David Ricardo 2

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David RicardoDavid Ricardo1772-18231772-1823

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Biographical DetailsBiographical Details► Ricardo was the third son of a Dutch Jew Ricardo was the third son of a Dutch Jew

who had made a fortune on the London who had made a fortune on the London Stock Exchange. Stock Exchange.

► Entered his father's business at age 14. Entered his father's business at age 14. ► By age 21 he had broken with his father By age 21 he had broken with his father

over religion, become a Unitarian, and over religion, become a Unitarian, and married a Quaker. married a Quaker.

► Continued as a member of the stock Continued as a member of the stock exchange. His acumen won him support of exchange. His acumen won him support of an eminent banking house. an eminent banking house.

► Acquired a fortune in a few years.Acquired a fortune in a few years.► Used it to indulge his tastes in literature and Used it to indulge his tastes in literature and

science, specially in mathematics, science, specially in mathematics, chemistry, and geology.chemistry, and geology.

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Arrival as an EconomistArrival as an Economist

► Interest in economic issues started in Interest in economic issues started in 17991799 upon upon reading Adam Smith's reading Adam Smith's Wealth of Nations. Wealth of Nations.

► Studies economics for 10 years with increasing Studies economics for 10 years with increasing interest. interest.

► First published work was in 1810:First published work was in 1810: The High Price of The High Price of Bullion, a Proof of the Depreciation of Bank Notes Bullion, a Proof of the Depreciation of Bank Notes 1810.1810.

► It stemmed from Ricardo’s letters in the It stemmed from Ricardo’s letters in the Morning Morning Chronicle Chronicle the previous year. the previous year.

► He reconfirmed Hume and Smith in the Quantity He reconfirmed Hume and Smith in the Quantity Theory of Money.Theory of Money.

► Provided fresh stimulus to a controversy over a specific Provided fresh stimulus to a controversy over a specific policy of the Bank of England with regard to the supply policy of the Bank of England with regard to the supply of money: The Currency Question.of money: The Currency Question.

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The Currency Question 1The Currency Question 1

► The wars with France had cause a very large The wars with France had cause a very large outflow of gold.outflow of gold.

► The government prohibits Bank of England The government prohibits Bank of England (BoE) from paying for its notes in gold under (BoE) from paying for its notes in gold under the Bank Restriction Act of 1797. the Bank Restriction Act of 1797. Thus it did not have to issue notes against its Thus it did not have to issue notes against its

holdings of gold.holdings of gold.►Without this ‘anchor’, it substantially Without this ‘anchor’, it substantially

increased the notes issued and the amount increased the notes issued and the amount of lending.of lending.

► By 1813, the price of gold had increased to By 1813, the price of gold had increased to ₤5.10 from ₤3.17 in 1799.₤5.10 from ₤3.17 in 1799.

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►Directors of BoE did not acknowledge Directors of BoE did not acknowledge any link between increase in credit, any link between increase in credit, the increase in gold prices and the the increase in gold prices and the deprecation of the sterling.deprecation of the sterling.

►Ricardo argued the reverse: Ricardo argued the reverse: Increase in bank notes caused the price Increase in bank notes caused the price

level to increase. level to increase. This in turn depreciated the exchange This in turn depreciated the exchange

rate, andrate, and Led to an outflow of gold. Led to an outflow of gold.

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►Thus, the de-linking from the gold Thus, the de-linking from the gold standard because of gold outflows was standard because of gold outflows was worsening the problem: worsening the problem: leading to leading to more of the samemore of the same..

►Ricardo argued BoE’s lending policy Ricardo argued BoE’s lending policy must be consistent with general must be consistent with general economic conditions.economic conditions.

► It must manage the volume of money It must manage the volume of money and credit. and credit.

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►The Currency Question was pivotal in The Currency Question was pivotal in the development of the theory of central the development of the theory of central banking. banking.

►The Bullion Committee, appointed by The Bullion Committee, appointed by the House of Commons, agreed with the House of Commons, agreed with Ricardo.Ricardo.

► It recommended the repeal of the Bank It recommended the repeal of the Bank Restriction Act…repealed in 1819.Restriction Act…repealed in 1819.

►The debate sealed Ricardo’s position of The debate sealed Ricardo’s position of pre-eminence as an Economist.pre-eminence as an Economist.

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Company of Good FriendsCompany of Good Friends

►Ricardo had the company of influential Ricardo had the company of influential people whose views went of to shape people whose views went of to shape his thoughts:his thoughts: James MillJames Mill, father of John Stuart Mill, and a , father of John Stuart Mill, and a

friend of his own father, a leading friend of his own father, a leading philosopher and economist, became his philosopher and economist, became his political and editorial adviser.political and editorial adviser.

Jeremy BenthamJeremy Bentham, the Utilitarian , the Utilitarian philosopher. philosopher.

Thomas MalthusThomas Malthus, whose theory of , whose theory of population was accepted by Ricardo.population was accepted by Ricardo.

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Corn Laws ControversyCorn Laws Controversy

► In 1815 a controversy arose over the Corn In 1815 a controversy arose over the Corn Laws. Laws. Falling wheat prices had led Parliament, under Lord Falling wheat prices had led Parliament, under Lord

Liverpool, to raise the tariff on imported wheat. Liverpool, to raise the tariff on imported wheat. A popular outcry ensued. A popular outcry ensued.

► In response, Ricardo published his In response, Ricardo published his Essay on Essay on the Influence of a Low Price of Corn on the the Influence of a Low Price of Corn on the Profits of Stock Profits of Stock (1815).(1815). He argued that raising the tariff on grain imports He argued that raising the tariff on grain imports

increased the rents of landowners and decreased increased the rents of landowners and decreased the profits of manufacturers.the profits of manufacturers.

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Coup de GraceCoup de Grace

In addition to:In addition to:► Essay on the Influence of a Low Price of Essay on the Influence of a Low Price of

Corn on the Profits of Stock Corn on the Profits of Stock (1815)(1815)

► The High Price of Bullion, a Proof of the The High Price of Bullion, a Proof of the Depreciation of Bank Notes Depreciation of Bank Notes (1810) (1810)

► the publication of his magnum opus, the publication of his magnum opus, Principles of Political Economy and Taxation Principles of Political Economy and Taxation (1817), shook the intellectual world and (1817), shook the intellectual world and dominated the next fifty years. dominated the next fifty years.

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Principles of Political Economy Principles of Political Economy and Taxation and Taxation 11► In this book, he:In this book, he:

Examined the principles by which the social product Examined the principles by which the social product was distributed among the "three classes of the was distributed among the "three classes of the community:” the landlords, the workers, and the community:” the landlords, the workers, and the capital owners. capital owners.

He explained that the relative domestic values of He explained that the relative domestic values of goods are dominated by the amount of labor goods are dominated by the amount of labor required in their production, and that the required in their production, and that the component of rent is eliminated from production component of rent is eliminated from production costs. costs.

He applied his findings widely and elaborated He applied his findings widely and elaborated various other economic principles, including the various other economic principles, including the important role of diminishing returns and the important role of diminishing returns and the principle of comparative advantage. principle of comparative advantage.

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Principles of Political Economy Principles of Political Economy and Taxation and Taxation 22►Whereas Malthus fretted about Whereas Malthus fretted about glutsgluts

Ricardo assumed Ricardo assumed full-employmentfull-employment. . ►Thus, the only real economic issue to Thus, the only real economic issue to

clarify, which was the overarching clarify, which was the overarching theme of theme of Principles,Principles, was how national was how national income was distributed between the income was distributed between the three groups. three groups.

►He wrote to Malthus:He wrote to Malthus:

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Theory of RentTheory of Rent

►A summary of the Ricardian view of A summary of the Ricardian view of RentRent The increase in the price of grain, whether The increase in the price of grain, whether

due to tariffs or due to increased demand due to tariffs or due to increased demand through population growth, increase the through population growth, increase the Rent on land.Rent on land.

High prices cause high rents, not the other High prices cause high rents, not the other way round.way round.

Rent is both a differential return on Rent is both a differential return on differential fertility, and the surplus over differential fertility, and the surplus over labor and normal capital costs.labor and normal capital costs.

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Definition of RentDefinition of Rent

►To Ricardo, rent was “To Ricardo, rent was “that portion of that portion of the produce of the earth, which is paid the produce of the earth, which is paid to the landlord for the use of the to the landlord for the use of the original and indestructible powers of original and indestructible powers of the soilthe soil”.”.

►Alfred Marshall later expanded this Alfred Marshall later expanded this definition to “definition to “the income derived from the income derived from the ownership of land and other free the ownership of land and other free gifts of naturegifts of nature.” .”

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Differential Rent 1Differential Rent 1

► Ricardo’s ideas on rent developed in the context of Ricardo’s ideas on rent developed in the context of the Corn Laws. the Corn Laws.

► The consequent high price of corn provided the The consequent high price of corn provided the incentive of increased cultivation of corn. incentive of increased cultivation of corn.

► As the most fertile lands were being used up, in As the most fertile lands were being used up, in many places, corn cultivation was moving to land many places, corn cultivation was moving to land higher up on the slopes. higher up on the slopes.

► These lands were less fertile in that their ability to These lands were less fertile in that their ability to retain water was limited. retain water was limited.

► These new, least fertile, lands were brought under These new, least fertile, lands were brought under cultivation as long as the addition to the value of cultivation as long as the addition to the value of output would cover the costs of cultivation on the output would cover the costs of cultivation on the least fertile acreage cultivated. least fertile acreage cultivated.

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Differential Rent 2Differential Rent 2► On the intra-marginal land, that of higher fertility, the On the intra-marginal land, that of higher fertility, the

cost of cultivation per unit of output would be cost of cultivation per unit of output would be belowbelow that price. that price.

► This difference between cost and price accrued to the This difference between cost and price accrued to the owners of land, who benefited in this way from the owners of land, who benefited in this way from the fertility of the soil, a "free gift of nature."fertility of the soil, a "free gift of nature."

► The least fertile, newest sown, marginal land, what The least fertile, newest sown, marginal land, what Ricardo called the “extensive margin” of cultivation, Ricardo called the “extensive margin” of cultivation, received no rent; the rent was zero. received no rent; the rent was zero.

► It was, thus, the differences in fertility that brought It was, thus, the differences in fertility that brought about the surplus for landowners the return to them. about the surplus for landowners the return to them.

► Hence, it was called differential rent.Hence, it was called differential rent.► According to Ricardo, land begins to earn rent when According to Ricardo, land begins to earn rent when

less fertile land is brought under cultivation. less fertile land is brought under cultivation. ► Ricardo used the Law of Diminishing Returns in the Ricardo used the Law of Diminishing Returns in the

most effectively to his analysis of the determination of most effectively to his analysis of the determination of rent. rent.

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►As Ricardo put it:As Ricardo put it:

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► Competition would force farmers to pay Competition would force farmers to pay landowners this Rent.landowners this Rent.

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Scarcity Rent 1Scarcity Rent 1► If all land is of the If all land is of the samesame fertility, would fertility, would

there be any rent, or would it there be any rent, or would it necessarily be zero?necessarily be zero?

►Ricardo answered that Rent will be Ricardo answered that Rent will be positive even if the fertility is uniform positive even if the fertility is uniform if land is scarce. if land is scarce.

►He observed that rent emerged also as He observed that rent emerged also as cultivation was pushed to the cultivation was pushed to the "intensive margin" through more "intensive margin" through more intensiveintensive use of land. use of land.

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Scarcity Rent 2Scarcity Rent 2► The intensive margin would exist even if all land The intensive margin would exist even if all land

were of equal fertility, were of equal fertility, ifif land were in scarce land were in scarce supply.supply.

► This is This is scarcityscarcity rent, as against rent, as against differentialdifferential rent. rent.

► If the additional cost of cultivation were less than If the additional cost of cultivation were less than the addition to the value of output, more labor and the addition to the value of output, more labor and capital would be applied to any given piece of capital would be applied to any given piece of land.land.

► This would happen until net value of the output of This would happen until net value of the output of the last unit of labor and capital hired had fallen to the last unit of labor and capital hired had fallen to the level of its incremental cost. the level of its incremental cost.

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Scarcity Rent 3Scarcity Rent 3

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Rent: Further DevelopmentsRent: Further Developments► Since return to any factor of production can be similarly Since return to any factor of production can be similarly

determined, why should the return to land be separately determined, why should the return to land be separately considered? considered?

► Unlike other factors of production, the supply of land is Unlike other factors of production, the supply of land is fixed; a higher price will not call forth more land. fixed; a higher price will not call forth more land.

► In essence, its supply price is In essence, its supply price is zerozero. . ► However, the supply of labor or capital is responsive to However, the supply of labor or capital is responsive to

the factor price. the factor price. ► Hence, rent was redefined as the Hence, rent was redefined as the return to any factor of return to any factor of

production above its supply priceproduction above its supply price.. The entire return to land is rent since its supply price is The entire return to land is rent since its supply price is

zero.zero. Rent may be a component of return to any other factor; if Rent may be a component of return to any other factor; if

the return exceeds the opportunity cost of the factor. the return exceeds the opportunity cost of the factor. For instance, a singer may earn much less in employment For instance, a singer may earn much less in employment

outside the opera; i.e., her opportunity cost is much less outside the opera; i.e., her opportunity cost is much less than her earning. The portion above the alternative than her earning. The portion above the alternative earning possibility constitutes rent.earning possibility constitutes rent.

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Theory of Value 1Theory of Value 1► Stressed the importance of relative, not Stressed the importance of relative, not

absolute prices or nominal price.absolute prices or nominal price. Nominal price is dependent on Money in Nominal price is dependent on Money in

circulation, as per the discussion on the Currency circulation, as per the discussion on the Currency question.question.

► For most goods, exchange value (relative For most goods, exchange value (relative price) came from:price) came from: Scarcity; and amount of labor used in its Scarcity; and amount of labor used in its

production.production. Dependent on objective cost factors, not Dependent on objective cost factors, not

subjective factors such as tastes and preferences.subjective factors such as tastes and preferences.

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Theory of Value 2Theory of Value 2

► For For non-reproduciblenon-reproducible goods, exchange value was goods, exchange value was determined determined onlyonly by scarcity. by scarcity. These goods are in fixed supply. [Quote, p.118]These goods are in fixed supply. [Quote, p.118]

► Labor Theory of ValueLabor Theory of Value Did take into account the use of capital.Did take into account the use of capital. But since capital is a But since capital is a producedproduced good, the exchange value of good, the exchange value of

the good depended on the labor time used in the production the good depended on the labor time used in the production of capital that is used.of capital that is used.

► It follows that because land is not a produced good, It follows that because land is not a produced good, use of land adds no labor time to the exchange value use of land adds no labor time to the exchange value of the good. Hence, of the good. Hence, land rent is not a component of land rent is not a component of production cost.production cost.

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Theory of Value 3Theory of Value 3

► Labor Theory of Value not accurate if:Labor Theory of Value not accurate if: Differing Capital-Labor ratios are used in Differing Capital-Labor ratios are used in

Industries. This would lead to wrong assessment Industries. This would lead to wrong assessment of true value if one looked at labor time as the of true value if one looked at labor time as the method to value. He argued that this was not an method to value. He argued that this was not an empiricallyempirically significant issue since the amount of significant issue since the amount of capital used was small relative to that of labor capital used was small relative to that of labor used.used.

Workers have different skills. Then simply adding Workers have different skills. Then simply adding labor time does not work. Adjustment for labor labor time does not work. Adjustment for labor quality would be needed.quality would be needed.

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Theory of Value 4: WagesTheory of Value 4: Wages

►Wages do not affect the exchange value Wages do not affect the exchange value (relative prices), only the amount of labor (relative prices), only the amount of labor used does. Assumes that:used does. Assumes that: Labor market is competitive; then,Labor market is competitive; then,

►Relative price Px/Py = WLx/WLy = Ly/Lx Relative price Px/Py = WLx/WLy = Ly/Lx No differences in K/L ratio.No differences in K/L ratio. Labor is of uniform quality; homogeneous.Labor is of uniform quality; homogeneous.

►When the wage changes, the profit changes, When the wage changes, the profit changes, but not the relative price of the good. but not the relative price of the good. Since price is given by (international) Since price is given by (international)

competition, higher wage implies lower profit. competition, higher wage implies lower profit. But relative price does not change (see above)But relative price does not change (see above)

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Theory of Value 5: ProfitTheory of Value 5: Profit

►Ricardo had a pessimistic view of Ricardo had a pessimistic view of profit:profit: Wage and Profit are inversely related Wage and Profit are inversely related Profit rate is guided by the profit on Profit rate is guided by the profit on

marginal land.marginal land. Eventually, profit rate would decline to Eventually, profit rate would decline to

zero.zero.

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►Wage and Profit are inversely related Wage and Profit are inversely related Goods price set by international Goods price set by international

competitioncompetition If wage rises and profit does not change, If wage rises and profit does not change,

domestic price of good increasesdomestic price of good increases BOP deficit ensues, gold outflow occurs, BOP deficit ensues, gold outflow occurs,

money supply and, therefore, prices fall to money supply and, therefore, prices fall to original leveloriginal level

So profit must have fallenSo profit must have fallen

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►Profit rate is guided by the profit on Profit rate is guided by the profit on marginal land.marginal land. On such land, revenue only covers labor cost On such land, revenue only covers labor cost

and ‘normal profit’ and there is no rent.and ‘normal profit’ and there is no rent. If profit of industry increases above normal, If profit of industry increases above normal,

capital moves from marginal land to industrycapital moves from marginal land to industry Agriculture output falls, industrial output risesAgriculture output falls, industrial output rises Process of reallocation continues until, in the Process of reallocation continues until, in the

new equilibrium, the profit on marginal land new equilibrium, the profit on marginal land is again equal to the profit in industryis again equal to the profit in industry

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Theory of Value 8: ProfitTheory of Value 8: Profit► Eventually, Diminishing Returns will cause Eventually, Diminishing Returns will cause

the profit rate to decline to zero.the profit rate to decline to zero.

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►Diminishing Returns causes profit to decline to Diminishing Returns causes profit to decline to zero.zero. Capital accumulation occurs and arable land is used Capital accumulation occurs and arable land is used

up. K/L increases from A up. K/L increases from A B B C. C. Population expands, the demand for food increases, Population expands, the demand for food increases,

causing an increase in food prices. This causes causing an increase in food prices. This causes increase in land use and Rent increases: R increase in land use and Rent increases: R R’.R’.

The rising price of food in turn this increases the The rising price of food in turn this increases the Wage: W Wage: W W’. W’.

Because of diminishing returns, the additions to Because of diminishing returns, the additions to output become smaller. These additions are output become smaller. These additions are swallowed by the rising Wages and Rent, so the swallowed by the rising Wages and Rent, so the Profit gets squeezed.Profit gets squeezed.

Ultimately, the profit falls to zero. Ultimately, the profit falls to zero.

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Policy Implications: WagePolicy Implications: Wage

►He did not recommend a Wage policy. In later He did not recommend a Wage policy. In later writings he argued against the Poor Laws. writings he argued against the Poor Laws.

► Argued that increasing the Wage would Argued that increasing the Wage would reduce employable workers and Profit. reduce employable workers and Profit.

► This would make both the rich and the poor This would make both the rich and the poor worse off.worse off.

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Policy Implications: TaxPolicy Implications: Tax

►Taxes on Rent were not shiftable. Taxes on Rent were not shiftable. [Harks back to the Physiocrats…they [Harks back to the Physiocrats…they argued that final burden of tax was on argued that final burden of tax was on landlords]. Why?landlords]. Why?

►Productivity differentials on land were Productivity differentials on land were constant.constant.

►Since rent was a residual, the tax would Since rent was a residual, the tax would not raise the price of corn.not raise the price of corn.

►Marginal land would have zero rent, so Marginal land would have zero rent, so would pay zero tax.would pay zero tax.

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Policy Implications: Corn Policy Implications: Corn LawsLaws► Elimination of Corn Laws would reduce Elimination of Corn Laws would reduce

domestic corn production and, therefore, the domestic corn production and, therefore, the demand for land.demand for land.

► As corn price fell, so would rent fall.As corn price fell, so would rent fall.► Capital would shift to manufactures as corn Capital would shift to manufactures as corn

price fell.price fell.►Wage would be governed by the Iron Law of Wage would be governed by the Iron Law of

Wages…fall in food price Wages…fall in food price fall in nominal fall in nominal Wage.Wage.

► Profit would thus increase.Profit would thus increase.

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Law of Comparative Law of Comparative Advantage 1Advantage 1► Labor/Output Labor/Output ► Labor = 1000Labor = 1000

► Absolute Advantage: US has absolute Absolute Advantage: US has absolute advantage; its labor productivity is higher in advantage; its labor productivity is higher in both goodsboth goods

► Comparative Advantage: Japan has Comparative Advantage: Japan has comparative advantage in TV. Its comparative advantage in TV. Its opportunity cost in terms of corn is ¼ that opportunity cost in terms of corn is ¼ that in the US. in the US.

► Free trade price bounded between ¼ and 1.Free trade price bounded between ¼ and 1.

TVTV CornCorn

USUS 2020 2020

JapanJapan 2525 100100

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Law of Comparative Law of Comparative Advantage 2Advantage 2► Labor Theory of Value Labor Theory of Value

technology technology opportunity opportunity cost cost C.A. C.A.

► Specialization in production; Specialization in production; allocative efficiencyallocative efficiency

► Increase in world productionIncrease in world production► Partners share gains from Partners share gains from

trade; mutual benefittrade; mutual benefit► CA sets pattern of tradeCA sets pattern of trade

5050

5050

CornCorn

TVTV► USUS

ProductionProduction

ConsumptiConsumptionon

4040

1010

CornCorn

TVTV► JapaJapa

nn

ProductionProduction

ConsumptiConsumptionon

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Law of Comparative Law of Comparative Advantage 3Advantage 3

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Unemployment 1Unemployment 1► Strong belief in full employment…later Strong belief in full employment…later

embodied in Say’s Law: embodied in Say’s Law: ► ““Supply creates its own demand.”Supply creates its own demand.”► Combined income of factors equals Combined income of factors equals

combined value of output.combined value of output.►Now, do people have the will to spend?Now, do people have the will to spend?► If some do not, there is saving.If some do not, there is saving.► But this saving is ‘consumed’ by borrowers But this saving is ‘consumed’ by borrowers

who buy capital goods.who buy capital goods.► So the So the product mix C+Iproduct mix C+I will vary but always will vary but always

will equal C+S.will equal C+S.

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Unemployment 2Unemployment 2

►There There couldcould be excess production (glut) be excess production (glut) of individual goods.of individual goods.

► If so, their price will decline, so will profit.If so, their price will decline, so will profit.►Capital will shift to Capital will shift to otherother uses, where uses, where

there is greater demand.there is greater demand.►But there would not be a general glut or But there would not be a general glut or

general unemployment.general unemployment.►Though, there could be Though, there could be technologicaltechnological

unemployment.unemployment.

Documents

David Ricardo 2