Basically, the terms of trade of a country are determined by the relative intensity of its import demand and export demand as compared to that of the other country. That is to say, the terms trade depend upon:
(a) Elasticity of demand for imports of the country concerned (Dm);
(b) Elasticity of demand for its exports by the foreign country (Dx);
(c) Elasticity of supply of its exports (Sx); and
(d) Elasticity of supply of its import (i.e., exports of the foreign country) (Sm).
These four kinds of elasticities are collectively described as the “reciprocal demand elasticity Changes in reciprocal demand elasticity obviously bring about changes in the terms of trade.
The reciprocal demand elasticity is conditioned by the relative intensity of demand. The relative intensity of demand, in turn, depends upon a host of factors, such as:
(i) Size of the population and population growth. A country having a large and high population growth will have relatively greater import intensity.
(ii) Resourcefulness of the export supply.
(iii) Nature of goods imported and exported. Primary products have generally inelastic demand while with increase in income manufactured goods have elastic demand.
(iv) Diversification of products also influences elasticity of demand. A country producing large variety of goods will have high export intensity and less import intensity, as it can produce most of the goods domestically.
(v) Tastes and the capacity to buy may also be regarded as imported factors. Tastes determine the type of goods to be imported by the country and its economic advancement determine its capacity to buy, i.e., the quantity of the goods to be purchased.
(vi) Government’s policy also affects country’s relative demand position. Tariffs, import quotas and other restrictions artificially restrict the import demand of a country, improving its terms of trade.
It follows that any change in any of these factors will cause a change in the relative intensity of demand of a country and affects its terms of trade.
However, the major factors which can affect the terms of trade are:
1. Shifts in demand for imports and/or exports.
4. Economic development.