TERMS OF TRADE

1. Gross Barter Terms of Trade

The Gross Barter Terms of Trade is the ratio of import quantity index to export quantity index. An
increase in gross barter terms of trade indicates an improvement in the trade condition of a nation.
The concept of gross barter terms of trade used in the theory of reciprocal demand and in neo-
classical theory to measure gains from international trade.

2. Net Barter or Commodity terms of trade

This is the most commonly used expression for the terms of trade changes in the contemporary
world. The gross barter terms concept uses quantity index for imports and exports whereas the net
barter or commodity terms concept makes use of the price index for imports and exports.

The distinction between ‘Gross’ and ‘Net’ barter terms of trade was introduced by Taussing in 1927
(F.W. Taussing).

3. Income Terms of Trade

Since it is very important for any country to take into account changes in its volume of exports
resulting from export price changes, it is useful to correct the movements in commodity terms for
changes in export volume. This is done by the concept of income terms of trade, which was first
formulated by G. S. Dorrance in 1948-49.

A rise in income terms of trade only indicates that the country can obtain a larger volume of
imports from the sale of its exports; its ‘capacity of import’ – based on exports has increased. A
change in the income terms of trade index cannot be interpreted as a measure of the gain from

trade or an indicator of welfare. It should be used simply as a measure of the quantity of imports
bought by exports.

4. Single Factorial Terms of Trade

The single factorial terms of trade is the ratio of the export price index and the import price index
adjusted for changes in the productivity of the factors used in export production.

While income terms of trade correct the commodity terms of trade for changes in the export
volume, there is another attempt to correct commodity terms for changes in the productivity in
producing export goods. The single factorial term of trade is an attempt in that direction. It was
Jacob Viner who developed the concepts of single and double factorial terms of trade in 1937.

Here we are concerned not so much with the question of global inequalities but the significance of
single factorial terms trade as a terms of trade concept. Constant single factorial terms indicate an
effort by the country to achieve productivity increases within but losing out that productivity gain
to the foreign countries and thereby helping to increase the standards of living in the foreign
countries but not itself.
 5. Double Factorial Terms of Trade

When the commodity terms of trade are corrected for changes in productivity in producing both
exports and imports. It is termed as ‘double factorial terms of trade’.

Measurement of Terms of Trade

Gross Barter Terms of Trade

The Gross Barter Terms of Trade is the ratio of import quantity index to export quantity index. An
increase in gross barter terms of trade indicates an improvement in the trade condition of a nation.
The concept of gross barter terms of trade used in the theory of reciprocal demand and in neo-
classical theory to measure gains from international trade.

Symbolically Gross Barter Terms of Trade is expressed as following:

G= (Iq/ Xq) × 100

Where Iq stands for the import quantity index, Xq for export quantity index and G for Gross Barter
Terms. We multiply the whole expression Iq/ Xq by 100 to get rid of decimal. Let understand the
concept with following example

The quantity index of imports and exports for the base year (say 2010) will always be equal to 100.
The base year will serve as the benchmark period with which we can measure changes in the gross
barter terms of trade in any given subsequent year – say 2011, 2012, 2013,.., 2020 etc. Let look at
the following hypothetical sets:

2010 base year: G=(100/100) × 100 = 100 (Base Year)

2011 G=(120/100) × 100 = 120 (improvement)

2012 G=(120/120) × 100 = 100 (no change)

2013 G=(100/120) × 100 = 83.33 (deterioration)

For year 2011, the import quantity index is up from 100 to 120 and the export quantity is the same.
This means that in 2011 we export the same quantity as in 2010 but we import more in 2011 than
in 2010. In other words, the purchasing power of exports has gone up in 2011 compared to the base
year 2010.

In 2012, compared with the base year 2010 there has been no change in gross barter terms.
Because both the import and export quantity index numbers have gone up from 100 to 120
between these periods.

In brief, an increase in the import quantity index tends to improve gross barter terms, while an
increase in the export quantity index would tend to worsen the gross barter terms of trade.
 Net Barter or Commodity terms of trade

This is the most commonly used expression for the terms of trade changes in the contemporary
world. The gross barter terms concept uses quantity index for imports and exports whereas the net
barter or commodity terms concept makes use of the price index for imports and exports.

The distinction between ‘Gross’ and ‘Net’ barter terms of trade was introduced by Taussing in 1927
(F.W. Taussing).

Symbolically Net Barter Terms of Trade is expressed as following:

N= (Xp/ Ip) × 100

Where Ip stands for the price index number of import, Xp for price index number of export and N
for Net Barter Terms. We multiply the whole expression Xp/ Ip by 100 to get rid of decimal. Let
understand the concept with following example

The price index of imports and exports for the base year (say 2010) will always be equal to 100.
The base year will serve as the benchmark period with which we can measure changes in the net
barter terms of trade in any given subsequent year – say 2011, 2012, 2013, 2020 etc. Let look at the
following hypothetical sets:

2010 base year: N=(100/100) × 100 = 100 (Base Year)

2011 N=(120/100) × 100 = 120 (improvement)

2012 N=(120/120) × 100 = 100 (no change)

2013 N=(100/120) × 100 = 83.33 (deterioration)

There is a general belief that improvement in commodity terms of trade would mean an
improvement in the economic welfare of the country. Because when the exports prices go up we
sell our goods at a higher price, and when the import prices go down, we will be able to buy foreign
goods at a lower price. In either case, commodity terms improve and the country is better off in
terms of economic welfare. In brief the commodity terms of trade are the most commonly used
measure of terms of trade changes in a country, although it is not so easy to derive immediate
welfare implications from commodity terms of trade changes.

Income Terms of Trade

Since it is very important for any country to take into account changes in its volume of exports
resulting from export price changes, it is useful to correct the movements in commodity terms for
changes in export volume. This is done by the concept of income terms of trade.

Symbolically Income Terms of Trade is expressed as following:

I=NXq
Where N refers to net barter or commodity terms of trade index (i.e. Xp/ Ip ), Xq stands for the
export quantity index and I stands for income terms of trade. To understand the concept we need to
look at following examples

2010 base year: I=(100 × 100 / 100) = 100 (Base Year)

2011 I=( 90 × 120 / 100) = 108 (improvement)

2012 I=(110 × 80 / 120) = 88 (deterioration)

For the base year 2010, we assign a value of 100 for all the three variables, i.e export price index,
import price index and the export quantity index. Income terms of trade index must be 100 for the
base year 2010. In year 2011 there is a fall in the export price index with no change in the import
price index suggesting that the commodity terms have worsened. But there has been increase in the
export quantity index from 100 to 120 in 2011. A 10 percentage decrease in the export price index
is matched by a 20 percentage point increase in the export quantity so that in the end, we notice
that there has been an 8 percent improvement in the income terms of trade in 2011 compared with
the base year 2010.

Single Factorial Terms of Trade

While income terms of trade correct the commodity terms of trade for changes in the export
volume, there is another attempt to correct commodity terms for changes in the productivity in
producing export goods. The single factorial term of trade is an attempt in that direction.

Symbolically Single Factorial Terms of Trade is expressed as following:

S = N. Xp

Where N refers to commodity terms, Xp stands for the export productivity index, and S refers for
single factorial terms of trade. The following example will make the point clear:

2010 base year: S=(100 × 100 / 100) = 100 (Base Year)

2011 S=( 90 × 100 / 100) = 90 (deterioration)

2012 S=(90 × 120 / 100) = 108 (improvement)

For the base year 2010, we assign a value of 100 for all the three variables, i.e export price index,
import price index and the export productivity index. The index of S, therefore, must also have a
value of 100 for the base year 2010.

In 2011, there has been a drop in export price index by 10 percent which is not offset by rise in
export productivity index so that single factorial terms have deteriorated by 10 percentage points.

Here we are concerned not so much with the question of global inequalities but the significance of
single factorial terms trade as a terms of trade concept. Constant single factorial terms indicate an
effort by the country to achieve productivity increases within but losing out that productivity gain
to the foreign countries and thereby helping to increase the standards of living in the foreign
countries but not itself.

Double Factorial Terms of Trade

When the commodity terms of trade (N) are corrected for changes in productivity in producing of
exports and imports, the result is the double factorial terms of trade.

Symbolically Double Factorial Terms of Trade is expressed as following:

D = N. (Xp / Mp )

Where N refers to commodity terms, Xp and Mp stands for the export productivity index and
import productivity index, and D refers for double factorial terms of trade. The double factorial
terms of trade will diverge from single factorial terms when there is a change in the factor cost of
producing imports. This has no significance to the importing country because it only means that
there has been an increase or a decrease in productivity in the country from which it is importing
goods.
SECULAR DETIRIORATION HYPOTHESIS: (PREBISCH-SINGER HYPOTHESIS)
The Hypothesis

The Prebisch-Singer hypothesis was initially developed by Hans Singer in 1948-49 and was later
developed by Raul Prebisch. It argues that the prices of primary commodities will decline over time
relative to manufactured goods which leads to a decline in terms of trade for developing countries
as developing countries are usually the exporter of primary products and developed nations the
producer and exporter of manufactured goods. However, through this relationship, Prebisch and
Singer focused on the rising per capita income gap between the developing and developed world
arising due to the international trade. According to them, due to this static specialization in the
production of primary commodities, developing world has been excluded from enjoying the fruits
of technological progress mainly found in the industrial nations.

They argued this on the basis of three facts:

1. Developing countries specialize in the production and export of primary commodities and
industrialized countries specializes in production of manufactures.

2. Technical progress is mainly concentrated in industry

3. Terms of trade of primary goods relative to manufactured goods has declined since 19th century.

Due to these facts, developing countries has failed to benefit from the technical progress and have
suffered from the declining terms of trade.

The Classical School of Thought

The classical economists however had an exactly opposite approach to what was conceived by
Prebisch and Singer. They thought that primary products will overtime experience a rise in terms of
trade relative to manufactures. They based their argument on the basis that diminishing returns
operate in primary products production and manufactures experience increasing returns. Also, the
technical progress in manufactures will exceed that of primary products and hence supply of
manufactures will grow faster than the supply of primary commodities. Also, primary products
producing nations need not industrialize as trade will increase the prices of the exports of primary
products relative to the prices of imports of manufactured goods. This can be better explained with
the help of a diagram-

The vertical axis shows the relative price of primary products in terms of manufactures, and the
horizontal axis shows the relative quantity- the quantity of primary products divided by the
quantity of manufactured goods. The supply and demand curves intersection show the world
equilibrium at point E.

As technical progress in manufactured goods exceed that of primary goods, the relative supply of
manufacture increases while the relative supply of primary products declines. As the relative
supply curve (S1) shifts to the left, the relative price of primary products rises and the relative
quantity declines. The new equilibrium is at E2 now and the terms of trade for primary product
export rises. This leads to the welfare gains from primary product exporting nations.

However, according to Prebisch and Singer, this doesn’t work. The terms of trade for primary
products relative to manufactures actually declines. The reason for the same is explained in the
next section.

Evolution of the theory

According to Prebisch and Singer, the above mechanism doesn’t work. The relative price of primary
goods actually fall and this has been empirically seen in the case of United Kingdom from 1876 to
1947. This was shown by Hans Singer, then working in the United Nations Department of Economic
Affairs in New York City, in his paper titled "Post-war Price Relations between Under-developed
and Industrialized Countries". Its subsequent follow-up by the United Nations in 1949 led actually
to the origin of the Prebisch-Singer hypothesis and the related debate. It was observed in these
reports that during the sixty years preceding 1938 primary product prices had fallen relative to
prices of manufactures.

Various explanations: Prebisch-Singer Hypothesis

Explanation by Prebisch (Supply-side argument)

According to Prebisch, labor unions work well in industrialized nations and are weak in developing
nations. Hence, workers are able to extract higher wages in industrial nations as compared to
primary products producing nations. Thus cost of primary product rises by less than the cost of
manufactured goods. This decline in costs increases the relative supply of primary products shifting
the relative supply curve to the right and the relative price decreases leading to a decline in terms
of trade.

Explanation by Singer (Demand-side argument)

Singer’s argument is based on income and price elasticities. It is usually observed that primary
products have low income elasticity. So as and when income rises, the demand for primary
commodities decline rapidly than demand for manufactured goods leading to a decline in relative
price of primary goods. This would lead to a leftward shift in relative demand curve leading to a
worsening of terms of trade for developing nations.

Both Prebisch and Singer advocated that developing countries should industrialize
 Empirical Evidence
The Prebisch-Singer hypothesis has generated much debate. It has been criticized by academicians
such as Jacob Viner (1953), R. E. Baldwin (1955), G. M. Meier (1958), G. Haberler (1961), R. E.
Lipsey (1963), Harry Johnson (1967), Paul Bairoch (1975), Ronald Findlay (1981), and hence
discarded the hypothesis.

It is criticized on the grounds that if it will be reasonable to treat the relative prices of goods
equivalent to terms of trade. Developing countries do not export only primary goods and developed
countries do not only specialize in manufactured goods. So commodity prices cannot be treated as
synonymous to terms of trade.

The fact that industrialized countries do not export only manufactures was addressed early on by
Meier and Baldwin (1957), who pointed out the many primary commodities, like wheat, beef, wool,
cotton and sugar, are heavily exported by industrialized countries. Indeed, Diakosavvas and
Scandizo note that the developing country share of agricultural primary commodities was only 30%
in 1983, down from 40% in 1955. Yet Spraos (1980) argues that this fact is immaterial, because the
same trends that are observed in the broad index of primary commodity prices are found in a
narrower index that includes only developing-country products.

Since the 1980s, a series of studies undertaken by John Spraos (1980), David Sapsford (1985),
Prabirjit Sarkar (1986a, b, 1994, 2005), Sarkar and Singer (1991), E. R. Grilli, and M.C. Yang (1988),
and many others questioned the validity of the criticism and provided strong statistical support for
the Prebisch–Singer hypothesis, thereby bringing it back to the limelight.