Friday, August 28, 2009

J. S. Mill’s Reciprocal Demand Theory of International Trade

Ricardo expounded the theory of comparative advantage without explaining the ratios at which commodities would exchange for one another. It was J. S. Mill who discussed the problem of ratios in detail in term of his theory of “Reciprocal Demand”. The term ‘reciprocal demand’ was introduced by Mill to explain the determination of the equilibrium terms of trade. It is used to indicate a country’s demand for one commodity in terms of the quantities of other commodities it is prepared to give up in exchange. It is reciprocal demand that determines the terms of trade which in turn determine the relative share of each country. Equilibrium would be established at that ratio of exchange between the two commodities at which quantities demanded by each country of the commodity which it imports from the other should be exactly sufficient to pay for another.

To explain his theory of reciprocal demand, Mill first restated the Ricardian theory of comparative costs, “Instead of taking as given the output of each commodity in two countries, with the labour costs different, he assumed a given amount of labour in each country but differing outputs. Thus his formation ran in terms of comparative advantage or comparative effectiveness of labour, as contrasted with Ricardo’s comparative labour cost.

Assumptions:

Mill’s theory of reciprocal demand is based on the following assumptions.

1. There are two countries, say, England and Germany.

2. There are two commodities, say, linen and cloth.

3. Both the commodities are produced under the law of constant returns.

4. There are no transport costs.

5. The needs of the two countries are similar.

6. There is perfect competition.

7. There is full employment.

8. There is free trade between the two countries.

9. The principle of comparative costs is applicable in trade relations between the two countries.

Given these assumptions Mill’s theory of reciprocal demand can be explained with the help of following table.

Quantities of Commodities Produced:

Country

Output Of

Linen Cloth

Germany

England

10 10

6 8

Suppose Germany can produce 10 units of linen or 10 units of cloth within one man-year and England can produce 6 units of linen or 8 units of cloth with the same input of labour-time. According to Mill “This supposition then being made, it would be in the interest of England to import linen from Germany and of Germany to import cloth from England”. This is because Germany has an absolute advantage in the production of both linen and cloth, while England has the least comparative advantage in the production of cloth. This can be seen from their domestic ratios and international exchange ratios.

Before trade, the domestic cost ratios of linen and cloth in Germany is 1:1 and in England is 3:4. If they were to enter into trade Germany’s advantage over England in the production of linen is 5:3 (or 10:6) and in the production of cloth 5:4 (or 10:8). Since 5/3 is greater than 5/4. Germany possesses greater comparative advantage in the production of linen. Thus it is in Germany’s interest to export linen to England in exchange of cloth. Similarly England’s position in the production of linen is 3/5 (or 6/10) and in production of cloth is 4/5 (or 8/10). Since 4/5 is greater than 3/5, it is in the interest of England to export cloth to Germany in exchange for linen.

Miller’s theory of reciprocal demand relates to the possible terms of trade at which the two commodities will exchange for each other between the two countries. The terms of trade refer to the barter terms of trade between the two countries i.e. the ratio of the quantity of imports for given quantity of exports of a country. And “the limits to the possible barter terms of trade (the international exchange ratio) are set by domestic exchange ratios established, by the relative efficiency of labour in each country. To take an example in Germany 2 inputs of labour time produce 10 units of linen and 10 units of cloth, while in England the same labour produces 6 units of linen and 8 units of cloth. The domestic exchange ratio between linen and cloth in Germany is 1:1 and 1:1.33 in England. Thus the limits of possible terms of trade are linen: 1 cloth in Germany and 1 linen: 1.33 cloths in England. Thus the terms of trade between the two countries will be between 1 linen or 1 cloth or 1.33 cloth.

But actual ratio will depend upon reciprocal demand i.e. “the strength and elasticity of each country’s demand for the other country’s product”. If Germany’s demand for England’s cloth is more intense (inelastic) then the terms of trade will be nearer 1:1 Germany will be prepared to exchange one unit of linen with one unit of cloth of England. The terms of trade will move against it and in favour of England. Consequently Germany’s gain from trade will be less than that of England. On the other hand if Germany’s demand for England’s cloth is less intense (more elastic) then the terms of trade will be nearer 1:1.33. Germany will be prepared to exchange its one unit of linen with 1.33 units of cloth of England. The terms of trade will move in favour of Germany and against England. Consequently Germany’s gain from trade will be greater than that of England.

In short “(1) The possible of barter terms is given by the respective domestic term of trade as set by comparative efficiency in each country (2) with in this range, the actual terms of trade depend on each country’s demand for the other country’s produce and (3) finally, only those barter terms of trade will be stable at which the exports offered by each country just suffice to pay for the imports it desires”.

Criticism of the Theory:

Mill’s theory of reciprocal demand is based on almost the same unrealistic assumptions that were adopted by Ricardo in his doctrine of comparative advantage. Thus the theory suffers from weaknesses. Besides there are some additional criticism made by Viner, Graham and others.

1. Mills theory of reciprocal demand does not take into account the domestic demand for the product, as pointed out by viner, each country would export its product only after satisfying its home demand. Thus the demand curve for Germany would not be below the line until the domestic demand was satisfied and same applies to England.

2. According to Graham Mills analysis is valid only if the two countries are of equal size and the two commodities are of equal consumption value. In absence of these two assumptions if one country is small and the other large, the small country gains the most on both counts, first if it produced a high value commodity, it will adopt the cost ratios of its big partner and second the two trading countries being of unequal size the terms of trade will be fixed at or near the comparative costs of the large country. Graham further criticises Mill for emphasising demand and neglecting supply in determining international values. According to him the application of the reciprocal demand makes it appear that demand alone is of interest he maintains that production cost (supply) are also of paramount importance to international trade.

3. Another weakness of Mill’s reciprocal demand analysis is that it makes no allowance for fluctuations in incomes in the two trading countries which are bound to influence the terms of trade between them.

4. Further the theory is based on barter terms of trade and relative price ratios. Thus it neglects all sickness of prices and wages, all transitional inflationary and over valuation gaps and all balance of payment problems.

1 comment: