David Ricardo Articulated and rigorously formulated “Classical economics”

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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

Ricardo’s 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

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?

Essence of Ricardo’s 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

Framework of Analysis

  • What are Ricardo’s 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

Framework of Analysis

  • What are Ricardo’s 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

Framework of Analysis

  • What are Ricardo’s 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

Framework of Analysis

  • What are Ricardo’s assumptions?

  • Perfect competition

  • Rational economic actors

  • Malthusian population thesis

  • Wages fund doctrine – wage is equal to wages fund/labor force

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

Framework of Analysis

  • What is the role of the market?

  • Ricardo advocated free markets, free international trade, free movement of labor

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

Ricardo’s Theory of Rent

  • Rent exists because of

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

Ricardo’s 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.

Ricardo’s 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

Ricardo’s 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

Ricardo’s 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 Ricardo’s value theory, first look at what Smith had to say

Smith’s 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.

Ricardo’s 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

Ricardo’s 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

Ricardo’s 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.”

How does Ricardo measure the quantity of labor?

  • Time necessary to produce the product

  • Basically, clock hours used in production

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.

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.

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

  • To understand this, you have to go back to Ricardo’s 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

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 wasn’t really interested in short term relative price differences, he was concerned with changes in relative prices over time. 

Ricardo’s 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)

Ricardo’s Distribution Theory

  • Ricardo agreed with Smith regarding falling profits over time, but he disagreed with Smith’s 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 Smith’s cost of production theory of value, since in Smith’s 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 Smith’s ideas of decreasing commodity prices and a limited number of investment opportunities by relying on Say’s Law.   

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)

So, why do profits fall over time? (cont’d)

  • 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

So, why do profits fall over time? (cont’d)

  • 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?

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

Ricardo’s Theory of International Trade

  • Principle of Comparative Advantage

    • NOT Smith’s Absolute Advantage
  • Based in differences in relative prices (costs of production) between countries

  • Basis of two-way gains from trade

Principle of Comparative Advantage

Principle of Comparative Advantage (cont’d)

  • 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. 

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.

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

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.

Perspectives on Aggregate Demand (cont’d)

  • Adam Smith’s 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.

Perspectives on Aggregate Demand (cont’d)

  • Malthus’ perspective

  • Malthus believed that an economy could suffer from insufficient aggregate demand. 

  • While he did accept Smith’s 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 Smith’s world may save the economy in Malthus’ world since they will spend their income on consumer goods.

Perspectives on Aggregate Demand (cont’d)

  • Ricardo’s perspective

  • Supply side economics. 

  • Production (output) creates income sufficient to purchase all of the output. 

  • This is a simplified version of Say’s Law (supply creates its own demand)

Ricardo’s 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."

Ricardo’s Theory of Money (continued)

  • Believed that paper money should be convertible into gold

  • Restricts government’s power to create money

  • Thus reducing inflationary pressures

  • But remember, money is neutral with respect to changes in relative prices

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