Ricardo factor price by MikeJenny


									David Ricardo
   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
   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
   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
   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
   What are Ricardo’s assumptions?
   Labor cost theory – changes in relative
    prices over time are explained by
    changes in labor cost measured in
   Neutral Money – Changes in the money
    supply do not cause changes in relative
Framework of Analysis
   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
   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
   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
   What is the economic/
    environment of Ricardo?
   Rising grain prices, rising rent
   Growth of industrialization, decline of
   Landlords wanted restricted trade,
    capitalists wanted “free” trade
Framework of Analysis
   What is the role of the market?
   Ricardo advocated free markets, free
    international trade, free movement of
Framework of analysis
   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
   Rent exists because of
       Diminishing returns in agriculture –
        diminishing returns begin immediately
       Scarcity (fixed amount) of fertile land (like
Ricardo’s Theory of Rent from
the Product Side
   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
   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 –

   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 price-
       The high price of corn is not determined by high
       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
   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
   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
   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
Ricardo’s Theory of Value
   Remember that Ricardo was interested
    in changes in income distribution over
   So, with respect to value theory, he was
    interested in changes in relative prices
    over time
Ricardo’s Labor Theory of
   “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?
   Time necessary to produce the product
   Basically, clock hours used in
How does Ricardo account for
the fact that labor skills vary?
   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
How does Ricardo account for capital
goods as a factor influencing prices?
   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?

   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?
   Obviously, different industries have different rates of
   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
   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
   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
   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?

   The size of profits is determined
    residually by the extent of cultivation on
    land and the historically-given real
   When economy is “young” profits are
   Wages will increase, and population
So, why do profits fall over time?

   When population grows, food
    production must increase
   Less fertile land is brought into
   Rents rise, profits in agriculture fall
   Why do profits overall fall?
Is there anything that can forestall
this inevitable stationary state?

   Technological Progress
   International Trade
       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
   Principle of Comparative Advantage
       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
          Output of Cloth   Output of pottery
          per worker per    per worker per
          day               day
England        50 yds           150 plates

France         30 yds           120 plates
Principle of Comparative
Advantage (cont’d)
   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
   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
   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
   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)
   Adam Smith’s perspective
   Landlords spent on luxury goods and were parasites,
    workers did not have enough income to save and
   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
Perspectives on Aggregate
Demand (cont’d)
   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)
   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
   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
   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      (continued)

   Believed that paper money should be
    convertible into gold
   Restricts government’s power to create
   Thus reducing inflationary pressures
   But remember, money is neutral with
    respect to changes in relative prices

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