Terms of trade is used in international trade theory as a measure of the relative price of exports and imports. It is calculated as the ratio according to which two commodities are exchanged between two countries.
Ricardian trade model delimits the boundaries within which the terms of trade must lay in international trade for countries to trade goods. However, it does not determine the exact proportion in which these occur. Nevertheless, determining the exact terms of trade is an argued matter as there are numerous different theories which at the same time go through a wide range of complexity levels.
Probably the simplest model is that of the classical economics which states that in a two country trade, all of the excess production of one country will be exchanged for all the excess production of the second country. However, for this calculation to work, we ought to analyse also the demand of traded goods. John Stuart Mill’s equation of international demand, which basically states that the terms of trade are determined so as to equate the value of exports and imports, show this relationship. In Mill’s words “the produce of a country exchanges for the produce of other countries, at such values as are required in order that the whole of her exports may exactly pay for the whole of her imports”.
It can be easily seen the origin of the main critique regarding this calculation: it is too theoretical. If such terms of trade were applied in actual international transactions, economies would never run a trade deficit or surplus. However, since we know most of them do run a trade deficit or surplus, we must agree that both the Ricardian trade model and Mill’s equation of international demand have a few flaws. Nevertheless, as Jagdish N. Bhagwatipointed out in his article “The Pure Theory of International Trade: A Survey”, 1964, this model ought to be analysed form a normative point of view, since it does help prove the welfare proposition that trade is beneficial.