In its simplest form, the concept of “Terms of Trade” between two items or two sets of items represents their prices in terms of each other, that is, the ratio at which they are exchanged (“sold”) against each other. The term can be used in relation to trade transactions both within an economy and between two or more economies.
Within Domestic Economy:
Within an economy, the concept is normally used to express the purchasing power of goods/services produced by one sector in terms of the goods/services produced by another sector or the rest of the economy.
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For example, the Economic Survey issued every year by the Government of India contains, with reference to a selected base year, several series of wholesale price index numbers, including the categories of (a) primary articles and their main components, (b) fuel, power, light and lubricants, (c) manufactured articles and their main components, and (d) all commodities put together.
Changes in these price index numbers can be used to estimate changes in the purchasing power of one set of items in terms of the other.
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Such estimates are known as the terms of trade between the two relevant sets of items under study.
For example, if we consider index numbers of wholesale prices (average of weeks, 1993-94 = 100), then for the year 2000-01, the price index of primary articles was 163, while that of manufactured products was 142.
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Thus it means that, in 2000-01, compared with the base year 1993-94, purchasing power of primary articles as expressed in manufactured articles had gone up, on the average, by 14.8% [(163/142) 100 = 114.8)].
In other words, in 2000-01, compared with the base period 1993-94, the terms of trade had improved for primary articles and deteriorated for manufactured articles.
In International Trade:
Similarly, in the context of international trade, this term refers to the rate at which exports of a country are paid for in its imports or the rate at which it has to pay for its imports in the form of its exports.
In other words, terms of trade of a country is a measure of the average price of its exports expressed in its imports, or the average price of its imports expressed in its exports.
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Its terms of trade are said to improve if, for some given imports, it pays with smaller exports or if, for some given exports, it gets more imports.
It also means that the gains of a country per unit of its international trade increase if its terms of trade improve, and vice versa.
However, an increase (reduction) in per unit gain from trade does not necessarily imply an increase (reduction) in its total gain also since that depends upon the change in both (i) gain per unit of trade and (ii) the volume of trade.