Mills theory of reciprocal demand

Explanation of Mill's Theory in simple manner for UG and PG students

1. Why this theory 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 made Ricardo’s theory of comparative cost determinate by stating the conditions for equilibrium terms of trade. Mill provides answer to this question that where, between the limits, international trade will actually take place.

2. Mill’s Theory of Reciprocal Demand: The Ricardian failure to determine the exact rate of international exchange between the two countries was on account of an excessive emphasis upon the supply aspect and a complete neglect of demand aspect. It was J.S. Mill, who attempted to remove this lacuna in the Ricardian comparative costs theory.

3. Continue .... According to him, the actual ratio at which commodities are transacted between two countries depends crucially upon the strength and elasticity of each country’s demand for the product of the other or the reciprocal demand. By reciprocal demand, Mill meant the quantities of exports that a country would offer at different terms of trade, in return of varying quantities of imports. In other words, reciprocal demand refers to the intensity of demand for the product of one country in the other country.

4. Assumptions The trade takes place between two countries, A and B. trade is in two commodities, X and Y. In both the countries, the production is governed by constant return to scale. The trade between two countries is governed by the principle of comparative costs.

5. Continue ..... The pattern of demand is similar in two countries. There are perfectly competitive conditions in the market. There is no restriction on trade and government follows a policy of laissez faire. There is full employment of resources in both the countries.

6. Continue ....... There is an absence of transport costs. The exports of each country are sufficient to pay for its imports. Mill has considered that amount of labour is fixed and different units of goods are produced with this fixed amount of labour. Trade is based on comparative advantage between both countries.

7. Output produced with fixed labour units Mill’s theory of reciprocal demand can be explained on the basis of Table- Country Units of Linen Units of Cloth England 10 10 Germany 6 8

8. Specialisation On the basis of comparative advantage England Specialise in Linen Export of Linen Import of Cloth Germany Specialise in Cloth Export of Cloth Import of Linen

9. Domestic TOT England’s Domestic terms of trade 1L=1C and Germany’s Domestic terms of trade 3L= 4C or 1.5L=2C or O.75L=1C

10. Gains from trade On the basis of Domestic TOT England has to sacrifice 1L for producing 1C If England has to sacrifice less than 1L by importing 1C then international trade will be in favour of England. Germany can produce only 0.75L by sacrificing 1C If Germany gets more than 0.75L by exporting 1C then international trade will be in favour of Germany.

11. Determination of TOT through OFFER CURVE

12. Diagram shows OA=Domestic TOT of Germany OB=Domestic TOT of England OE=England’s offer curve OG=Germany’s offer curve AOB area=Area between lines OA & OB(dotted area)=International trading Area OR=International TOT line Shaded area =No trade Zone

13. Criticisms to Mill’s Theory of Reciprocal Demand: (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.

14. Continue ..... (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.

15. Conclusion ..... The theoretical structure of J.S. Mill’s theory of reciprocal demand rests upon the foundation of Ricardian principle of comparative costs. Consequently, the theoretical assumptions in Mill’s theory are almost the same as in the Ricardian theory. That makes Mill’s theory of reciprocal demand susceptible to similar weaknesses as are found in the Ricardian analysis. 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.