20. Terms of Trade Flashcards
What is Comparative advantage?
Comparative advantage occurs when one country can produce a good or service at a lower opportunity cost than another. This means a country can produce a good relatively cheaper than other countries.
What is the theory of Comparative advantage?
The theory of comparative advantage states that if countries specialise in producing goods where they have a lower opportunity cost – then there will be an increase in economic welfare.
What are the limitations of Comparative advantage?
- Transport costs may outweigh any comparative advantage
- Increased specialisation may lead to diseconomies of scale
- Governments may restrict trade; in reality protectionism can distort comparative advantage
What are terms of trade?
This measures the price index of exports divided by the price index of imports.
It is expressed as a percentage so in the base year it will be 100 .
How do you work out terms of trade?
Index of Export Prices/Index of Import Prices x 100
How to improve terms of trade?
Improving terms of trade for a country means:
that for every unit of exports sold it can buy more units of imported goods.
This creates a benefit in terms of how many goods need to be exported to buy a given amount of imports.
It can also have a beneficial effect on domestic cost-push inflation as an improvement indicates falling import prices relative to export prices.
How to worsen terms of trade?
Worsening terms of trade for a country means:
that for every unit of exports sold it can buy fewer units of imported goods.
This is a disadvantage in terms of how many goods need to be exported to buy a given amount of imports.
It can also have a damaging effect on domestic cost-push inflation as a worsening in terms of trade indicates rising import prices relative to export prices.
What is the main impact of terms of trade?
The main impact of changes in the terms of trade is the effect on the standard of living.
What is the Heckscher-Ohlin theory?
The H-O theory believes that different countries are endowed with varying proportions of different factors of production
Some countries (e.g. Bangladesh) have large population and large labour resources
Other countries (e.g. Sweden) have abundance of capital but are short of the labour resource
Thus, a country with a large labour force will be able to produce labour intensive goods (e.g. clothes) at a lower cost
Countries with large supply of capital will specialise in those goods that involve capital intensive mode of production
Conclusion of Terms of Trade
Improved terms of trade may be good as they may indicate positive economic growth- as export prices are rising relative to import prices there is relatively more income coming into the country.
Improving terms of trade may be damaging in the slightly longer term as they may the economy less competitive in international trade. To get round this countries may need to find new sources of comparative advantage
