Model Answer
0 min readIntroduction
Terms of Trade (TOT) represent the ratio of a country’s export prices to its import prices. A favorable TOT implies a country can obtain more imports for a given quantity of exports. The determination of these terms is central to understanding international trade dynamics. Offer curves, introduced by Marshall, graphically represent the quantities of a commodity a country is willing to export at different relative prices. The intersection of these curves for trading partners establishes the equilibrium terms of trade, ensuring mutually beneficial exchange.
Understanding Offer Curves
An offer curve shows the relationship between the price of an export commodity and the quantity of that commodity a country is willing to offer for sale. It slopes negatively, reflecting the law of supply. As the relative price of the export good rises, the country is willing to export more. Conversely, as the price falls, the quantity offered decreases.
Determining Equilibrium Terms of Trade
Consider two trading countries, A and B. Country A exports wheat and imports cloth from Country B. Country B exports cloth and imports wheat from Country A. The equilibrium terms of trade are determined where the offer curve of Country A (showing the quantity of wheat it offers at different relative prices of wheat and cloth) intersects the offer curve of Country B (showing the quantity of cloth it offers at different relative prices of wheat and cloth).
Graphical Representation
Imagine a diagram with the relative price of wheat on the Y-axis and the quantity of wheat on the X-axis. The offer curve of Country A slopes downwards. Similarly, another diagram shows the relative price of cloth on the Y-axis and the quantity of cloth on the X-axis, with Country B’s offer curve sloping downwards. The point where these curves intersect determines the equilibrium relative price of wheat and cloth, and hence the terms of trade.
Mechanism of Adjustment
If the initial terms of trade are unfavorable to Country A (i.e., the price of wheat is too low relative to cloth), Country A will offer less wheat, shifting its offer curve upwards. This scarcity increases the price of wheat and reduces the price of cloth, moving towards the equilibrium. Conversely, if the terms of trade are unfavorable to Country B, it will offer less cloth, leading to a price increase for cloth and a decrease for wheat. This process continues until the offer curves intersect, establishing a stable equilibrium.
Limitations
The offer curve analysis assumes constant costs of production and perfect competition. In reality, costs may increase as production expands, and markets are often imperfectly competitive. Furthermore, the model doesn’t account for transportation costs or trade barriers.
Example: India and USA
Consider India exporting textiles to the USA and importing machinery from the USA. The intersection of India’s offer curve for textiles and the USA’s offer curve for machinery will determine the equilibrium terms of trade – the ratio of textile prices to machinery prices. Changes in demand or supply in either country will shift the offer curves and alter the terms of trade.
Conclusion
In conclusion, the equilibrium terms of trade are determined by the intersection of the offer curves of trading partners, reflecting the quantities each country is willing to export at different relative prices. This mechanism ensures a mutually beneficial exchange, although the model’s assumptions should be acknowledged. Shifts in offer curves due to changes in production costs, demand, or trade policies can alter the terms of trade, impacting the welfare of trading nations.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.