International Trade Theory and Policy
by Steven M. Suranovic

Trade 30-2

Determinants of the Terms of Trade

The terms of trade which is ultimately decided upon by the two trading farmers will depend on a variety of different and distinct factors. Below we describe many of these factors.

  • Preferences

In order for any trade to occur, each farmer must desire some of the other commodity and be willing to give up some of his own good in order to obtain it. In other words, the expected utility of consuming some quantity of oranges by Farmer Jones must be greater than the expected disutility of not consuming some quantity of apples. It seems reasonable in this case that each farmer would prefer to consume a variety of goods, and thus the incentive to trade exists. However, how many oranges will be exchanged for how many apples will still depend on a many other things.

  • Uncertainty

In this situation each farmer is unlikely to have well-defined preferences. Farmer Smith may never have tasted an apple and Farmer Jones may never have tasted an orange. One simple way to resolve this uncertainty is for the farmers to offer free samples of their products before an exchange is agreed upon. Without a sample, the farmers would have to base their exchanges on their expectations of how they will enjoy the other product. Free samples, on the other hand, can be risky. Suppose a sample of oranges is provided and Farmer Jones learns that he hates the taste of oranges. He might then decide not to trade at all.

  • Scarcity

The relative quantities of the two goods available for trade will affect the terms of trade. If Farmer Smith came to the market with 100 oranges to Farmer Jones' 10 apples, then the terms of trade would likely be different than if the farmers come to the market with an equal number. Similarly, if the farmers come to the market with 10 oranges and apples respectively, but recognize that they have an entire orchard of apples and an entire grove of oranges waiting back at home, then the farmers are more likely to give up a larger amount of their product in exchange.

  • Size

The size of the apples and oranges are likely to influence the terms of trade. One would certainly expect that Farmer Smith would get more apples for each orange if the oranges were the size of grapefruits and the apples the size of golf balls than if the reverse were true.

  • Quality

The quality of the fruits will influence the terms of trade. Suppose the apples are sweet and the oranges are sour. Suppose the apples are filled with worm holes. Suppose the oranges are green rather than orange. What is the vitamin, mineral, and calorie contents of each of the fruits? Quality could also be assessed by noting the number of uses for each product. For example, apples can be eaten raw, turned into applesauce, squeezed into juice, made into pies and covered with caramel.

  • Effort

Although a pure exchange model assumes that no production takes place, imagine momentarily that some effort is required to harvest the fruit. What if apples grew at the top of tall trees that required a precarious climb? What if predatory wolves lived in the orange grove? Surely these farmers would want to take these factors into account when deciding the terms for exchange.

  • Persuasion

The art of persuasion can play an important role in determining the terms of trade. Each farmer has an incentive to embellish the quality and goodness of his product, while diminishing the perception of quality of the other product. Farmer Smith might emphasize the high quantities of Vitamin C found in oranges, while noting that apples are relatively vitamin deficient. He might argue that oranges are consumed by beautiful movie stars who drive fast cars, while apples are the food of peasants. He might also under-emphasize his own desire for apples. The more persuasive Farmer Smith, the more likely he is to get a better deal in exchange. Note that the farmer's statements need not be truthful as long as the other farmer is uncertain about the quality of the other product. In this case, differences in the persuasive abilities of the two farmers can affect the final terms of trade.

  • Expectations of Future Relationship

If the farmers expect that the current transaction will not be repeated in the future then there is a potential for the farmers to misrepresent their product to the other. Persuasion may take the form of outright lies if the farmers do not expect to meet again. However, if the transaction is hoped to be the first of many to come, then untruthful embellishments will be less likely.

  • Government Policies

If a taxman stands ready to collect a tax based on the amounts traded between the two farmers, this is likely to affect the terms of trade. Also if laws forbid someone to misrepresent their product to another or face penalties, then this will also affect the farmer's behavior in determining the terms of trade.

  • Morality

Imagine that Farmer Smith was raised to always tell the truth while Farmer Jones missed those lessons during his upbringing. In this case Farmer Jones might be more likely to misrepresent his apples and extract a more favorable terms of trade.

  • Coercion

Finally, the terms of trade can also be affected by coercion. If Farmer Jones threatens Farmer Smith with bodily injury, he might be able to force an exchange that Farmer Smith would never agree to voluntarily. At the extreme, he could demand all of Farmer Smith's oranges and not give up any apples in exchange.

International Trade Theory and Policy - Chapter 30-2: Last Updated on 7/18/06