Terms of Trade and Gains from Trade

The Terms of Trade is the actual rate at which one country's good exchanges for another's good in international trade — how many units of Wheat one unit of Cloth actually trades for once the two countries begin exchanging.

For trade to benefit BOTH countries, the international exchange ratio must lie between the two countries' own domestic opportunity costs for that good. In the worked example above, India's domestic cost of Cloth is 2 units of Wheat, while Country B's is only 1.2 units of Wheat. Any international terms of trade between 1.2 and 2 units of Wheat per unit of Cloth benefits both countries: India can obtain Cloth more cheaply than producing it domestically (paying less than 2 Wheat per Cloth), and Country B can sell Cloth for more Wheat than its own domestic cost of 1.2 Wheat per Cloth. A terms of trade of, say, 1.5 units of Wheat per unit of Cloth, is one example within this mutually beneficial band. …