David Ricardo

1
David Ricardo

• Articulated and rigorously formulated Classical
  economics
• Personal friend of Malthus, although they
  disagreed about much of economics
• He did incorporate some of Malthus ideas
• Elected to Parliament in 1819
• Friend of John Stuart Mill

2
Ricardos methodology

• Adam Smith relied on deductive analysis and
  descriptive narratives
• Ricardo also relied on deductive reasoning, but
  more interested in analysis rather than
  description
• Interested in theory as a basis of policy

3
Framework of Analysis

• What are the questions that David Ricardo is
  asking?
• What determines the distribution of income
  between workers, landlords and capitalists?
• What determines wages, rent and profit? More
  specifically, what determines changes in relative
  factor prices over time?
• Or, what determines changes in the distribution
  of income over time?

4
Essence of Ricardos Model

• Per capita wages remain at subsistence level in
  the long run because of wages fund doctrine
• Landlords contribute nothing to the economy
  they receive rent simply by holding land, which
  was fixed in supply.  They only consume, not save
• The profits of capitalists are the only source of
  investment (capital accumulation)
• Over time, the distribution of income will favor
  landlords, in part because of the ideas of Smith
  in regard to the declining rate of profit

5
Framework of Analysis

• What are Ricardos assumptions?
• Labor cost theory changes in relative prices
  over time are explained by changes in labor cost
  measured in hours
• Neutral Money Changes in the money supply do
  not cause changes in relative prices

6
Framework of Analysis

• What are Ricardos assumptions?
• Fixed coefficients of production fixed
  capital/labor ratio for each production process,
  does not change as level of output changes
• Constant returns to scale in manufacturing
  horizontal supply curve, MC is constant

7
Framework of Analysis

• What are Ricardos assumptions?
• Diminishing returns to scale in agriculture
  upward sloping supply curve, MC increases
• Full employment flexible wages ensure full
  employment of labor via market forces

8
Framework of Analysis

• What are Ricardos assumptions?
• Perfect competition
• Rational economic actors
• Malthusian population thesis
• Wages fund doctrine wage is equal to wages
  fund/labor force

9
Framework of Analysis

• What is the economic/ political/cultural/social
  environment of Ricardo?
• Rising grain prices, rising rent
• Growth of industrialization, decline of
  agriculture
• Landlords wanted restricted trade, capitalists
  wanted free trade

10
Framework of Analysis

• What is the role of the market?
• Ricardo advocated free markets, free
  international trade, free movement of labor

11
Framework of analysis

• What is the role of government?
• Limited role for government provide basic
  infrastructure to aid in functioning of markets
• Judicial system, roads, national defense

12
Ricardos Theory of Rent

• Rent exists because of
• Diminishing returns in agriculture diminishing
  returns begin immediately
• Scarcity (fixed amount) of fertile land (like
  Malthus)

13
Ricardos Theory of Rent from the Product Side

• As more labor and capital are applied to a fixed
  amount of land, the marginal product decreases. 
  This makes if profitable to bring  less
  productive land into production
• But because a bushel of corn from less productive
  land sells for the same price as a bushel from
  highly productive land, tenant farmers are
  willing to pay more to rent the highly productive
  land.
• Result the landowners, not the tenant farmers,
  are the ones who gain from productive land.

14
Ricardos Theory of Rent from the Cost Side

• As more labor and capital are applied to a piece
  of land, the marginal cost of production
  increases
• Equilibrium condition Price marginal cost of
  the last unit produced by the least efficient
  (highest cost) producer

15
Ricardos Theory of Rent Conclusions

• Rent is a payment to the landlord that equalizes
  the rate of profits (profits earned by tenant
  farmers) on land of differing fertilities
• Rent is price-determined, not price-determining
• The high price of corn is not determined by high
  rents
• Rather, high rents are determined by high price
  of corn BECAUSE
• As the price of corn increases, more less fertile
  land is brought into production

16
Ricardos Theory of Value

• What do we mean by theory of value?
• We are talking about what determines prices. (or,
  for Ricardo, relative prices)
• To understand Ricardos value theory, first look
  at what Smith had to say

17
Smiths Value Theory

• According to Smith, in an undeveloped economy,
  the exchange value (price) of a product depends
  upon the quantity of labor embodied in each
  Labor Theory of Value
• How do we measure the quantity of labor?
• When Smith tried to answer this question, he
  ended up with wages as a measure of quantity.
• In a more advanced society, the value (price) of
  a product is determined by the cost of production
  Wages profit rent (Profit includes
  interest).  In the long run, with competition,
  price cost.  How does this compare with the
  model of perfect competition that you studied in
  principles of microeconomics?
• This is the cost of production theory that your
  textbook refers to on pages 126-127.

18
Ricardos Theory of Value

• Ricardo did not like the cost of production
  theory of value because it was used to argue FOR
  the Corn Laws
• Ricardo believed that tariffs would reduce
  profits and reduce growth in the economy

19
Ricardos Theory of Value

• Remember that Ricardo was interested in changes
  in income distribution over time
• So, with respect to value theory, he was
  interested in changes in relative prices over time

20
Ricardos Labor Theory of Value

• The value of a commodity, or the quantity of any
  other commodity for which it will exchange,
  depends on the relative quantity of labor which
  is necessary for its production, and not on the
  greater or less compensation (wages) which is
  paid for that labor.

21
How does Ricardo measure the quantity of labor?

• Time necessary to produce the product
• Basically, clock hours used in production

22
How does Ricardo account for the fact that labor
skills vary?

• Labor is not homogeneous
• Wages will reflect differences in the skills of
  labor, BUT the wage differentials will remain
  constant over time (assumption)
• Therefore, changes in relative prices of goods
  will not be due to changes in wage differentials,
  but due to changes in the quantity of labor used
  to produce the product.

23
How does Ricardo account for capital goods as a
factor influencing prices?

• Capital is stored up labor since labor is
  required to product the capital good (e.g., a
  machine).  Therefore, the depreciation of capital
  is simply equal to the amount of labor that was
  used to produce that capital good.
• For example, if a machine has 10 hours of labor
  imbedded in it, and if it has a useful life of 5
  years, then each year 2 units of labor will be
  expended as machine is used up.  Therefore,
  capital is simply converted into units of labor.

24
How does Ricardo account for land as a factor
influencing prices?

• To understand this, you have to go back to
  Ricardos theory of rent.  The amount of rent is
  determined by the price of the output (e.g.,
  wheat), and at the margin no rent is received on
  land.  Rent is determined by the price of the
  product the price of the product is NOT
  determined the  amount of rent

25
How does Ricardo account for profits as a factor
influencing prices?

• Obviously, different industries have different
  rates of profit
• These differences do affect prices
• However, in the long run the rate of profit will
  equalize between industries. 
• Ricardo assumed that any profit differential in
  the short run was not important enough to
  influence relative prices. 
• AND REMEMBER that Ricardo wasnt really
  interested in short term relative price
  differences, he was concerned with changes in
  relative prices over time. 

26
Ricardos Labor Theory of Value

• Although he may, at times, have seemed to
  backpedal on his labor theory of value he did
  feel that the quantity of labor was, by far, the
  most important determinant of value (prices)

27
Ricardos Distribution Theory

• Ricardo agreed with Smith regarding falling
  profits over time, but he disagreed with Smiths
  reasoning.
• Remember that Smith believed that profits would
  fall as a result of competition in the labor
  market resulting in higher wages.  Ricardo
  pointed out that this is inconsistent with
  Smiths cost of production theory of value, since
  in Smiths theory, prices are determined by
  wages, and so if wages rise, prices rise rather
  than profits falling. 
• Ricardo argued that per capita wages would not
  rise because of the Malthusian population theory,
  that is, higher wages would result in an increase
  in the size of the labor force
• Ricardo rejected Smiths ideas of decreasing
  commodity prices and a limited number of
  investment opportunities by relying on Says
  Law.   

28
So, why do profits fall over time?

• Three classes
• landowners (who spend their rental income on
  luxuries)
• workers (who spend their wage income on
  necessities)
• capitalists (who save most of their profit income
  and reinvest it)

29
So, why do profits fall over time? (contd)

• The size of profits is determined residually by
  the extent of cultivation on land and the
  historically-given real wage
• When economy is young profits are high
• Wages will increase, and population grows

30
So, why do profits fall over time? (contd)

• When population grows, food production must
  increase
• Less fertile land is brought into production
• Rents rise, profits in agriculture fall
• Why do profits overall fall?

31
Is there anything that can forestall this
inevitable stationary state?

• Technological Progress
• International Trade
• Ricardo was against the Corn Laws because he
  thought they would hasten the stationary state
  because they gave more rents to landlords via
  higher grain prices

32
Ricardos Theory of International Trade

• Principle of Comparative Advantage
• NOT Smiths Absolute Advantage
• Based in differences in relative prices (costs of
  production) between countries
• Basis of two-way gains from trade

33
Principle of Comparative Advantage
Output of Cloth per worker per day Output of pottery per worker per day
England 50 yds 150 plates
France 30 yds 120 plates
34
Principle of Comparative Advantage (contd)

• In this case England has an absolute advantage in
  both products. 
• You can be sure that France would NOT be happy to
  find out that they should import both products
  from England. 
• Ricardo focused on opportunity cost to determine
  comparative advantage and a basis for two-way
  trade. 

35
Principle of Comparative Advantage

• In England, 50 yards of cloth has an opportunity
  cost of 150 plates, or, 1 yard of cloth costs 3
  plates. 
• In France, 30 yards of cloth has an opportunity
  cost of 120 plates, or 1 yard of cloth costs 4
  plates.
• Therefore, cloth is relatively cheaper in
  England, so England has a comparative advantage
  in cloth and should export cloth to France. 
• In England, 150 pieces of pottery costs 50 yards
  of cloth, so 1 piece of pottery costs 1/3 yard of
  cloth. 
• In France, 120 pieces of pottery costs 30 yards
  of cloth, so 1 piece of pottery costs ¼ yard of
  cloth. 
• Therefore, pottery is relatively cheaper in
  France, so France has a comparative advantage in
  pottery and should export pottery to England in
  exchange for cloth. 
• It can also be shown that both countries can gain
  from this experience.  In fact, when countries
  specialize in products in which they have a
  comparative advantage, world production increases.

36
Ricardo and full employment

• Will a capitalist economy be stable and always at
  a full employment level?
• We can look at this from the perspective of
  aggregate demand

37
Perspectives on Aggregate Demand

• Some mercantilists discussed the concept of
  insufficient aggregate demand - too much saving
  causes spending to fall, which results in lower
  production and unemployed resources.

38
Perspectives on Aggregate Demand (contd)

• Adam Smiths perspective
• Landlords spent on luxury goods and were
  parasites, workers did not have enough income to
  save and invest. 
• BUT, when capitalists saved and invested, the
  invested funds were channeled to the production
  of capital goods, so that what is annually saved
  is as regularly consumed as what is annually
  spent, and nearly in the same time too but it is
  consumed by a different set of people. 
• Therefore, there cannot be insufficient aggregate
  demand.

39
Perspectives on Aggregate Demand (contd)

• Malthus perspective
• Malthus believed that an economy could suffer
  from insufficient aggregate demand. 
• While he did accept Smiths argument for the
  short run, in the long run he believed that the
  savings-investment process could not go on
  forever. 
• Too much saving leads to more capital
  accumulation than the economy can absorb.  Saving
  leads to lower consumption but higher investment,
  which leads to the capacity to produce more
  consumer goods in the future. 
• While supply theoretically creates its own demand
  (potential demand), it may not be effective
  demand. 
• The landlords who were parasites in Smiths world
  may save the economy in Malthus world since they
  will spend their income on consumer goods.

40
Perspectives on Aggregate Demand (contd)

• Ricardos perspective
• Supply side economics. 
• Production (output) creates income sufficient to
  purchase all of the output. 
• This is a simplified version of Says Law (supply
  creates its own demand)

41
Ricardos Theory of Money

• He was a bullionist
• Believed in "commodity theory" or "metallic
  theory" of money. 
• Money is simply gold, silver and other precious
  metals.
• The price of money is just like that of any other
  commodity cost of production.
• More explicitly, he regarded the long run value
  of money to be equal to the costs of extracting
  from mines the precious metals that either
  constituted commodity money (coins) or the gold
  that underlay convertible paper money.
• Fiat money, where notes are neither a commodity
  nor convertible to it, remain outside the scope
  of his theory.
• "Gold and silver, like all other commodities, are
  valuable only in proportion to the quantity of
  labour necessary to produce them and bring them
  to market...The quantity of money that can be
  employed in a country must be depend on its
  value...Though paper money has no intrinsic
  value, yet, by limiting its quantity, its value
  in exchange is as great as an equal denomination
  of coin, or of bullion in that coin."

42
Ricardos Theory of Money (continued)

• Believed that paper money should be convertible
  into gold
• Restricts governments power to create money
• Thus reducing inflationary pressures
• But remember, money is neutral with respect to
  changes in relative prices