ToT = Terms of Trade

A country's terms of trade (ToT) is the weighted average of its average export prices over it's average import price times 100.  A value of 100 means the prices for both are the same, but if in the next year the country sees a ToT of 103, that means the country's exports now buy 3% more than what they did the year before and we've seen an improvement in the terms of trade.  Conversely, if the number is 97, then the country's exports can now only buy 97% of what they could wth their exports.  This is a deterioration of a country's terms of trade. 


Why do ToT's change?
In the SR...
- forces of supply and demand for exports
- relative inflation increases or decreases
- exchange rate fluctuations

In the LR...
- consumer incomes
- improvement in worker/FoP productivity

PED for exports: %∆ demand for exports / %∆ average price of exports
- if elastic, good for when export prices are falling (bigger change in demand, more export revenue)


PED for imports: %∆ demand for imports / %∆ average price of imports
- if inelastic, bad for when export prices are falling (smaller change in demand, less revenue)

Interesting article : Coping with Terms-of-Trade Shocks in Developing Countries (please read and evaluate)

Maximizing Total Revenue (TR)

Firms need to be aware of the price elasticity of demand (PED) for their products (i.e. where they are on their demand curves) to determine the level of profit maximization. For most products (all non-perfectly competitive goods), firms face a normal downward-sloping demand curve which implies PED falls as firms make more output. To sell more, the firm needs to lower the price, and, thus, demand and average revenue (AR) fall accordingly. Marginal revenue, which is twice as steeply sloped as AR, also falls as output increases and goes beneath the x-axis, representing diminishing returns and falling revenue as output grows too big. MR falls faster than AR because revenue is lost as firms have to lower prices to sell more product.

As shown by this graph, firms should lower prices if in the elastic part of their demand curve until unit elasticity is achieved. Similarly, firms should raise prices if in the inelastic part of their demand curve until unit elasticity is achieved. Unit elasticity is the key point, where total revenue (TR) is maximized. This relationship is critical for firms determine and give employment to many economists!

Video: Elasticity of Demand

Elasticity...PED, yED, XED, PES oh my!

The demand for g/s is NOT static nor uniform!  For some products, like medication, when the price increases, the quantity demanded will not fall dramatically.  However, if the price for a trip to Tahiti increases, quantity demanded plummets.  Why?  The answer is that g/s have different price, cross and income elasticities of demand.

Price elasticity of demand (PED) is the measure of responsiveness of the quantity demanded for a g/s as a result of change in price of the same g/s.

PED = %∆Qd/%∆p

PED = 0 : perfectly inelastic

PED < 1 : inelastic (i.e. insulin) 
PED = 1 : unit elastic 
PED > 1 : elastic (i.e. restaurant dinners)

PED = ∞ : perfectly elastic

Income elasticity of demand (yED) is the measure of the responsiveness of the quantity demanded of a g/s as a result of a change in the income of the consumers demanding the good.

yED = %∆Qd/%∆y

yED > O : normal good (i.e. shirts, cars, haircuts)

yED < 0 : inferior good (i.e. poor cut of meat, public transportation)
0 < yED < 1 : necessity good (still normal) 
yED > 1 : superior good (still normal)

Cross elasticity of demand (XED) measures the responsiveness of the quantity demanded of one g/s as a result of the change to the price of another g/s. XED = %∆Qda/%∆pb

XED > O : substitutes (i.e. Pepsi and Coke)

XED < 0 : complements (i.e. mp3s and mp3 players)

Price elasticity of supply (PES) measures the responsiveness of the quantity supplied of g/s as a result of a change in price of product.

PES = %∆Qs/%∆p

PES < 1 : inelastic (harder to supply more quickly) 
PES > 1 : elastic (easier to supply more quickly)