Effects of changes in the terms of trade

Export revenues and the balance of trade

If the terms of trade improve because export prices rise, the effect on export revenue depends on the price elasticity of demand (PED) for exports:

• Price inelastic demand (common for commodities and essentials in the short run): revenue rises, so the trade balance improves.
• Price elastic demand (common for manufactures with close substitutes): the volume of exports falls more than proportionately, so revenue falls and the trade balance worsens.

A deterioration caused by falling export prices works the opposite way.

Living standards

An improvement means a given volume of exports buys more imports, so real incomes can rise: households can consume more imported goods. But if the improvement comes from high domestic inflation or an appreciation that makes exports uncompetitive, output and jobs in exporting industries may fall, hurting living standards.

For primary product exporters, a deterioration (for example a collapse in a commodity price) cuts export earnings, government revenue and the ability to import capital goods.

Cause matters

Always identify the cause:

• Improvement from rising world demand for exports (for example a commodity boom): usually good, as prices and volumes rise.
• Improvement from domestic inflation or appreciation: may harm competitiveness.
• Deterioration from productivity gains that cut export prices: may be good, as volumes rise.

This is a strong evaluation point in essays such as 'Evaluate factors that might cause a country's terms of trade to worsen' (a 20-mark question in the October 2023 paper).

Worked example

Export prices rise by 10%. PED for exports is -1.5. Estimate the change in export revenue.

1. Quantity demanded falls by 1.5 x 10 = 15%
2. New revenue index = 1.10 x 0.85 = 0.935

Answer: Revenue falls by about 6.5%

Check yourself

1. Export prices rise by 10% and PED for exports is -0.4. Calculate the percentage change in export revenue to 1 decimal place.
   Show answer

   5.6 %. Volume falls 4%; revenue index = 1.10 x 0.96 = 1.056, a rise of 5.6%.

2. Export prices fall by 20% and PED for exports is -0.5. Calculate the percentage change in export revenue (negative for a fall).
   Show answer

   -12.0 %. Volume rises 10%; revenue index = 0.80 x 1.10 = 0.88, a fall of 12%.

3. A country's terms of trade improve because its export prices rise. Its trade balance is most likely to improve if demand for its exports is
   • price inelastic
   • price elastic
   • perfectly elastic
   • unit elastic
   Show answer

   price inelastic. Inelastic demand means volume falls proportionately less than price rises, so revenue rises.

4. Why can an improvement in the terms of trade raise living standards?
   • Exports always rise in volume
   • Imports become more expensive
   • Unemployment always falls
   • Each unit of exports buys more imports
   Show answer

   Each unit of exports buys more imports. Real purchasing power over imports rises.

5. Explain why an improvement in the terms of trade caused by high domestic inflation may harm an economy.
   Show answer

   Higher domestic prices make exports less price competitive and imports relatively cheaper, so export volumes fall, the trade balance can worsen, and output and jobs fall.. The 'improvement' reflects lost competitiveness.

6. A collapse in world copper prices would most likely cause, for a copper-dependent economy,
   • an improvement in its terms of trade
   • higher import prices only
   • a stronger currency
   • lower export earnings and government revenue
   Show answer

   lower export earnings and government revenue. Export prices fall, worsening the terms of trade and cutting earnings and taxes.

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Sources

• Pearson Edexcel International Advanced Level in Economics specification (issue 2)
• Pearson Edexcel IAL Economics WEC14/01 mark scheme, October 2023

Last updated 8 November 2026. Spotted a mistake? Tell us.