ECON 307 - Ricardo and Mill

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 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 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.

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

The Central Problem to Ricardo was distribution theory (to wages, to capital investment, etc.) and what effects changes in distribution have on capital accumulation and economic growth.

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.”

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

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

The Market Price or S & D of labor (in the long run -- the market price and the natural price of labor were the same. In the short run, they could be different. More on this later).

Elaborating the idea of a wage-fund, Ricardo regarded this as a more or less fixed aggregate of wage goods (so it was basically a real wage), a sort of predetermined share for labor in the national income. This fund was the main determiner of the demand for labor.

So Demand for Labor determined by overall progress – capital, productivity, profits etc. The more productivity in general, the greater the national income, 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, the capitalist 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. But if too much of the revenue earned went to labor -- they would suffer in the long run from fewer jobs and lower wages. There needed to be a balance.

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

Increase in population meant an increase in the supply of labor and was bound to lead to a decrease in wages (had to split the wage fund up among more people).

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

Remember - Ricardo did not do the following graphical representation of his theories -- this is the modern interpretation.

1) Capital increases in quantity and in value (prices and profits have increased), output increases and the demand for labor increases.

The demand for labor increases -- this increases the market price of labor AND the natural price of labor (since the price of goods and services have increased and profits have increased - the value of capital has increased -- therefore, we need a higher wage for subsistence - BUT we can support a higher population (movement along the supply curve of labor), so the natural rate of employment increases.

Depends on if prices and profits increase or not. If the value of capital increases, then it will be permanent, since that feeds into the wage (natural).

On the other hand, if the amount of capital increases - but not its value, then this will not be permanent. Demand for labor will shift back down - and we will return to the lower natural price of labor.

So again, the price of labor (wage), expressed in real terms, was variable with different times and different regions - depending upon the overall productivity (value of capital) in that time and region! But the ultimate check on how far the wages would increase (profit, etc.) was the amount of land available in the region. More on this later.

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.

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,

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

Therefore an increase in prices of agriculture leads 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 Returns: He discussed diminishing returns to land.

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

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. And this lead to an incremental (marginal) decrease in output.

His diminishing returns was not clear - but it has been interpreted (at least one interpretation) as: equal successive (marginal) increments of the variable factor yield decreasing increments of the product (that is, as we add one marginal variable factor, we will get a marginal decrease in output).

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.

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.

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.

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

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

(1) Malthusian population theory (as you can see in his analysis of the stationary state).

In an expanding economy the level of investment 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, this leads to the 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."

John Stuart was educated by his father (James Mill). He was given an extremely rigorous, some would say harsh, upbringing, and was deliberately shielded from association with children his own age other than his siblings. His father, a follower of Bentham had as his explicit aim to create a genius intellect that would carry on the cause of utilitarianism. This intensive study however had injurious effects on Mill's mental health, and state of mind. At the age of 21 he suffered a nervous breakdown. Nevertheless, this depression eventually began to dissipate, as he began to find solace in the poetry of William Wordsworth.

Mill refused to study at a university. Instead he followed his father to work for the British East India Company until 1858. Between the years 1865-1868 he served as Lord Rector of the University of St. Andrews. During the same period, 1865-8, he was an independent Member of the Parliament. During that time, Mill advocated easing the burdens on Ireland, and became the first person in parliament to call for women to be given the right to vote.

In 1851, Mill married Harriet Taylor after 21 years of an intimate friendship (while she was still married). Taylor was married when they met, and their relationship was close during the years before her first husband died. Brilliant in her own right, Taylor was a significant influence on Mill's work and ideas during both friendship and marriage. His relationship with Harriet Taylor reinforced Mill's advocacy of women's rights. He cites her influence in his final revision of On Liberty, which was published shortly after her death, and she is referenced in The Subjection of Women. Taylor died in 1858, only seven years into her marriage to Mill.

Mill died in France in 1873 and is buried alongside his wife (in France).

He wrote on method, utility, individual freedom and representative government, etc.

According to Mill, in the social sciences the empirical, or inductive, method could not be relied on solely – since causes of social phenomena are often complex and interwoven and effects not easily distinguishable from one another (going from specific to general).

So deduction was a check on the errors of causal empiricism (general to specific).

Ceteris Paribus: J.S. Mill also showed the importance of the ceteris paribus clause as an instrument of deductive reasoning which enabled the student to determine separately the effects of one cause out of a number of conflicting causes.

Benthamite utilitarian philosophy was strengthened by J.S. Mill through the introduction of the concept of “economic man” – (which linked human behavior to the economy) an individual who is

“determined by the necessity of his nature to prefer a greater portion of wealth to a smaller” and is “able of judging of the comparative efficacy of means of obtaining the possession of wealth.”

A maximization principle. But he was aware of the purely hypothetical nature of his concept. How can an economist know if another has maximized? Indeed, how can the “economic man” know?

Mill’s Principles of Political Economy was his most influential work in Economics.

But the laws of distribution were a matter of changing values, mores and social philosophies and tastes…. Therefore malleable and need history as well as economics to understand them.

Capital and capital accumulation were very important as with Smith, Say, Ricardo, etc.

Given Say’s Law, employment and increased levels of employment and output are dependent on capital accumulation and investment of capital.

Unemployment of resources – except in the short run – was not possible because of Say’s Law.

Saving leads investment, so a general glut was impossible. Mill added to Say by talking about how the interest rate would guarantee that Saving = Investment and therefore Aggregate Demand = Aggregate Supply in the long run.

Therefore, as long as it was flexible S = I in the long run and there would not be a leakage to the system.

This is where Mill also discusses the theory now known as "crowding out." (from your reading)

Mill asks, "Did the government, by its loan operations, augment the rate of interest? . . . So long as the loans do no more than absorb this surplus [of capital accumulation], they prevent any tendency to a fall of the rate of interest, but they cannot occasion any rise."

If interest rates do increase: Mill says, " . . . this is positive proof that the government is a competitor for capital with the ordinary channels of productive investment . . . " Therefore, when the government borrows money from the public -- that money could have been invested by the private sector and increased productivity. This is a large opportunity cost of government borrowing according to Mill.

2. If the capital would not have been used in productive investment (opportunity cost low). Mill's way of answering this was if the interest rate was driven up or not when the government entered the loanable funds market.

Like Ricardo – the economy went from a progressive state to a stationary state. But Mill did not believe this stationary state was undesirable – once it is reached, problems of distribution could be evaluated and social reforms put in place.

“It is scarcely necessary to remark that a stationary condition of capital and population implies no stationary state of human improvement. There would be as much scope as ever for all kinds of mental culture, and moral and social progress; as much room for improving the Art of Living, and much more likelihood of its being improved, when minds ceased to be engrossed by the art of getting on” (Principles p. 751).

To Mill this stationary state in economics became kind of a “utopia” – having achieved affluence, the state could get on with solving the problems that really matter – equality of wealth and opportunity.

Supply and demand - -the first clear British contribution to static equilibrium price formation was developed by Mill. Using verbal analysis, however.

Here we get the formulation of Demand and Supply schedules showing the functional relation between Price and Quantity D and Quantity S, ceteris paribus.

“A ratio between demand and supply is only intelligible if by demand we mean quantity demanded, and if the ratio intended is that between the quantity demanded and the quantity supplied. But again, the quantity demanded is not a fixed quantity, even at the same time and place; it varies according to the value; if the thing is cheap, there is usually a demand for more of it than when it is dear.” (Principles p. 446).

“The idea of a ratio, as between demand and supply, is [therefore] out of place, and has no concern in the matter: the proper mathematical analogy is that of an equation. Demand and supply, the quantity demanded and the quantity supplied, will be made equal. If unequal at any moment, competition equalizes them, and the manner in which this is done is by an adjustment of the value. If the demand increases, the value rises; if the demand diminishes, the value falls; again, if the supply falls off, the value rises; and falls if the supply is increased” (Principles p. 448).

He was “in direct line to Alfred Marshall” who is the father of Neo-Classical analysis.

With his price adjustments that establish conditions of reciprocal equilibrium….markets adjusting to each other and all achieve equilibrium.

J.S. Mill was a zealot in the matter of social reform, but in a way that would preserve individual freedom.

“The only purpose for which power can be rightfully exercised over any member of a civilized community against his will” is to prevent harm to others.

“After the means of subsistence are assured, the next in strength of personal wants of human beings is liberty.”

There was much socialist criticism at this time and Mill often answered his critics.

Mill was very concerned with greater equality of wealth and opportunity: thus he wrote with great concern on issues such as wealth redistribution, equality of women, rights of laborers, consumerism and education.

Were I framing a code of laws according to what seems to me best in itself, without regard to existing opinions and sentiments, I should prefer to restrict…what any one should be permitted to acquire, by bequest or inheritance. Each person should have power to dispose by will of his her whole property; but not to lavish it in enriching some one individual, beyond a certain maximum, which should be fixed sufficiently high to afford the means of comfortable independence. The inequalities of property which arise from unequal industry, frugality, perseverance, talents, and to a certain extent even opportunities, are inseparable from the principles of private property, and if we accept the principle [as Mill did] we must bear with these consequences of it; but I see nothing objectionable in fixing a limit to what any one may acquire by the mere favour of others; without any exercise of his faculties, and in requiring that if he desires any further, he shall work for it (Principles, pp. 227-229).

Mill attacked wealth accumulation for its own sake – breaking from the other classical economists to a point – economic distribution is as important or more so than economic growth.

To Mill social reform was not simply the destruction of oppressive institutions –

Rather it consists in …”the joint effect of the prudence and frugality of individuals, and of a system of legislation favoring equality of fortunes, so far as is consistent with the just claim of the individual to the fruits, whether great or small, of his or her own industry” (Principles, p. 749)

So he wanted to: distinguish between income and wealth: limit the size of bequests and inheritances.

Many believe that his friend/wife contributed to his writings (she was not allowed to publish under her own name, being a woman). Most especially, Mill gave her credit for adding to The Subjection of Women:

"What marriage may be in the case of two persons of cultivated faculties, identical in opinions and purposes, between whom there exists that best kind of equality, similarity of powers and capacities with reciprocal superiority in them---so that each can enjoy the luxury of looking up to the other, and can have alternately the pleasure of leading and of being led in the path of development---I will not attempt to describe. To those who can conceive it, there is no need; to those who cannot, it would appear the dream of an enthusiast. But I maintain, with the profoundest conviction, that this, and this only, is the ideal of marriage; and that all opinions, customs, and institutions which favour any other notion of it, or turn the conceptions and aspirations connected with it into any other direction, by whatever pretences they may be coloured, are relics of primitive barbarism. The moral regeneration of mankind will only really commence, when the most fundamental of the social relations is placed under the rule of equal justice, and when human beings learn to cultivate their strongest sympathy with an equal in rights and in cultivation.

As you saw in the reading, equality was also an issue with Mill with respect to taxes. Somewhat similar to Smith, he said that taxes should be:

Equality of burden or sacrifice was important to Mill. If someone had a great ability to produce, then they could pay more taxes because the "sacrifice" would not be as high to them as to someone without the ability.

Necessary – power to tax, coin money, est. system of weights and measure, protection against force and fraud, contract enforcement, protect property rights, provide of “public goods.”

He did say that laissez-faire should be the rule – any departure from it “unless required by some great good, is a certain evil.” But his exceptions are many.