Exam 3: Comparative Advantage and the Production Possibilities Frontier

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The most frequently used measure of changes in the gains from trade is the commodity terms of trade. The commodity terms of trade measures the relationship between the average prices a country receives for its exports and the average prices a country pays for its imports. This measure is calculated by dividing the price index of a country's exports by the price index of its imports. Over time, changes in a country's terms of trade indicate whether a country can obtain more or fewer imports per unit of exports. However, an improvement in a country's terms of trade does not necessarily reflect an improvement in a country's overall welfare. Likewise, deterioration in a country's terms of trade does not necessarily reflect a deterioration in a country's overall welfare. A change in a country's terms of trade may reflect a change in international economic conditions or it may reflect a change in domestic economic conditions. If a country's terms of trade change as a result of a change in international conditions, we can conclude that an improvement in the terms of trade enhances a country's welfare and that a deterioration in the terms of trade is equivalent to a reduction in the country's welfare. If the terms of trade change as a result of a change in domestic economic conditions, the effect on a country's welfare is uncertain. The net effect on total welfare depends on which is larger--the change in the country's welfare due to the change in the terms of trade or the change in the country's welfare due to the change in domestic production. Although changes in the terms of trade do not accurately measure the changes in a country's welfare, business and government officials often use it as a rough indication of how a country is doing in the world economy