wine, while its partner gives up only half a unit of wine. Any exchange ratio between those two opportunity costs leaves both better off than producing alone, but a ratio closer to one country's cost hands more of the gain to the other. At the national level, improving terms of trade, meaning export prices rising relative to import prices, let a country buy more imports for the same volume of exports. Commodity exporters, for instance, see their terms of trade swing sharply as world prices for their goods rise and fall.

Test Your Knowledge

Questions on this topic from the EconRecall fact bank:

• What do economists mean by the "terms of trade"?
  The rate at which one good is exchanged for another between trading partners
• For trade to be mutually beneficial in the standard model, where must the agreed terms of trade fall?
  Between the two countries' opportunity costs of producing the good
• In AP Macroeconomics, for both parties to benefit from trading two goods, where must the agreed terms of trade fall?
  Between the two parties' opportunity costs of producing the good