Terms of trade and trade barriers: tariffs and quotas

1. Terms of trade: meaning

The terms of trade are the rate at which a country’s exports exchange for its imports, that is, how many units of imports it obtains for a unit of exports. They decide how the gains from trade are shared between countries. They are measured by index numbers: an index above 100 (compared with the base year) is a favourable movement (each unit of exports buys more imports); below 100 is unfavourable.

2. Concepts (components) of terms of trade

The classification is mainly that of Jacob Viner, with Taussig and Dorrance.

1. Net barter (commodity) terms of trade (Taussig): the ratio of the export price index to the import price index. N = (P_x / P_m) × 100. This is the concept usually meant.
2. Gross barter terms of trade (Taussig): the ratio of the quantity of imports to the quantity of exports. G = (Q_m / Q_x) × 100. A rise means more imports are received for a given volume of exports.
3. Income terms of trade (G.S. Dorrance): the net barter terms multiplied by the export quantity index. I = (P_x / P_m) × Q_x. It measures a country’s capacity to import from its export earnings, which matters most for developing countries.
4. Single factoral terms of trade (Viner): the net barter terms adjusted for productivity in the export industries. S = (P_x / P_m) × Z_x, where Z_x is the productivity index of exports. It shows the imports obtained per unit of domestic factors used in exports.
5. Double factoral terms of trade (Viner): adjusted for productivity in both export and import industries. D = (P_x / P_m) × (Z_x / Z_m).
6. Real cost and utility terms of trade (Viner): adjust the single factoral terms for the disutility of producing exports and the utility of imports; they cannot be measured in practice.

Worked numerical

Base year = 100. In the current year: export price index 120, import price index 150, export quantity index 140, import quantity index 120, productivity index of export industries 110, of foreign import industries 105.

Interpretation. The net barter terms have worsened by 20 per cent: export prices rose less than import prices. But because export volume grew by 40 per cent, the income terms of trade are 112: the country’s capacity to pay for imports has actually risen. A fall in the net barter terms is not always a loss.

Factors affecting the terms of trade

• Reciprocal demand (Mill): the elasticity and intensity of each country’s demand for the other’s goods.
• Elasticity of supply of exports.
• Nature of goods: primary products face inelastic and unstable demand. Prebisch and Singer argued that the terms of trade of primary-producing countries tend to decline over the long run.
• Tariffs and quotas: a large country can improve its terms by a tariff.
• Devaluation: normally worsens the net barter terms.
• Economic growth, technical progress and changes in tastes.

3. Trade barriers

Trade barriers are restrictions imposed by governments on the free flow of goods: tariff barriers (duties) and non-tariff barriers (quotas, licensing, exchange control, technical standards, subsidies).

4. Tariffs

A tariff is a tax or duty levied on goods when they cross the national frontier, most often on imports. In India customs duty is levied under the Customs Act, 1962 and the Customs Tariff Act, 1975.

Kinds

• By basis: specific (a fixed sum per unit, say Rs. 500 per tonne), ad valorem (a percentage of value) and compound (both).
• By purpose: revenue tariffs and protective tariffs.
• By direction: import, export and transit duties.
• Others: single-column and multi-column (preferential) tariffs; countervailing duties against subsidies; anti-dumping duties.

Effects of a tariff (partial equilibrium, Kindleberger)

Suppose the world price of a good is Rs. 100 and a 20 per cent tariff raises the domestic price to Rs. 120. Then:

1. Price effect: the domestic price rises by the tariff (fully, for a small country).
2. Protective (production) effect: domestic output rises because home producers can now sell at Rs. 120.
3. Consumption effect: consumers buy less at the higher price; consumer surplus falls.
4. Import (trade) effect: imports fall, by the rise in output plus the fall in consumption.
5. Revenue effect: the government collects the tariff on remaining imports.
6. Redistribution effect: income passes from consumers to producers (higher producer surplus) and to the government.
7. Terms of trade effect: a large country can force down the world price of its imports, improving its terms of trade.
8. Balance of payments effect: fewer imports improve the balance of payments.
9. Income and employment effect: spending shifts to home goods.
10. Competitive effect: protection can make home industry inefficient.

In a demand-supply diagram, the deadweight loss is two triangles: the production loss (resources pulled into high-cost home production) and the consumption loss.

5. Quotas

A quota is a quantitative restriction: a limit on the physical quantity or value of a good that may be imported (or exported) in a period.

Kinds

• Tariff quota: a fixed quantity imported at a low duty, any excess at a higher duty.
• Unilateral quota: fixed by the importing country alone.
• Bilateral quota: negotiated with the exporting country.
• Mixing quota: producers must use a minimum proportion of home inputs.
• Import licensing: licences issued up to the quota amount.

Effects

The price, protective, consumption and import effects are similar to those of a tariff, but the quantity is fixed directly. The revenue does not go to the government unless licences are auctioned; the gain (“quota rent”) goes to the licence-holders. Quotas encourage corruption in the allotment of licences and can create domestic monopolies.

6. Tariffs and quotas compared

Quotas are quicker and surer in a balance of payments crisis, but tariffs are generally preferred because they keep competition and the price mechanism alive.

How this is examined

For “terms of trade and its components”, define, list the six concepts with formulas, work a short numerical and list the factors affecting them. For the tariff essay, define, classify and give the effects as a numbered list. For “tariffs and quotas”, define each, give the kinds briefly, and use the comparison table.