Theory of Reciprocal Demand
The Supply side analysis of Ricardo describes the
outer limits within which the equilibrium Terms of
Trade must fall. The domestic price ratios set the outer
limits for the equilibrium terms of trade. Mutually
beneficial trade for both nations occurs if the
equilibrium terms of trade lies between two nations’
domestic price ratios. According to the theory of
reciprocal demand, the actual price at which trade
occurs depends on the trading partners’ interacting
demands. The idea was first propagated by John
Stuart Mill.
Theory of Reciprocal Demand
Suppose, Canada is having Comp. Adv in Wheat and US in Autos.
Canada expresses an enormous demand for autos. As a result
Canada will produce and also import auto. As Canada is
willing to pay more for auto, US will realise its gain from
selling auto to Canadians at higher price and the price will be
near to the domestic price of Canada.
In terms of the figure in the next slide, in this case TOT for US will
improve or move from point A towards point C. Starting from point
A (assuming gains from trade is evenly distributed), an improving
TOT for US implies that a given quantity of auto exports buys larger
amount of wheat imports.
In an extreme case, if the auto demand of Canada could be so high
that TOT will coincide with the domestic price ratio of Canada or it
will reach point C. According to Mill, equilibrium TOT depends on
the relative strength of each nation’s demand for the other country’s
product.
Internationl equilibrium
Equilibrium Terms-of-Trade (TOT) limits
3 Canada price ratio (2:1)
2.5 Improving US terms of trade
2
C tt1 (1:1)
Wheat
Improving Canadian terms of trade
1.5
D E
1
A US price ratio (0.5:1)
0.5
B
0
0 0.5 1 1.5 2 2.5 3 3.5 4
Autos
Equilibrium Terms-of-Trade (TOT) and Offer Curve
Offer curves can be used to demonstrate the determination
of TOT between two countries.
• US offer curve indicates the amount of Autos (exports) that it
is willing to offer Canada for different amounts of
Wheat(import).
• Similarly, Canadian offer curve indicates the amount of
Wheat (exports)Canada is willing to offer the United States
for different amount of Autos(import).
These curves bring together the supply characteristics
embodies in a nation’s PPC and a demand pattern
depicted in CICs.
OFFER CURVE
Offer Curve is a helpful tool in international trade analysis. It is
defined as a collection of points denoting optimal trade (i.e
export and import) pattern of a country for each possible
international price line (Terms of Trade).
So, an offer curve tells us at a glance the different
commodity combinations a country is willing to trade at any
given terms of trade.
It also shows the total expenditure (exports in our case) of one
commodity that country is willing to make at any given
exchange ratio in order to obtain a certain quantity of other
commodity.
This curve also shows the demand for each commodity in
terms of the other commodity. Hence it can be said a
reciprocal demand curve.
Derivation of Offer Curve
Step I. The concept of Equilibrium with respect to
International Price Line (TOT)
W P1, C1 are production and
consumption point with respect to
TOT 1.
P2
P1
C2
C1
TOT 2
TOT 1
C
P2, C2 are production and consumption point with respect to
TOT 2.
Step II. Drawing Offer Curves of both the countries
Exports (imports)of W Note: Terms of trade line is
being drawn with a positive
slope. For example OA, OB, etc
E
With OA as price line Country
B
A D 1 is willing to export OW1 of W
W 1
R and import OC1 of C.
Similarly for OB also.
OD Country 1’s
Offer Curve. OE
Country 2’s Offer
O C1 Imports (exports) of C
Curve
‘R’ IS THE POINT OF INTERNATIONAL EQUILIBRIUM.
‘OB’ is the equilibrium terms of trade.
International equilibrium
Equilibrium terms of trade
United States
Wheat (Canadian export/US imports)
tt0
tt1
B
113
100 Canada
A
60
C
80 100 150
Autos (US exports/Canada imports)
Changing equilibrium terms of trade
United States tt1 Canada1
Wheat (Canadian export/US imports)
160 tt0
B
Canada0
100
A
100 120
Autos (US exports/Canada imports)
Elasticity of Offer Curve
Elasticity ()= OH/OK
Wheat (Export)
H E
O Cloth (Import)
Elasticity= - dDQ/Q)/(dP/P)
•Ignore the negative sign ( for the time being)
• Relative price is reflected as (W/C). In other
words it is the price of import (cloth) in terms
of exports (wheat)
Now, go back to the diagram
Bring back the negative sign here
Elasticity and Shape of
Offer Curve
>1 : An upward sloping Offer Curve. This implies that if import
price falls, total expenditure in terms of exports increase.
=1, A horizontal straight line offer curve. More of imports is
associated with constant level of exports. So, total expenditure in
terms of exports remain constant.
<1, Backward bending offer curve within a range. As import price
falls demand of imports rises slowly. Country is more and more
unwilling to accept an increase in the amount of imports.
Equilibrium with the help of Trade Indifference Curve (TIC)
It is a locus of different combinations of export and import each of
which renders same level of utility to the residents of the country so
that at each point on it country remains indifferent in respect of the
choice of any trade volume.
W (import)
CIC I
CIC II C
C
(import) (export)
TIC
W
(export)
TICs and Offer Curve Offer Curve
TOT lines
W
(Import)
(Export)
C
TICs
Immiserising Growth Hypothesis
By J. Bhagwati
Computers (Import)
B
D
A
tt2
tt1
Coffee(export)
