Comparative cost theory does not tell what the actual terms of trade will be

Comparative cost theory does not tell what the actual terms of trade will be. It gives only the upper and lower limits of the range in which the trade between the two countries will be mutually beneficial.

The terms of trade refer to the rate of exchange and are determined by the cost ratios of production. If Indian wheat is exchanged for English cloth at a rate of 1 Wheat = .9 Cloth, then all gains of trade will go to India.

This is the upper limit. If Indian wheat is exchanged for English cloth at the rate of 1 Wheat = .5 Cloth, then all gains will go to England. This is the lower limit.

The actual terms of trade will be determined between these two limits. If Indian wheat is exchanged for English cloth at the rate of I Wheat = .7 Cloth, then the gains from trade will be evenly distributed between India and England.

The terms of trade as reflected by the cost ratios of production are represented through the offer curve. Line I represents the offer curve of India which is drawn on the basis of India’s barter rate (or cost ratio) 1 Wheat = .5 cloth.

Line E is the offer curve of England which is drawn on the basis of England’s domestic barter rate (or cost ratio) 1 Wheat = .9 Cloth. India’s offer curve (I line) shows that India wants more than .5 units of cloth for 1 unit of wheat exported.

England’s offer curve (E line) shows that England is willing to offer less than .9 units of cloth for 1 unit wheat imported. Thus, 1 Wheat = .5 Cloth and 1 Wheat = .9 Cloth are the two limits of the range in which the actual rate of exchange (terms of trade) will be determined.

The actual rate of exchange will be determined on the basis of the relative bargaining strength of the two countries. If the actual rate of exchange is fixed at the upper limit, i.e., 1 Wheat = .9 Cloth (as indicated by the offer curve E), it means India is powerful and England is weak in bargaining.

Or, in other words, England’s demand for India’s wheat is inelastic. In such a situation, the whole gain from trade (i.e., AB or .9 – 5 = .4 cloth per unit of wheat) will go to India.

On the other hand, if the actual rate of exchange is fixed at the lower limit, i.e., 1 Wheat = .5 Cloth (as indicated by the offer curve I), it means England is strong and India is weak in bargaining and the whole gain from trade (i.e., AB or .4 cloth per unit of wheat) will be received by England.

But, if both the countries are equally strong in bargaining the actual rate of exchange will be determined in the middle of the two limits, i.e., 1 Wheat = .7 Cloth (as indicated by the offer curve T).

The total gain from trade (i.e., AB or, .4 units of cloth per unit of wheat) will be equally distributed between India and England. India’s gain will be AC or .2 units of cloth per unit of wheat and England’s gain will be BC or .2 units of cloth per unit of wheat.