Download David Ricardo

David Ricardo
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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
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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
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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
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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
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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
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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
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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
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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
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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
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What is the role of the market?
Ricardo advocated free markets, free
international trade, free movement of
labor
Framework of analysis
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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
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Rent exists because of
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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
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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
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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
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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 pricedetermining
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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
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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
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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
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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
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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
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“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?
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Time necessary to produce the product
Basically, clock hours used in production
How does Ricardo account for
the fact that labor skills vary?
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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?
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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?
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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?
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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
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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
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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?
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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)
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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)
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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?
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Technological Progress
International Trade
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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
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Principle of Comparative Advantage
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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
England
France
Output of Cloth
per worker per
day
50 yds
30 yds
Output of pottery
per worker per
day
150 plates
120 plates
Principle of Comparative
Advantage (cont’d)
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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
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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
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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
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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)
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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)
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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)
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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
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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
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(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