Terms of Trade

Quick Summary

• Terms of trade measure the value of exports compared to imports
• Favourable terms (above 100%) mean export prices are rising faster than import prices
• Unfavourable terms (below 100%) mean import prices exceed export prices
• Nigeria often faces unfavourable terms because we export raw materials, import manufactured goods
• WAEC tests calculation methods and factors affecting terms of trade

Understanding Terms of Trade

When Nigeria sells crude oil to other countries and buys cars from Japan, the prices matter greatly. If crude oil prices rise while car prices stay same, Nigeria benefits. But if car prices rise faster than oil prices, Nigeria loses. This relationship between export and import prices is called terms of trade.

Terms of trade answer this question: “How much can we buy with what we sell?” If Nigeria exports 1 barrel of crude oil worth $80 today but next year that same barrel costs $100, while the Toyota car we import stays at N10 million, our terms of trade improved. We can buy more with our exports.

Every country watches its terms of trade closely. Favourable terms mean economic growth, jobs, and prosperity. Unfavourable terms lead to debt, inflation, and economic hardship. For developing countries like Nigeria, understanding this concept helps explain many economic challenges.

How to Calculate Terms of Trade

The standard formula economists use worldwide is:

Terms of Trade (TOT) = (Export Price Index / Import Price Index) × 100

Understanding the Components

Export Price Index: A number showing the average price of all goods a country sells to other countries. If Nigeria’s main exports are crude oil, cocoa, and rubber, this index tracks their combined prices.

Import Price Index: A number showing the average price of all goods a country buys from other countries. Nigeria imports cars, machinery, electronics, food items – this index tracks their combined prices.

Step-by-Step Calculation Example

Example 1: Favourable Terms of Trade

Suppose Nigeria has these price indices:

• Export Price Index = 120
• Import Price Index = 100

Calculation:
TOT = (120 / 100) × 100
TOT = 1.2 × 100
TOT = 120%

Interpretation: This is favourable! The 120% means Nigeria’s export prices rose 20% compared to import prices. We can buy more imports with the same amount of exports. Our purchasing power increased.

Example 2: Unfavourable Terms of Trade

Now suppose:

• Export Price Index = 80
• Import Price Index = 100

Calculation:
TOT = (80 / 100) × 100
TOT = 0.8 × 100
TOT = 80%

Interpretation: This is unfavourable! The 80% means import prices are higher than export prices by 20%. Nigeria must export more goods to buy the same amount of imports. Our purchasing power decreased.

Real-World Nigeria Example

In 2014, crude oil (Nigeria’s main export) sold at $110 per barrel. By 2016, prices crashed to $30 per barrel. Meanwhile, imported rice prices stayed high around N30,000 per bag. This represented severely unfavourable terms of trade.

Practical impact:

• In 2014: Export 1 barrel of oil = Buy 4 bags of rice
• In 2016: Export 1 barrel of oil = Buy only 1 bag of rice

Nigeria needed to export 4 times more oil to buy the same amount of rice. This crashed the naira value and triggered economic recession.

Favourable vs Unfavourable Terms of Trade

Factors Affecting Terms of Trade

1. Global Commodity Prices

Nigeria exports crude oil, cocoa, rubber, and other primary products. When global prices for these commodities rise, our terms of trade improve. When they fall, our terms worsen.

Recent examples:

• 2008-2014: Oil boom period – crude oil reached $110/barrel. Nigeria enjoyed favourable terms of trade, economy boomed
• 2015-2016: Oil crash – prices fell to $30/barrel. Terms of trade collapsed, triggering recession
• 2020: COVID-19 pandemic – oil briefly went negative. Worst terms of trade in decades
• 2021-2022: Post-COVID recovery – oil rose to $90/barrel. Terms of trade improved significantly

2. Exchange Rate Changes

When the naira weakens against dollar, imports become more expensive even if foreign prices stay constant. This worsens terms of trade for Nigeria.

Example:
A Toyota car costs $20,000 in Japan.

• At N360/$1, the car costs N7.2 million in Nigeria
• At N750/$1, the same car now costs N15 million

Import prices doubled due to naira devaluation, automatically worsening Nigeria’s terms of trade.

3. Demand and Supply in International Markets

If global demand for crude oil rises (maybe due to cold winter in Europe), oil prices increase. Nigeria’s export earnings rise, improving terms of trade. Conversely, if demand falls, our terms worsen.

Similarly, if supply of goods Nigeria imports (like wheat, rice, cars) decreases globally due to war or natural disasters, import prices rise. This worsens our terms of trade.

4. Production Costs

Rising production costs for exports worsen terms of trade. If Nigeria’s cost of extracting crude oil rises due to pipeline vandalism, theft, or aging infrastructure, profit margins shrink even if international prices stay constant.

5. Trade Policies and Tariffs

Import tariffs imposed by countries buying Nigerian exports reduce demand and prices. Export subsidies given by competing countries make their products cheaper, forcing Nigeria to reduce prices to compete.

Example: When European Union imposed tariffs on Nigerian crude oil, it reduced demand and lowered prices, worsening our terms of trade.

6. Quality and Value Addition

Countries exporting processed goods enjoy better terms of trade than those exporting raw materials. Nigeria exports raw cocoa beans at $2,500 per ton. Switzerland imports our cocoa, processes it into chocolate, and sells chocolate bars back to Nigeria at huge profits.

If Nigeria processed cocoa into chocolate locally, we’d export higher-value products and enjoy better terms of trade.

Why Developing Countries Like Nigeria Often Face Unfavourable Terms of Trade

Most developing countries, including Nigeria, consistently experience unfavourable terms of trade. Several structural reasons explain this:

1. Export Primary Products, Import Manufactured Goods

Nigeria exports crude oil, agricultural products (cocoa, rubber, cotton), and solid minerals – all raw materials. We import cars, electronics, machinery, processed foods – all manufactured goods.

Problem: Raw material prices fluctuate wildly and often decline long-term. Manufactured goods prices stay stable or rise steadily. Over time, this creates permanently unfavourable terms.

Historical trend: In 1960, 1 ton of cocoa could buy 10 bicycles from Europe. Today, 1 ton of cocoa buys only 2 bicycles. The terms of trade deteriorated 80%!

2. Low Price Elasticity of Demand for Primary Products

When crude oil prices fall, consuming countries don’t suddenly buy much more oil. When prices rise, they don’t drastically reduce consumption. Demand stays relatively stable regardless of price.

This means price changes for Nigerian exports don’t significantly increase quantity sold. We can’t make up for low prices by selling more volume.

3. Price Volatility

Primary commodity prices swing wildly based on weather, political events, speculation. Crude oil ranged from $30 to $140 per barrel in the past decade. Such volatility makes planning impossible and often catches Nigeria with unfavourable prices.

Manufactured goods prices remain relatively stable, protecting importing countries from sudden shocks.

4. Limited Bargaining Power

Nigeria competes with many other oil-exporting countries. Buyers can easily switch suppliers, forcing Nigeria to accept lower prices. We’re price-takers, not price-makers.

Contrast this with specialized technology manufacturers like Apple or Samsung. They set prices because few alternatives exist.

Impact of Terms of Trade on Nigerian Economy

Favourable Terms of Trade Benefits

• Increased national income: More foreign currency earned from exports
• Stronger naira: Higher demand for naira as export earnings increase
• Higher employment: Export industries expand and hire more workers
• Improved living standards: Government can afford more imports and development projects
• Debt repayment: Easier to service foreign debts with higher export earnings
• Investment attraction: Foreign investors see strong economy and invest more

Unfavourable Terms of Trade Problems

• Lower national income: Export same volume but earn less revenue
• Weaker naira: Must devalue currency to afford imports
• Job losses: Export industries struggle and lay off workers
• Inflation: Import costs rise, pushing up prices of everything
• Debt crisis: Harder to repay foreign loans when currency is weak
• Reduced government spending: Less money for schools, hospitals, roads

Common WAEC Exam Mistakes

Practice Questions

Multiple Choice Questions

1. Terms of trade is calculated as:
a) (Import price index ÷ Export price index) × 100
b) (Export price index ÷ Import price index) × 100 ✓
c) (Export value ÷ Import value) × 100
d) (Total exports – Total imports) × 100

2. A terms of trade result of 85% indicates:
a) Favourable terms of trade
b) Unfavourable terms of trade ✓
c) Balanced terms of trade
d) Neutral terms of trade

3. If Nigeria’s export price index is 140 and import price index is 100, the terms of trade is:
a) 40%
b) 100%
c) 140% ✓
d) 240%

4. Which factor most affects Nigeria’s terms of trade?
a) Population growth
b) Crude oil prices ✓
c) Agricultural productivity
d) Tourism revenue

5. Developing countries often face unfavourable terms of trade because they:
a) Export manufactured goods and import raw materials
b) Export raw materials and import manufactured goods ✓
c) Export and import the same products
d) Don’t engage in international trade

Essay/Theory Questions

Question 1: Calculate the terms of trade for Nigeria using the following data: Export Price Index = 110, Import Price Index = 150. Is the result favourable or unfavourable? Explain. (6 marks)

Examiner’s Tip: Show all calculation steps clearly. Write the formula first, substitute values, calculate, then interpret the result with explanation.

Sample Answer:

Formula: Terms of Trade (TOT) = (Export Price Index ÷ Import Price Index) × 100

Substituting values:
TOT = (110 ÷ 150) × 100
TOT = 0.733 × 100
TOT = 73.3%

Interpretation: The result of 73.3% represents unfavourable terms of trade because it is below 100%. This means Nigeria’s import prices are 26.7% higher than export prices. Nigeria must export more goods to afford the same quantity of imports. This reduces purchasing power and hurts the economy.

Question 2: Explain FOUR factors that affect a country’s terms of trade. (8 marks)

Examiner’s Tip: Each factor needs clear explanation with example. Don’t just list factors – explain how each one affects terms of trade.

Sample Answer:

1. Global commodity prices: When international prices of a country’s export products rise, terms of trade improve. For example, if crude oil prices increase from $50 to $80 per barrel while import prices remain stable, Nigeria’s export earnings increase, leading to favourable terms of trade.
2. Exchange rate fluctuations: Currency devaluation makes imports more expensive in local currency even if foreign prices stay constant. When the naira weakens from N360/$1 to N750/$1, the cost of imports doubles in naira terms, worsening Nigeria’s terms of trade.
3. Demand and supply conditions: Increased global demand for a country’s exports raises export prices and improves terms of trade. If European countries increase demand for Nigerian cocoa due to chocolate industry growth, cocoa prices rise, benefiting Nigeria’s terms of trade.
4. Quality and value addition: Countries exporting processed goods enjoy better terms of trade than those exporting raw materials. If Nigeria processes crude oil into refined petroleum products before exporting, the higher value-added exports command better prices, improving terms of trade.

Question 3: Distinguish between favourable and unfavourable terms of trade. (10 marks)

Examiner’s Tip: Use comparison table or clear contrasting points. Show differences in calculation, meaning, and impact.

Sample Answer:

Question 4: State FIVE reasons why developing countries like Nigeria often experience unfavourable terms of trade. (5 marks)

Examiner’s Tip: Question says “state,” so brief clear points are sufficient. No need for long explanations.

Sample Answer:

1. They export primary products (raw materials) which have volatile and declining prices
2. They import manufactured goods which have stable and rising prices
3. Primary products have low price elasticity of demand in international markets
4. They have limited bargaining power as price-takers rather than price-makers
5. They lack value addition and processing industries to export higher-value products

Question 5: Explain THREE effects of unfavourable terms of trade on the Nigerian economy. (6 marks)

Examiner’s Tip: Focus on negative impacts with clear explanations showing the cause-effect relationship.

Sample Answer:

1. Reduced national income: Unfavourable terms mean Nigeria earns less foreign currency from exports while paying more for imports. This reduces total national income and limits government revenue for development projects, healthcare, and education.
2. Currency devaluation: When export earnings decline relative to import costs, demand for foreign currency exceeds supply. This forces the naira to weaken against the dollar, making all imports more expensive and fueling domestic inflation.
3. Increased external debt: To maintain import levels despite reduced export earnings, Nigeria must borrow foreign currency. This increases external debt burden and diverts future resources to debt servicing instead of development.

Memory Aids for WAEC Success

Remember the formula using: “EPIC × 100”

• Export Price Index on top (numerator)
• ÷ Import Price Index
• × 100

Remember interpretation: “100 is the LINE”

• Above 100 = Favourable (Good)
• Below 100 = Unfavourable (Bad)
• Exactly 100 = Neutral (Equal)

Remember why Nigeria struggles: “Raw OUT, Made IN”

• Raw materials exported (oil, cocoa, rubber)
• Made goods imported (cars, phones, machines)
• This creates unfavourable terms long-term

Related Topics You Should Study

Terms of trade connects to many other Commerce and Economics topics tested by WAEC:

• Balance of Trade – Compares total export value to total import value (different from terms of trade)
• Balance of Payment – Records all economic transactions between Nigeria and other countries
• Favourable Balance of Trade – When export value exceeds import value
• Unfavourable Balance of Payment – When payments to other countries exceed receipts
• International Trade – Basic concepts, advantages, and disadvantages
• Import and Export Procedures – Documents and processes for international trade
• Exchange Rate – How currency values affect trade
• Export Promotion – Government measures to boost exports

Key Takeaways

Terms of trade fundamentally affects every Nigerian’s life. When our terms of trade are favourable, the naira strengthens, inflation falls, and living standards improve. When unfavourable, we face currency devaluation, high inflation, and economic hardship.

The 2015-2016 recession Nigeria experienced resulted directly from collapsed terms of trade when oil prices crashed. The 2021-2022 partial recovery came when oil prices rose again. This shows how dependent Nigeria remains on commodity prices and why diversifying the economy matters.

For WAEC success, master the calculation formula completely. Practice with different numbers until you can calculate quickly and interpret results correctly. Understand the difference between terms of trade and balance of trade – WAEC frequently tests this distinction.

Remember: Developing countries like Nigeria will continue facing unfavourable terms of trade until we move from exporting raw materials to manufacturing and exporting finished products. This explains why industrialization and value addition remain critical national goals.