Prove mathematically that an improvement of a country’s terms of trade increases its real income. Why...

Prove mathematically that an improvement of a country’s terms of trade increases its real income. Why is this considered an important result? Explain

Expert Solution

Let's assume a simple case wherein a country can produce 10 units of a good x or 20 units of y with the resources it has. Let's assume that good y is the one where it has a comparative advantage, implying that it will export good y and import good x. Obviously it won't do the trade if the price it gets is less than 1/2 units of x for each y it exports, since it can do as well locally.

Assume that the terms of trade it faces are 0.6 of x for each y it exports, so it gets 1 extra x for every 10 y it exports, as compared to what it would be able to get if it was an autarky.

We can clearly see that this gain of 1 unit of x is a real benefit for this country. If the terms of trade improve to 0.7, then it would gain one additional unit and so on. From the perspective of this country this is a real benefit (or real income).

It is important (from the perspective of a particular country as well as from a global viewpoint) because improvement in terms of trade make it attractive for countries to trade and specialize in the products where they have comparative advantage. This makes the global output of goods increase .

Rahul Sunny answered 1 year ago

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