The Classical School--David Ricardo

David Ricardo (1772-1823)

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LECTURE NOTES ECO 54 UDAYAN ROY

David Ricardo (1772-1823)

I will divide my discussion of Ricardo into the following topics:

• Income Distribution
• Theory of Value
• Law of Comparative Advantage
• Ricardian Equivalence
• Deductive Analysis

Ricardo’s Theory of Income Distribution

Consider Table 1 below. It shows how food output on a plot of land depends on the quality of the land—type A being the most fertile and type F being the least fertile—and the number of workers on each plot.

Functional Distribution of Income: There are three factors of production—land, labor, and capital goods (such as shovels)—and three classes of people—landlords, workers, and capitalists. Landlords earn rent, workers earn wages, and capitalists earn profits. Ricardo wanted to show how the total output of a society is distributed among wages, rent, and profits.

Fixed Proportions: Ricardo assumed that the amount of capital goods per worker is fixed. For example: one shovel per worker, as in the table. (Of course, workers have to pay for the use of the capital goods they borrow from the capitalists. This payment is called profits, as we saw in the last paragraph.)

For Ricardo’s theory to work, the population and the economy’s stock of shovels would both need to grow at the same rate in a growing economy. Unfortunately, the mechanisms that led to the growth of labor and capital goods in Ricardo’s theory are such that the two growth rates would not be equal except by coincidence.

Diminishing Returns: Following Turgot and others, Ricardo assumed that the increase in output from each additional worker would decrease as the number of workers increases.

Wages: Ricardo used the Malthusian Iron Law of Wages, which argued that the wage would in the long run equal the subsistence wage, which is the bare minimum necessary for survival. Let’s say the subsistence wage per worker is 25.

Rent as Residual: Ricardo assumed that each landlord hires labor and capital at the prevailing market-wide prices for these two resources and keeps as rent whatever output is left.

Case 1 (One Worker): Suppose there is only one worker and one shovel in the economy. We already know that the worker’s wage is 25. What is the profit earned by the shovel’s owner? Could it be 60? No, because in that case total demand would be for 3 workers and three shovels and that would exceed supply. Could it be 70? No, because in that case there would be no demand for even one worker. The only possibility is that the profit earned by each shovel is 65 (or, more precisely, just slightly more than 65). In this case, the owner of Plot A will employ the worker and the shovel. All other plots of land will remain uncultivated.

Total output would be 100. After paying wages = 25 and profit = 65, the residual rent would be 10.

Zero-Rent Land: The best available land that is not earning rent for its owner is defined as zero-rent land. As we just saw, when the number of workers is one, Plot B is the zero-rent land.

Profits: Profits can be calculated as the output producible on zero-rent land by one worker and one shovel minus the worker’s subsistence wage. Profits are the main source of capital accumulation. If the current rate of profit is higher than the minimum rate of profit that is acceptable to capitalists, more capital will be accumulated.

Extensive Margin Rent: When the rent earned by a landlord is due solely to superior fertility of the land, that rent is called rent on the extensive margin. More precisely, this rent is the excess of the output that could be produced with one worker on this landlord’s land over what one worker could produce on zero-rent land. We saw that when the number of workers is one, zero-rent land is Plot B. Therefore, extensive-margin rent on Plot A = 100 - 90 =10. Therefore, in this case, all of rent is extensive margin rent.

In this way, Ricardo ended up with the same theory of rent that James Anderson had earlier proposed.

Case 2 (Three Workers): Suppose now that there are 3 workers and 3 shovels. Using the logic used in Case 1 above, we can work out the details. Wage is 25 per worker as before. Profit per shovel would have to be 55(or, more precisely, just slightly more than 55). This will ensure that the landlords will demand exactly 3 workers and 3 shovels, as is required for equilibrium. Plot A will employ 2 workers and shovels and Plot B will employ 1 worker and shovel. Plot C will be zero-rent land.

The owner of Plot B will produce 90 and, after paying 25 as wage and 55 as profit, will collect a residual rent of 10. This is also Plot B’s rent on extensive margin.

The owner of Plot A will produce 190 and, after paying 50 as wage and 110 as profit, will collect a residual rent of 30. Of this, only 20 is rent on extensive margin. The remaining rent, 10, is called rent on the intensive margin.

Intensive Margin Rent: Rent earned from the intensive use of land is called rent on the intensive margin. Using this concept, Ricardo is able to explain that rent would be paid even when all land is of the same quality, as long as the amount of available land is not infinite. This follows from the application of Turgot’s idea of diminishing returns to shovel-equipped labor on a fixed amount of land.

Case 3 (Six Workers): Suppose now that there are 6 workers and 6 shovels. Using the logic used in Case 1 above, we can work out the details. Wage is 25 per worker as before. Profit per shovel would have to be 45(or, more precisely, just slightly more than 45). This will ensure that the landlords will demand exactly 6 workers and 6 shovels, as is required for equilibrium. Plot A will employ 3 workers and shovels, Plot B will employ 2 workers and 2 shovels, and Plot C will employ 1 worker and shovel. Plot D will be zero-rent land.

The remaining details in the table above are left as an exercise.

Ricardo’s Theory of the Functional Distribution of Income: As shown in this example, Ricardo was able to work out how a society’s total out put was distributed to the different classes.

Falling Rate of Profit: An important conclusion is that as an economy develops, only landlords benefit.

As population increases, less and less fertile land is gradually brought into cultivation. This enables landlords to collect more rent on both the extensive and intensive margins.

The workers do not gain; they continue to receive the subsistence wage.

As the zero-rent land gets worse and worse, the output producible on it with one worker and one shovel decreases. But wages remain unchanged. Therefore, less is left as profit for the owner of the shovel.

Steady State: The falling rate of profit leads to a slowdown in capital accumulation. Ultimately growth stops altogether; a steady state is reached. (Ricardo assumed that only the profit income of the capitalists is used for the accumulation of new capital goods. The landlords are parasites who blow their rent earnings on consumer goods.)

Main Issue in Economics: This is why Ricardo came to the conclusion that it was a waste of time to worry about long-run economic growth. More important was the issue of how the steady state output is distributed among the different classes. Ricardo’s belief that total output will ultimately stop growing convinced him that the main issue in economics was not to figure out how economies grow richer but to figure out how the limited output in the economy’s stationary state is distributed or shared among the various sectors of the economy. Consider the following quote:

"Political Economy, you think, is an enquiry into the nature and causes of wealth -- I think it should rather be called an enquiry into the laws which determine the division of produce of industry amongst the classes that concur in its formation. No law can be laid down respecting quantity, but a tolerably correct one can be laid down respecting proportions. Every day I am more satisfied that the former enquiry is vain and delusive, and the latter the only true object of the science."

(David Ricardo, "Letter to T. R. Malthus, October 9, 1820", in Collected Works, Vol. VIII: p.278-9).

Returning to my example, you may be wondering, how would the number of workers increase from 1 to 3 to 6, as in my example, if the wage is always at the subsistence level? Ricardo’s not-entirely-satisfactory answer is as follows: Initially, the profit rate is high, as we saw in the example. This induces an increase in saving by capitalists. This tends to temporarily raise wages above the subsistence level. (According to Ricardo, the rise in saving also leads to an increase in the wages fund, which is a fund out of which the capitalists pay wages to workers. This leads to higher wages.) This leads to population growth, which brings wages back down to the subsistence level. In this way, there is an increase in both capital and labor and the wage returns to the subsistence level. Of course, when the rate of profit falls to a very low level, both capital accumulation and population growth come to an end. (Ricardo used the wages-fund theory of wages for the short run and the Malthusian iron law of wages for the long run, just as Adam Smith had done. Neither theory is of any interest today.)

Theory of Value

The theory of value used by Ricardo was the same as Adam Smith’s theory of value in the sense that they both held that price is equal to per unit cost.

However, Ricardo was able to explain why a Labor Theory of Value (LTV) was not fully satisfactory.

For simple economic activities such as hunting and fishing, the Labor Theory of Value was fine according to Ricardo: “If among a nation of hunters, for example, it usually cost twice the labor to kill a beaver which it does to kill a deer, one beaver should naturally exchange for, or be worth two deer”. This is an illustration of the classical idea that in the long run demand has no influence on (relative) prices.

But now consider a case where production takes time. Consider a ton of wheat and a ton of rice available for sale today. Suppose both require five hours of labor to produce. However, suppose wheat takes two years to mature after cultivation whereas rice is produced instantaneously. Therefore, the rice purchased today was made today whereas the wheat purchased today was made two years ago. So whereas the rice farmer would simply have to pay for five hours of labor upon the sale of the rice, the wheat farmer would have to pay for five hours of labor plus two years’ interest to the workers whom he has kept waiting for two years. As a result, the wheat would cost more than the rice even though both wheat and rice require the same amount of labor to produce. This is another way of saying that for complex cases the Labor Theory of Value is not valid.

Ricardo was also aware that even if wheat and rice took the same amount of time to be produced, the LTV would still be in trouble if the fertility of land varied from one place to another. When fertility varied from one plot of land to another, the amount of labor needed to produce a ton of wheat (or rice) would not be fixed but would instead depend on the fertility of the land being used. As a result the LTV could not be readily applied.

Suppose a ton of rice grown on less fertile Type B land requires 4 hours of labor whereas a ton of rice grown on more fertile Type A land requires 2 hours of labor. Would we then say that the price of the first ton of rice would be twice the price of the second ton of rice? Clearly such an application of the Labor Theory of Value would make no sense because the price of a ton of rice must necessarily be the same irrespective of what type of land it was produced on.

To restore the applicability of the LTV, Ricardo assumed that there would always be some land that farmers would use without paying any rent. (How come? Suppose we have land of different types, from the most fertile land to desert-type land on which nothing can grow. Then there would always be some types of land that would remain unused. Clearly, such land would not earn its owner any rent. Now consider the worst type of land that is in use. What would be the rent on this type of land? Since land that is even the slightest bit less fertile would earn no rent, the rent on this land must also be zero or very close to zero. Therefore, it is a good enough approximation to say that the least fertile land under cultivation must earn zero rent for its owner.) The cost—and, therefore, the price—of a ton of rice on such zero-rent land would be only the wages for the labor needed to make a ton of rice on zero-rent land. Therefore, one could say if a ton of wheat grown on zero-rent land required twice as much labor as a ton of rice grown on zero-rent land, then the price of a ton of wheat would be twice the price of a ton of rice.

Thus the LTV could be applied even when the fertility of land varies from plot to plot provided it is understood that what mattered was the labor needed for production of a good on zero-rent land.

What if agriculture requires workers and shovels? No problem. Simply calculate the labor needed to make shovels, measure the labor needed to make a ton of rice on zero-rent land as the sum of farm labor plus the labor needed to make the shovels and then apply the LTV as before. (Of course, I am using ‘shovels’ as a stand-in for all capital goods.)

Law of Comparative Advantage

Let us compare Ricardo's Law of Comparative Advantage compared with the earlier Law of Absolute Advantage. If A (Advancedland) is more productive than B (Backwardland) in every productive activity, would both countries benefit from trade?

• The law of absolute advantage has no answer to this question.
• Ricardo's law of comparative advantage showed that the answer is Yes.

Let us say that A takes 1 hour to make a unit of Food and 2 hours to make a unit of Clothes. And let us say that B takes 10 hours to make a unit of Food and 10 hours to make a unit of Clothes. So, when A makes a unit of Clothes, A is giving up the chance to make 2 units of Food. In other words, the (opportunity) cost of producing one unit of Clothes is 2 units of Food for A. Similarly, the (opportunity) cost of producing one unit of Clothes is 1 unit of Food for B. Let's say that A is currently making all of its own Food and Clothes. If so, B can offer 1.5 units of Food to A in return for 1 unit of Clothes and A will gladly accept. This deal will clearly benefit both A and B even though A is advanced and B is backward.

Ricardo's disagreement with Thomas Malthus on the import tariffs embedded in the Corn Laws—Ricardo was against the tariffs, of course—was rooted in his theory of trade.

Ricardian Equivalence

An idea of Ricardo on public finance has, under the name of Ricardian Equivalence, become an important player even in contemporary debates on how governments should pay for their expenditures. This says that, under certain conditions, it does not matter whether a government pays for its expenditures through taxes or through debt.

Tax-Financed Government Spending: Suppose the government spends one dollar this year and charges Ms. Citizen a tax of one dollar. The dollar leaves Ms. Citizen’s purse, never to return.

Debt-Financed Government Spending: The government pays for its expenditures by borrowing one dollar. Ms. Citizen breathes a sigh of relief at not having to pay taxes. But she quickly realizes that next year the government will have to pay the borrowed money back with interest. As the interest rate is 10%, the government will need $1.10 next year. As it can’t keep incurring new debts to repay old debts, there will come a time when the government will have to raise taxes to repay its debts. Let’s say the government will be forced to raise taxes by $1.10 to repay the debt it incurred this year. Ms. Citizen sees the tax coming. She puts one dollar in her bank account today. That way she will have $1.10 in her account a year later, and that will be just enough to pay next year’s anticipated tax. Ms. Citizen’s initial relief at having escaped the tax this year is, therefore, replaced with the realization that even in this case a dollar has left her purse, never to return.

Equivalence: Tax-financed government spending therefore has the same effect on Ms. Citizen as debt-financed government spending. Therefore, both the government and Ms. Citizen behave the same in the two regimes and the economic outcome is identical.

Deductive Analysis

Ricardo's analytical style was deductive. In deductive analysis, one first imagines a model economy (as it is usually much simpler to think about than an actual economy) and then figures out how that model economy would behave under alternative economic policies. If the model economy is essentially similar to actual economies, policies that are effective in the model economy will also be effective in actual economies. Ricardo's analytical style is very modern in the sense that it is similar to the way an economic theorist today may think through a problem.