Edexcel A-Level Economics · Revision notes
4.1.4 Terms of Trade
What the specification covers
In our own words — not the official specification wording
The ratio of export prices to import prices: how to calculate it, what moves it, and what a change in it does to a country.
- Calculating the index comparing a country's export prices with its import prices.
- What causes a country's export prices to move relative to its import prices.
- What a rise or fall in that ratio does to a country's trade position and living standards.
The terms of trade measure the rate at which a country's exports exchange for its imports. If export prices rise relative to import prices, each unit exported buys more imports — and the country is better off for the same volume of trade.
Calculating the terms of trade
Terms of trade = (index of export prices ÷ index of import prices) × 100
Both figures are index numbers, not actual prices, because a country exports and imports thousands of goods. The index is a weighted average of price changes, with weights reflecting each good's share of trade.
Worked example
In the base year, both indices are 100, so the terms of trade are 100.
Five years later, export prices have risen to an index of 115 and import prices to 105.
Terms of trade = 115 ÷ 105 × 100 = 109.5
The terms of trade have improved by 9.5%. Each unit of exports now buys about 9.5% more imports than in the base year.
Improvement and deterioration — and why the words mislead
- An improvement means export prices have risen relative to import prices. The index goes up.
- A deterioration means export prices have fallen relative to import prices. The index goes down.
The vocabulary is unfortunate, because an "improvement" is not automatically good news. If export prices rise because the currency appreciated, exports become less competitive and volumes may fall. A country can have improving terms of trade and a worsening trade balance at the same time.
Key distinction: This is the single most important point on this topic: the terms of trade measure prices, not quantities, and not the balance of trade.
What influences the terms of trade
Exchange rates. An appreciation raises export prices in foreign currency and lowers import prices in domestic currency, improving the terms of trade.
Relative inflation. If a country's inflation runs above its trading partners', its export prices rise faster, improving the terms of trade while damaging competitiveness.
World commodity prices. For a commodity exporter, a rise in the world price of its main export improves the terms of trade sharply. For a commodity importer, the same rise worsens them. This is why oil price changes affect exporters and importers in opposite directions.
Productivity. Rising productivity can lower export prices, worsening the terms of trade while improving competitiveness — again showing the two are different things.
Incomes and demand. Rising world income raises demand for goods with high income elasticity. Primary commodities tend to have low income elasticity, which underlies the Prebisch-Singer hypothesis: that the terms of trade of primary-commodity exporters tend to decline over the long run.
Tariffs and trade policy, which alter the prices actually paid.
The impact of a change
An improvement means imports become cheaper relative to exports.
- Living standards can rise, since a given volume of exports buys more imports.
- But if the improvement comes from an appreciation or higher relative inflation, export competitiveness falls, so volumes may drop.
- The effect on the current account depends on elasticities. If demand for exports is price-elastic, higher export prices reduce revenue and the balance worsens.
A deterioration means more must be exported to buy the same imports.
- Living standards may fall, particularly for a country dependent on imported essentials.
- But export competitiveness improves, so volumes may rise.
- For a developing economy reliant on primary exports, a sustained deterioration makes servicing foreign debt harder, since debt is usually denominated in foreign currency.
Evaluation: In every case the answer turns on why the terms of trade moved and how elastic demand is. Those two questions do most of the analytical work.
Key terms
| Term | Meaning |
|---|---|
| Terms of trade | The ratio of export prices to import prices, expressed as an index |
| Improvement | A rise in the index: export prices up relative to import prices |
| Deterioration | A fall in the index: export prices down relative to import prices |
| Index number | A figure expressing a value relative to a base year of 100 |
| Prebisch-Singer hypothesis | The claim that primary exporters' terms of trade decline over the long run |
Common mistakes
- Treating an improvement as automatically beneficial. It raises purchasing power per unit exported but can reduce competitiveness.
- Confusing the terms of trade with the balance of trade. One measures relative prices; the other measures the value of exports minus imports. They can move in opposite directions.
- Using actual prices instead of index numbers. The measure is built from weighted indices.
- Inverting the formula. Export prices are the numerator. Putting imports on top reverses every conclusion.
- Forgetting the volume response. A price change alters quantities traded, and the size of that response depends on elasticity.
How this has been examined
In the Edexcel papers indexed on this site, this topic has appeared in three formats:
- 2-mark "Explain" — asked twice (2025)
- 5-mark "Explain" data response — asked once (2018)
- 1-mark multiple choice — asked once (2025)
Where this goes next
The index numbers used here are the same tool as in 2.1.2 Inflation. The pattern of trade this ratio affects is 4.1.3 Pattern of trade, and the resulting flows are recorded in 4.1.7 Balance of payments. The exchange rate influence is developed in 4.1.8 Exchange rates, and the competitiveness question in 4.1.9 International competitiveness. The long-run concern for primary exporters reappears in 4.3.1 Measures of development.
Otti is an AI tutor built for A-Level students. Ask it anything, practise exam questions, and get instant feedback written like an examiner would give it — not just right or wrong, but why.
Get one answer marked free