The Terms of Trade
We have seen that world production can be increased when countries
specialize in the production of the goods for which they have a
comparative advantage and then trade with one another. We now ask:
How will these gains from specialization and trade be shared among
countries? The division of the gain depends on what is called the terms of
trade , which relate to the quantity of imported goods that can be
obtained per unit of goods exported. The terms of trade are measured by
the ratio of the price of exports to the price of imports.
A rise in the price of imported goods, with the price of exports
unchanged, indicates a fall in the terms of trade; it will now take more
exports to buy the same quantity of imports. Similarly, a rise in the price
of exported goods, with the price of imports unchanged, indicates a rise in
the terms of trade; it will now take fewer exports to buy the same quantity
of imports. Thus, the ratio of these prices measures the amount of imports
that can be obtained per unit of goods exported.
The terms of trade can be illustrated with a country’s production
possibilities boundary, as shown in Figure 32-7. The figure shows the
hypothetical case in which Canada can produce only wheat and cloth. As
we saw earlier, the slope of Canada’s production possibilities boundary
shows the relative opportunity costs of producing the two goods in
Canada. A steep production possibilities boundary, as we see in Figure