David Ricardo – The Ricardian System

  David Ricardo (1772-1823)

Life: Ricardo was the third of seventeen children.  At age 14, after a brief schooling in Holland, Ricardo joined his father at the London Stock Exchange, where he began to learn about the workings of finance. This beginning set the stage for Ricardo's later success in the stock market and real estate.

Ricardo rejected the orthodox Jewish beliefs of his family and eloped with a Quaker when he was 21, leading to estrangement from his close family. It seems likely, for example, that his mother never spoke to him again.

Ricardo became interested in economics after reading The Wealth of Nations in 1799 on a vacation.  This was Ricardo's first contact with economics. He wrote his first economics article at age 37 and within another ten years he reached the height of his fame.

Ricardo's work with the stock exchange made him quite wealthy, which allowed him to retire from business at the age of 42. He then purchased and moved to an estate in Gloucestershire in England.

In 1819 Ricardo took a seat in the British parliament.  He held the post until the year of his death in 1823. Ricardo advocated free trade while in the parliament.

Ricardo was a close friend of James Mill (father of John Stuart) who encouraged him in his political ambitions and writings about economics. There is evidence that some of the theories in Ricardo’s writings were actually those of James Mill.

Other notable friends included Bentham and Malthus with whom Ricardo had a considerable debate (in correspondence) over such things as the role of land owners in a society. He also was a member of London's intellectuals, later becoming a member of Malthus' Political Economy Club.

He died at Gatcombe Park at 51 years of age.

Most of the theories presented are from:  On the Principles of Political Economy and Taxation (1817)

Basic Principles:

Very much influenced by Adam Smith and others, his basic principles are:

Malthus population principle

The wage – fund doctrine

Classical rent theory

Diminishing marginal returns (vague)

Comparative Advantage

Free Trade

Say’s Law

Wage Theory:

The term wages are used by Smith and Ricardo to denote contractual payment for hired labor.

Basic to Ricardian Wage Theory was the distinction between the “market price” of labor and its “natural price.”

Market P of labor = S and D

Natural P of labor = subsistence wage

The natural price:  was defined as the amount which enables the workers to subsist and to perpetuate without increase or decrease. 

That price, expressed in real terms, was variable with different times and different regions.

The Market Price or S & D:

The Demand for Labor:

Wage Fund:  Elaborating the idea of a wage-fund, Ricardo regarded this as a more or less fixed aggregate of wage goods, a sort of predetermined share of labor in the national dividend, made available at the beginning of the period in which the goods were consumed.  This fund was the main determiner of the demand for labor.

So Demand for Labor determined by overall progress – capital, profit, etc.  The more productivity in general, the greater the national dividend, the more labor can be paid, the higher demand for it and the higher wages paid. 

If the wage fund eats up most of the profit, however, won’t continue to produce, demand for labor goes down.  So the more profitable capital was, the more demand for labor there was, and the higher wages were.

So D labor = f (productivity)

The Supply of Labor:

The Malthusian population theory provided the explanation for changes in the supply of labor.

Increase in population was bound to lead to a decrease in wages.

So S of labor = f (population)

The wage rates of specific categories of workers were held to be determined by supply and demand.

It remained a moot question whether expansions of the fund and ensuing wage increases would stimulate the growth of population.

It did – therefore: (the VALUE of capital held constant)

1)     If the market price (wage) exceeded the natural price (was above subsistence): (Graph)

2)     If the market price (wage) was below the natural price (was below subsistence): (Graph)

His “cases” with capital - change in the natural rate of employment:

1)     Capital increases in quantity and in value, addition of output increases and the demand for labor increases.

Here the natural price (wage) of labor will increase.  We will have an overall increase in the natural rate of employment. (Graph)

The market wage will also increase.

2)     Increase in the quantity of capital but not its value (prices and profits don’t increase).  Workers better off until again, an increase in population. (Graph)

In both cases an increase in capital causes an increase in output and the amount of labor employed.

The question:  Will the increase in wage be permanent or not?

Depends on if prices and profits increase or not.  The value of capital, since that feeds into the wage (natural).

Natural wage = subsistence = f (prices and profits - the value of capital).

If prices and profits increase, the natural wage will increase as well.

So wages increase or decrease for two reasons:

1)      supply and demand (market price of labor)

2)      price of commodities on which wages of labor are expended – changes in overall productivity (profitability) (natural price of labor)

The Theory of Rent

Referring to Smith’s observation that the supply of land, the natural factor of production, could not be increased when the prices of agricultural products were rising, Ricardo argued that:

Rent would accrue only when the price of agricultural products was in excess of their costs.

Therefore an increase in prices of agriculture lead to an increase in rent.

No rent accrued to land if the yield was produced at the highest costs just covered by the prevailing price. 

A Somewhat Fuzzy Concept of Diminishing Marginal Returns:  He discussed diminishing marginal returns to land.

Rents were determined by the differences between the values of agricultural products obtained by the employment of equal quantities of K and labor and costs of production. 

Such differential rents were bound to rise with each increase in population:

            Increase Population - Increase demand - Increase prices of agriculture - Increase rent.

This lead to the cultivation of land of poorer quality than before, or to a more intensified cultivation of land.

Land, labor and K were all homogenous factors to Ricardo. 

His diminishing returns was not clear - whether it meant:

a.    that a given ratio of increase in a variable factor is associated with a smaller ratio of increase in the total Q (that is, we increase a variable factor by 10% but only get a 5% increase in output)

b.    or equal successive increments of the variable factor yield decreasing increments of the product (that is, as we add one additional variable factor every time, we will get a decrease in output).

Perhaps he meant both.

The Ricardian System

The Central Problem to Ricardo was distribution theory and what effects changes in distribution have on capital accumulation and economic growth.

Basically Ricardo wanted to answer Malthus regarding the question of the Corn Laws (Malthus and Ricardo were friends but often disagreed).  Malthus favored the Corn Laws because he thought that free importation of grain would decrease prices (and wages) and lead to a depression.

But to Ricardo the Corn Laws signaled rise in wages (due to protection) and a fall in the profits and thus less K accumulation and an end to economic growth.

FYI:  A Corn Laws were first introduced in Britain in 1804, when the landowners, who dominated Parliament, sought to protect their profits by imposing a duty on imported corn.

The industrial classes saw the Corn Laws as an example of how Parliament passed legislation that favored large landowners. The manufacturers in particular were concerned that the Corn Laws would result in a demand for higher wages (less competition).

 

Controversy over Ricardo’s theory of Value:

Some interpret it as a strict labor theory of value.

However, others want to characterize Ricardo’s theory of value as a “real-cost” theory, where labor is the most important factor but capital is important as well.

It seems he may have used both definitions, depending upon what he was trying to explain.

To Ricardo the relation between value and labor time expended in production was straightforward:

“Every increase of the quantity of labor must augment the value of that commodity on which it is exercised as every diminuation must lower it.”

He added several qualifications to this, but sometimes side-stepped them to use a simple labor theory of value.

Exceptions mentioned by Ricardo:

(1)     Non-reproducible goods – Renoir or a bottle of wine…determined by scarcity alone!

(2)     With regard to capital he distinguished between fixed and circulating capital. 

a.     Circulating capital is “rapidly parishable and requires to be frequently reproduced” whereas

b.    Fixed capital “is of slow consumption.”

Value will increase as the ratio of fixed to circulating capital increases and as the durability of capital increases.

            Capital effects the value of goods in two ways:

(1)     Capital used up in production adds to the value

(2)     The capital employed per unit of time must be compensated (at the going rate of r).

So value was based on the real costs of labor and capital.  Ricardo held that the relative quantities of labor used in production are the major determinates of relative values.

Comparative Advantage – Free Trade

Originally suggested by Robert Torrens, British economist, The Economist Refuted (1808) and An Essay on the External Corn Trade.  But, according to Rothbard and others, it was really James Mill that fully developed the theory in "Colonies" for the Encyclopedia Britannica (1818).

In order to determine the advantages accruing from international trade, it was not appropriate to base the comparisons on absolute values.  But instead, should be based on opportunity costs (comparative values).

Rather, it was necessary to define the relationship which existed in each country between the labor costs of the various products, and to use these ratios for purposes of comparison.

The results of these comparisons could lead to the conclusion that the international exchange of certain goods was profitable even though the imported commodities could be produced domestically at less absolute costs then in the exporting country.

So here is Ricardo on this:

The example dealt with wine produced in Portugal for cloth in England.

Ricardo and Say’s Law

Remember that Say's law of markets tried to show that a "general glut" or over supply of goods would not happen in the long run if markets could clear on their own.  Prices would fall, increasing demand and/or profits would fall, decreasing supply.

The major figure on one side of the debate was our old friend, Thomas Malthus.  He argued that crises were a result of a "general glut" of goods (very Keynesian). The production of goods could outrun the ability or desire of people to purchase these goods, and it was this oversupply or under-consumption that led to an economic crisis.

On the other side of the debate were Ricardo, James and John Stuart Mill, and Say. Those ideas that are called Say's Law were developed by all of them in their attempt to show that the under-consumption thesis was wrong.

Say’s Law was dominant in Ricardo’s analysis.

An economic slump (stationary state) was not due to under-consumption, but not enough productivity.  Productivity must take place for inputs to earn income, then they can consume.   Investment and capital were key.

K and I high, Wages are high

|

Growing population

|

Pressure on food supply

|

Diminishing returns to K and L in agriculture

|

Utilize inferior plots of land

|

Costs of productivity increase, profits decrease (the natural wage must increase as the cost of production increases - therefore the % of the pie going to labor increases, profits decrease)

|

Decrease K and I as we approach stationary state.

The less desirable stationary state was viewed as the inevitable outcome of economic history.

Classical (Ricardian) economist analysis was long run – based on a few simple assumptions.  Key elements were:

(1)     Malthusian population theory

(2)     The principle of diminishing returns to agriculture

(3)     The wages-fund doctrine based on production.

In an expanding economy the level of I and wages is high and growing.  Capital accumulation is taking place.

But high wages induce population growth, and pressure on food supply – fixed land – lead to diminishing returns to capital and labor in agriculture and the necessity of utilizing inferior grades of land to feed a growing population.

Consequently, leads to costs of production increasing and profit decreasing.

Decreasing profits leads to decrease capital accumulation and investment as the stationary state is approached.

As Rothbard puts it:  "For Ricardo the key to the stifling of economic growth in any country, and especially in developed Britain, was the 'land shortage,' the contention that poorer and poorer lands were necessarily being pressed into use in Britain.  In consequence, the cost of subsistence kept increasing, and hence the prevailing (which must be the subsistence) money wage kept increasing as well.  But this inevitable secular increase of wages must lower profits in agriculture, which in turn brings down all profits.  In that way, capital accumulation is increasingly dampened, finally to disappear altogether."