Reasoning from a Price Change: Trade Edition

An important statistic in international trade economics is the “terms of Trade.”  The terms of trade is the ratio between export prices and import prices.  In other words, the terms of trade is a relative price telling us how many imports we can buy per dollar of exports.  A country’s terms of trade improves (gets larger) when export prices rise relative to import prices; people can now purchase more imports from abroad while giving up fewer exports.  Conversely, a country’s terms of trade decreases (gets smaller) when the price of imports rises relative to the price of exports; people have to pay more in exports to import the same value of imports.

For example, let’s say we have two countries: Whitebreak and Faltera.  Whitebreak exports wheat and imports artwork (and vice versa for Faltera).  Wheat sells for $1 and artwork sells for $1.  The terms of trade in this initial state is 1.  Now let’s say the price of wheat doubles to $2.  Whitebreak’s terms of trade improves to 2 ($2 for wheat / $1 for art).  Selling the same amount of wheat can now buy 2 pieces of art.  Whitebreak’s terms of trade has improved. Conversely, Faltera now must give up two pieces of art to buy the same amount of wheat.

The terms of trade have improved for Whitebreak, but are the residents of Whitebreak made better off?  It may be tempting to say, “Yes!  They can buy more with the same amount of resources.  Of course they are better off!”  As readers of the title of this piece have likely already deduced, that answer is incorrect.  Why prices changed tells us more about whether or not the people of Whitebreak are better off.  As Scott Sumner would say, never reason from a price change.

There are two reasons why the price of a good can change: an change in demand for that good or a change in supply.  If demand increases and the price of wheat rises, the people of Whitebreak are made better off: the quantity of wheat consumed in the world increases and the economic surplus generated in the wheat market increases.  Further, since Falterans are buying more, they are selling more art to Whitebreak, so Whitebreakian residents enjoy more decorations for their homes.  In this case, the terms of trade increase correlates with Whitebreak being better off.  Note that the Falterans also are better off even though their terms of trade have fallen because they increase the consumption of the goods they want.

But let us say that, rather than an increase in demand for Whitebreakian wheat, there is a blight that decimates the crop.  This decrease in supply would cause the price of wheat to rise.  Again, this increase in price for wheat would improve Whitebreak’s terms of trade with Faltera, but in this case the people of Whitebreak are certainly made worse off: they have less wheat to consume (and, consequently, less wheat to trade for art).  Their economic wellbeing deteriorates.  In this case, the terms of trade improvement does not signal improvement in the living standards of Whitebreakians.

In real life, both the price of exports and the price of imports are constantly changing.  Since the terms of trade is a ratio, it can also change depending on the percentage changes of prices.  For example, let’s say there is a recession and the prices for both Whitebreak wheat and Faltera art fall due to declining demand.  Art is a luxury good, so the decline will likely be more substantial for artwork rather than wheat.  If, say, wheat prices fall 3% but art prices fall 20%, the terms of trade will improve.  Again, this improvement is misleading regarding the wellbeing of Whitebreakians and Falterans.

Understanding this limitation to the terms of trade, or any statistic, is important for discussing trade policy.  Judging a policy’s success or failure by a single (or even a basket of) metrics can lead to incorrect reasoning if one does not understand the underlying data influencing the metric.

None of this is to say we need to abandon terms of trade.  It is a useful statistic.  But just like any statistic, we must be cautious in its use and interpretation.  Ultimately, the answer to whether a terms of trade improvement (or deterioration) is a good thing or a bad thing is: “it depends.”