Comprehensive Essay on the Theory of Reciprocal Demand of Trade

Ricardo’s comparative cost thesis stressed the existence of gain from international trade in the form of saving in resources from specialising and trading, rather than producing all the commodities at home. But how this gain would be distributed among the participating countries was not analysed by him. The task was completed by J.S. Mill in this Theory of Reciprocal Demand.

Mill’s Exposition of Comparative Advantage

J. S. Mill has restated the Ricardian concept of comparative cost difference in terms of comparative advantage or comparative effectiveness of labour in order to examine the question of international value, i.e., the ratios at which goods would exchange for one another. Ricardo had taken the given output of each commodity (wine and cloth) in two countries (England and Portugal) with the differing labour costs. Mill, on the other hand, assumed a given amount of labour in each country and considered differing output of the two goods due to differing labour efficiency.

Given the same labour input (of 100 man-hours), Portugal and England produce different outputs of wine and cloth. It can be seen that Portugal has an absolute advantage in producing both the goods (wine 3 against 1 and cloth 3 against 2). However, it has an explicit comparative advantage in wine making (comparing 3/1 and 3/2). England, on the other hand, has less comparative disadvantage in producing cloth. Thus, it is a paying proposition for Portugal to specialise in the production of wine and for England in producing cloth under free trade.

The limits to the possible commodity terms of trade or the exchange ratio of goods between the two countries will be established by the domestic exchange ratios set by the relative efficiency of labour in each country.

In Portugal, the domestic terms of trade will be:

1 W= 1 C

In England, it will be:

1 W=2C

Thus, the range of possible barter terms of trade is:

1 W = 1 C ; 2 C.

Thus, between 1 and 2 units of cloth for 1 unit of wine, the international terms of trade will be settled. At what point the actual terms will be settled depends on the reciprocal demand.

Mill’s Doctrine of Reciprocal Demand

According to Mill, reciprocal demand in international trade determines the terms of trade, which in turn determine the relative share of each trading country.

Mill defined terms of trade as the barter terms of trade which refers to the ratio of the quantity of imports received for a given amount of exports. He emphasised that, the actual barter terms of trade depend not on cost conditions alone, as Ricardo assumed, but fundamentally on demand conditions also.

Mill argued that, the actual ratio at which goods exchange between two countries will depend upon 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 fixed at the point at which the value of imports and exports of each country is in equilibrium.

The terms of trade, however, may be favourable to one country and unfavourable to another, depending upon the relative elasticity of demand for the country concerned, which determines the country’s relative share of total gain from the trade. Obviously, the country with an inelastic demand (for imports) will be prepared to give more of its commodity (exports) for a certain amount of other goods (imports), when a shortage in supply occurs.

The terms of trade will thus, be unfavourable to that country and consequently its gain from trade will be less. Similarly, if a country’s import demand is relatively elastic, it will offer less of its goods (exports) for a certain amount of imports. In that case, it will have favourable terms of trade and its share of gains will be larger. In other words, when a country can push the terms of trade towards the other country’s domestic cost ratio, its own gain increases.

To illustrate the point, suppose the cost ratio in England is such that a certain amount of labour produces 5 units of wine and 10 units of cloth, while the same in Portugal is 15 units of wine and 5 units of cloth. The domestic exchange ratio, in the absence of specialisation, will be:

This means one unit of wine can be exchanged with 2 units of cloth in England or 1/3 unit of cloth in Portugal. Hence, the extreme limits within which the terms of trade will lie are: 1 unit of wine = 2 units of cloth or 1/3 unit of cloth.

The actual exchange ratio, however, will be determined by the relative elasticity of demand on the part of Portugal for English cloth and on the part of England for Portuguese wine. Now, if Portuguese demand for English cloth is more intense so that the ratio of exchange may be determined as 1 unit of wine = 1/2 unit of cloth, this term of trade is more favourable to England and unfavourable to Portugal, because Portugal is required to part with more wine. On the other hand, if Portuguese wine is more intensely demanded, then the exchange ratio may be settled at 1 unit of wine = 1/2 of cloth. This is more favourable to Portugal and unfavourable to England so that the gain will be larger to Portugal and less to England.

In short, that country gains most from international trade whose exports are most in demand, and which itself has little demand for the things it imports, i.e., for the exports of other countries. And that country gains least which has the most insisted demand for the products of other countries. Thus, how much a country gains from trade depends upon the size and elasticity of demand of other countries for its commodities, compared with its own demand for their products, i.e., reciprocal demand elasticity.

To put in technical jargon: the reciprocal demand elasticity may be defined as the ratio of the proportional change in the quantity of imports demanded to the proportional change in the price of exports relative to the price of imports. Using X for the quantity of exports, M for the quantity of imports, Px for the price of exports and Pm for the price of imports and e for the elasticity of reciprocal demand, we may put:

By using this formula with the given quantity of imports and exports of a country, the reciprocal demand elasticity can be measured. Thus, if h = 1, the gain will be equally distributed between the two trading nations.

If e > 1, terms of trade are favourable to the country concerned and the share of gain ii relatively larger.

If e < 1, terms of trade are unfavourable to it and the share of gain is relatively less.

To sum up, Mill has presented a theory of terms of trade called the theory of reciprocal demand. Its broad features are:

1. Terms of trade determine each trading country’s share in the gain accruing from trade.

2. The limits in which the terms of trade would fall are set by the respective domestic cost ratios which are determined by the comparative productivity of each country.

3. The actual exchange ratio – the terms of trade that will be set within these limits, depends on the conditions of reciprocal demand for goods in two countries.

4. The terms of trade will be stable as long as the balance of trade of each country will be in equilibrium.