David Ricardo The First Economic Theorist

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David RicardoThe First Economic Theorist
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• ? David Ricardo (1772-1823)
• A stockbroker considered the first
  rigorous economic
• theorists
• Made major contributions building on
  Smiths ideas
• Best known for theory of land rent and
  theory of comparative
• advantage in international trade
• Frequent correspondent with Thomas
  Malthus

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• ? Ricardos Theory of Land Rent The Assumptions
• Land is divided into Farms of
  different soil qualities,
• ranging from Best Farm to Worst
  Farm
• Farms produce corn which is used to pay
  the next seasons
• workers (the wages fund) or to
  provide seed for planting
• (circulating capital) or to keep as
  rent
• Corn can be sold at national price
  (farms are price-takers)
• Capital and Labor work together in
  doses with fixed
• proportions labor receives only a
  subsistence wage capital
• earns a normal rate of profit
• On each farm there are diminishing
  returns to increased
• doses the average product (corn per
  dose) declines, so the
• marginal product is less than average
  product and declines
• even faster
• Good farms will be cultivated first,
  then poorer farms. The
• worst farm is the last to be
  cultivated

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• ? Ricardos Theory of Land Rent The Results
• Each farm will add doses until the
  marginal product of a dose
• equals the cost of a dosethe intensive
  margin
• Rent on each farm is the excess of total
  product over total
• cost of doses
• The best farm will use the most doses,
  produce the most
• corn, and receive the highest rent
• The worst farm produces just enough corn
  to pay for doses
• used it will produce the least corn and
  the landlord will
• receive no rentthe extensive margin
• Rent is not a necessary cost of
  productionit is the residual
• between output and costs rent is
  price-determined, not price
• determining
• Land is required for production, but it is
  not afactor of
• production, that is, not a required cost
  of producing

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• ? Ricardos Theory of Land Rent Policy
  Implications
• Ricardo argued for an end to the Corn
  Laws (1804-1846),
• which levied a stiff tariff on imported
  corn, because the Corn
• laws raised the price of corn,
  benefiting landlords (who would
• get increased rent) and harming
  manufacturers (who would
• have to pay higher real wages and would
  suffer a fall in
• profits).
• A confiscatory tax on rent could be
  introduced without
• affecting corn productionthe only
  effects would be on the
• distribution of incomelandlords would
  lose and the public
• would gain via increased revenues. On
  this same issue, see
• Henry George and the Fabian Society
• Note In Britain corn was a generic term for
  cereal grains. What we call corn was called maize.

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Ricardo on the Direction of Intl Trade

• ? Ricardos On International Trade Comparative
  Advantage
• Smith proposed that a country would
  produce and export
• a good if it was produced at a lower
  cost than in another
• country (Absolute Advantage)
• Ricardo argued that this could only be
  a temporary
• conditionsuppose a country could
  produce all goods at
• least cost. This would mean that the
  second country
• would export no goods, paying for
  imports with specie,
• driving prices down in the second
  country and up in the first.
• In the long run, imported goods must be
  paid for by
• exported goods, so each country must
  have something to
• export.

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? The Classic Example of Comparative Advantage
England and France both produce
corn and wine. France produces 2 cases
of wine for each bushel of corn (so the
French corn price of wine is 0.50) England
produces 1 case of wine for each bushel
of wheat (so the English corn price of
wine is 1.0). Question Which Goods
Will Each Country Export to the
other?
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Comparative Advantage and the Direction of Trade
Answer England specializes in corn and trades
with France for wine to (say) point e
France specializes in wine and trades with
England for corn to (say) point f
Eventually, world corn price of wine settles
between 0.5 and 1.0 Trade pattern
is determined by comparative advantage
Cases of Wine
E
E
F
Bushels of Corn
F
F
E
Analysis If France doesnt trade it must consume
along the line FF England will consume along
EE if it doesnt trade. Both
countries can improve their consumption
possibilities by specializing
in different products, then trading its surplus
France will specialize in wine and sell it to
England at Englands higher
priceconsuming along FF. England will
specialize in corn and sell it to
France at Frances higher price. The trade
pattern is determined by comparative advantage,
not by absolute advantage
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• ? General Gluts Ricardo vs. Malthus
• Malthus argued that an economy could
  suffer protracted
• periods of depressionperiods with
  excess capacity,
• including high unemployment
• Ricardo responded with Says Law
  Jean-Baptiste Say had
• argued that general gluts were
  impossible because goods
• trade for goods. By this he meant that
  the act of producing
• 100 worth of goods was simultaneously
  an act of creating
• 100 of income (wages and profits) to
  buy the goods.
• Thus, Supply creates its own Demand.
• Ricardo believed that what looked like a
  general glut was
• simply a transitional period when
  resources were shifting
• from declining industries to growing
  industries (buggy
• whips to auto horns).

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• ? Why Might Gluts Occur?
• One proposed source of gluts was excess
  saving Instead
• of spending the income received from
  producing goods,
• workers and capitalists could save
  (abstain from
• consuming)
• Saving (consumers abstaining from
  consumption)
• could generate offsetting demand only if
  it led to investing
• (business capital expenditures).
• In the early 19th century almost all
  saving was by
• businesses in the form of retained
  earnings that were
• intended to buy investment goods. So
  there was a strong
• link between saving and investment
• The subsequent development of financial
  institutions
• weakened the saving-investment link,
  making general gluts
• more likely

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• ? Gold Exports and Note Depreciation in the
  Napoleonic Wars
• England ran large international deficits
  to buy war goods,
• borrowing heavily to finance the wars.
  Poor wheat harvests
• compounded the deficit by raising
  imports of foodstuffs.
• The demand for foreign exchange increased
  sharply, leading
• to a price of gold, at the gold export
  point. Gold began
• flowing out of the Exchequer.
• To prevent the loss of gold, the
  Exchequer and the Bank of
• England suspended convertibility of
  notes into gold. As a
• consequence, the price of gold (in
  notes) rose to a premium
• above the mint parity stated in
  language of the day, notes
• depreciated.
• The reason for the note depreciation was
  hotly debated in
• The Bullionist Controversy, in which
  Ricardo played an
• important role.

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• ? The Bullionist Controversy
• Ricardo argued that the premium on notes
  was due to the
• suspension of convertibility the Bank of
  England had
• weakened the currency, thereby inducing
  inflation in the note
• price of gold and other goods. This
  became known as The
• Currency School.
• The Bank of England responded that it
  could not cause
• inflation because it adhered to the
  real bills doctrine,
• creating notes by discounting real
  bills (self-liquidating
• commercial notes created by trade). This
  became known as
• The Banking School.
• Who was right? Ricardo had the upper hand
  because the real
• bills doctrine was a fallacy see Adam
  Smith

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• ? Ricardos Invariable Measure of Value
• Ricardos Invariable Measure of Value was
  designed to serve
• two goals
• ? Provide a price index to compute
  real national output
• ? Determine the source of variation in
  relative prices
• Ricardo proposed using the commodity with
  average capital
• and labor per unit produced, and with
  average durability of
• capital. Its price (average cost of
  production) would be the
• average of all prices, against which both
  relative prices and
• the price level could be measured
• Ricardo arbitrarily chose gold as the
  average commodity, so
• the price of gold was his price index
• ? By dividing the value of national
  product in pounds sterling
• by the sterling price of gold the
  real value of national
• could be calculated
• ? If the price of a good is rising
  (falling) relative to gold, the
• cost of producing that good is rising
  (falling) relative to all goods

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? Ricardos View of the Dynamics of Economic
Growth As an economy grows its labor
and capital both grow As labor
increases, the demand for food (corn) rises,
the price of corn increases relative
to the price of manufactured goods
(cloth) As the price of corn rises,
less fertile land is brought into
production, and total land rent increases
The increasing price of corn relative to cloth
raises wage rates relative to the
price of cloth and the profit rate
declines In summary, as an economy
grows the share of output going to
rent increases, the profit rate on capital falls,
and the real wage rate rises