Suppose that freedonia and lamponia agree to trade. each country focuses its resources on producing only the good in which it has a comparative advantage. the countries decide to exchange 12 million pounds of lemons for 12 million pounds of tea. this ratio of goods is known as the terms of trade between fredonia and lamponia.

Fredonia and Lamponia

Exchange of 12 million pounds of lemons for 12 million pounds of tea:

The ratio of goods exchanged is known as the terms of trade between the two countries, because by exchanging 12 million pounds of lemons for 12 million pounds of tea, Fredonia and Lamponia have directly fixed the price of lemon to be equal to the price tea.

The exchange will merely be a trade by barter if the price of tea per pound is not the same price of lemons per pound.  But, by equating their prices and exchanging the same quantities, Fredonia and Lamponia have implicitly defined their terms of trade for lemon and tea respectively.

Explanation:

Generally, the trade terms between Fredonia and Lamponia represent the ratio of the export price of lemons and import price of tea. The ratio is calculated by dividing the price of the exports by the price of the imports and multiplying the result by 100.  In this implied situation, the ratio is 100% or 1 is to 1.

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