In this article we will discuss about Mill’s Theory of Reciprocal Demand:- 1. Changes in Demand and Supply 2. Reciprocal Demand Elasticity 3. Offer Curve Approach 4. Mill’s Paradox 5. Special Gains to Small Countries 6. Criticisms 7. Formula 8. Graphs.
J.S. Mill made Ricardo’s theory of comparative cost determinate by stating the conditions for equilibrium terms of trade. Comparative cost difference between the countries sets the outer limits between which international trade can take place profitably. It does not tell where, between the limits, international trade will actually take place. Mill provides answer to this question.
J. S. Mill propounded the theory of reciprocal demand or the law of international values to explain the actual determination of equilibrium terms of trade. According to him, the equilibrium terms of trade arc determined by the equation of reciprocal demand. Reciprocal demand means the relative strength and elasticity of demand of the two trading countries for each other’s product in terms of their own product.
A stable ratio of exchange will be determined at a level where the value of imports and exports of each country is in equilibrium. In Mill’s own words, “The actual ratio at which goods are traded will depend upon the strength and elasticity of each country’s demand for the other country’s product, or upon reciprocal demand. The ratio will be stable when the value of each country’s exports is just enough to pay for its imports.
Mill’s theory is based on the following assumptions- (i) Full employment conditions; (ii) Perfect competition; (iii) Free foreign trade; (iv) Free mobility of factors; (v) Applicability of the theory of comparative cost; (vi) Two country, two commodity model.
Ellsworth has summed up Mill’s theory of reciprocal demand in the following way:
(i) The possible range of barter terms is given by the respective domestic terms of trade as set by comparative efficiency in each country.
(ii) Within this range, the actual terms depend on each country’s demand for the other country’s produce.
(iii) Finally, only those barter terms will be stable at which the exports offered by each country just suffice to pay for the imports it desires.
Changes in Demand and Supply Conditions:
Mill’s theory of reciprocal demand is more than a simple truism. It indicates the forces and their modus operendi which bring about international equilibrium. Mill analysed the impact of changes in supply and demand conditions on the terms of trade.
1. Changes in Supply Conditions:
Changes in supply conditions as a result of cost-reducing improvements in technology bring changes in terms of trade. An improvement in the cloth industry of England increases the productivity in that industry, makes cloth cheaper in terms of Indian wheat (i. e., the same amount of wheat is exchanged for more cloth) and thus makes the terms of trade in favour of India, the importer of cloth in exchange for wheat.
2. Changes in Demand Conditions:
The extent to which the barter terms of trade change depends not only on the increased production in exporting country, but also on the importing country’s elasticity of demand for imports in terms of its exports.
(i) If India’s elasticity of demand for England’s cloth in terms of its own wheat is more elastic, then the barter terms of trade will change in favour of India more than the fall in price of cloth in terms of wheat.
(ii) If India’s demand for cloth in terms of wheat is unitary elastic, then the barter terms of trade turn in favour of India equal to the fall in the price of cloth in terms of wheat.
(iii) If India’s demand for cloth in terms of wheat is less elastic, then the barter terms of trade will change in favour of India less than the fall in the price of cloth in terms of wheat.
Reciprocal Demand Elasticity:
The reciprocal demand elasticity refers to the ratio of proportional change in the quantity of imports demanded to the proportional change in the price of exports relative to the price of imports. Thus, elasticity of reciprocal demand-
If e > 1, then terms of trade will be favourable for the concerned country and its share of gain will be larger; if e < 1, terms of trade will for the concerned country and the share of gain will be relatively less; if e = 1, the gain from trade will be equally distributed between the two countries.
The determination of equilibrium terms of trade can be graphically illustrated with the help of offer curve – a geometrical technique developed by Marshall. The offer curve is a typical demand curve as it shows the demand for one commodity (imports) in terms of the supply of another commodity (exports).
In Figure-3, we take up two countries, India and England. India produces only wheat and England only cloth. 01 is India’s offer curve indicating India’s demand for cloth in terms of wheat. It represents the quantities of wheat which India is willing to offer in exchange for English cloth.
As the quantity of cloth increases, India will be offering lesser and lesser amount of wheat in exchange for cloth. For example, in exchange for KW cloth, India is willing to offer OW wheat. Similarly, OE is England’s offer curve of cloth for wheat, representing England’s demand for Indian wheat.
For example, England is willing to offer CW cloth in exchange for OW wheat. T is the equilibrium point where TP cloth is exchanged for OP wheat. Here reciprocal demands are equal. Line OT shows the equilibrium terms of trade.
Effect of Change in Supply:
As a result of cost reducing improvement in the cloth industry of England, OE1 is England’s new offer curve. Now England is willing to offer C’W cloth for OW wheat, whereas previously she was offering CW cloth for OW wheat. The terms of trade change in favour of India as a result of this improvement.
The extent of change in terms of trade will depend upon the slope of India’s offer curve. Positively sloping India’s offer curve after point T (i.e., TI) represents India’s more elastic demand for cloth in terms of wheat and makes the terms of trade in favour of India more than the fall in cloth’s price in terms of wheat.
If India’s offer curve is vertical straight line after point T (i.e., TI1), it shows unitary elastic demand for cloth in terms of wheat and the terms of trade will change in favour of India equal to the fall in cloth price in terms of wheat. If India’s offer curve is backward sloping after point T (i.e., TI2), then the terms of trade will change in favour of India more than the fall in price of doth relative to wheat.
An important implication of the effect of improvement on the terms of trade is that a developing economy experiences unfavourable terms of trade as a result of technological advancement. In the words of Mill- “The richest country, ceteris paribus, gain the least by a given amount of foreign commerce- since, having a greater demand for commodities generally, they are likely to have a greater demand for foreign commodities, and thus modify the terms of interchange to their disadvantage.”
Edgeworth termed this phenomenon as ‘Mill’s Paradox’ and Bhagwati called it ‘immiserizing growth’. The explanation of this statement is that as consequence of an increase in productivity, the supply of export goods increases and the developing country is faced with a problem of finding foreign markets for it.
The situation is serious in those developing economies where the technological improvement is confined to the export industry only and foreign demand is inelastic.
There is a theoretical possibility that small country may gain more than large countries from international trade. This is because a small country can specialise in the production of single commodity without significantly affecting its price in the international market.
On the contrary, the large country specialises in the production of a single commodity, an increase in its supply will cause a fall in its price, thus adversely affecting the terms of trade. The small country may be able to trade with a large country at the price ratio prevailing in the large country or very close to it. This brings all gains to the small country.
Offer curve technique may be used to illustrate hypothetical case of special gains from trade to the small countries. Ts, represents the pre-trade exchange ratio in country S, which is a very small country, and TL is the pre-trade exchange ratio in country L, which is a very large country. OS is the offer curve of country S and OL is the offer curve of country L.
Country S is so small that its offer curve crosses the straight line portion of the offer curve of large country L. Thus, international trade takes place at the domestic exchange ratio in country L. This enables small country S to capture all the gains.
Criticisms to Mill’s Theory of Reciprocal Demand:
Mill’s theory of reciprocal demand has been criticised on the following grounds:
(i) The theory is based on unrealistic assumptions, such as perfect competition and full employment.
(ii) Actual trade is not restricted to two country, two commodity model.
(iii) Mill concentrates on the elasticity of demand, thus neglecting the impact of elasticity of supply. According to the modem economists, terms of trade are generally influenced by- (a) elasticity of demand for exports, (b) elasticity of demand for imports, (c) elasticity of supply exports, and (d) elasticity of supply of imports.
(iv) Graham has criticised the reciprocal demand aspect of Mill’s theory. It has exaggerated the role of reciprocal demand and neglected the comparative cost conditions in determining the terms of trade.
(v) Jacob Viner has criticised the theory as imperfect and inadequate.
(vi) Shadwell has criticised the theory by saying that in this theory the exchange ratio is fixed at a point where the value of imports and exports are in equilibrium as a mere truism. It does not throw any light on the determinants of terms of trade.
Bastable, however, does not agree with this criticism because Mill’s theory not only states the equilibrium, but also discusses the forces that operate to bring it about.