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David RicardoDavid Ricardo

The First Economic TheoristThe First Economic Theorist

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David Ricardo (1772-1823)

• A stockbroker considered the first rigorous economic theorists • Made major contributions building on Smith’s ideas • Best known for theory of land rent and theory of comparative advantage in international trade • Frequent correspondent with Thomas Malthus

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Ricardo’s Theory of Land Rent: The Assumptions

• Land is divided into “Farms” of different soil qualities, ranging from “Best Farm” to “Worst Farm” • Farms produce corn which is used to pay the next season’s workers (the “wages fund”) or to provide seed for planting (“circulating capital”) or to keep as rent • Corn can be sold at national price (farms are price-takers) • Capital and Labor work together in “doses” with fixed proportions; labor receives only a subsistence wage; capital earns a normal rate of profit • On each farm there are diminishing returns to increased doses; the average product (corn per dose) declines, so the marginal product is less than average product and declines even faster • Good farms will be cultivated first, then poorer farms. The worst farm is the last to be cultivated

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Ricardo’s Theory of Land Rent: The Results

• Each farm will add doses until the marginal product of a dose equals the cost of a dose—the “intensive margin” • Rent on each farm is the excess of total product over total cost of doses • The best farm will use the most doses, produce the most corn, and receive the highest rent • The worst farm produces just enough corn to pay for doses used; it will produce the least corn and the landlord will receive no rent—the “extensive margin” • Rent is not a necessary cost of production—it is the residual between output and costs; rent is price-determined, not price determining • Land is required for production, but it is not a”factor of production,” that is, not a required cost of producing

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Ricardo’s Theory of Land Rent: Policy Implications

• Ricardo argued for an end to the Corn Laws (1804-1846), which levied a stiff tariff on imported corn,* because the Corn laws raised the price of corn, benefiting landlords (who would get increased rent) and harming manufacturers (who would have to pay higher real wages and would suffer a fall in profits). • A confiscatory tax on rent could be introduced without affecting corn production—the only effects would be on the distribution of income—landlords would lose and the public would gain via increased revenues. [On this same issue, see Henry George and the Fabian Society]

*Note: In Britain corn was a generic term for cereal grains. What we call corn was called maize.

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David Ricardo's Theory of Differential Rent

Assumptions: Corn price = $10 per bushelDose cost = $900 labor + $100 profitDiminishing returns within farms (intensive margin)Diminishing returns across farms (extensive margin)

The Intensive MarginThe Best Farm The Poor Farm

Doses Total Average Marginal Average Average Marginal Total Average Marginal Average Average Marginal(K+L) Gross Revenue Gross Revenue Gross Revenue wage Profit Cost Gross Revenue Gross Revenue Gross Revenue wage Profit Cost

1 $10,000 $10,000 $10,000 $900 $100 $1,000 $5,000 $5,000 $5,000 $900 $100 $1,0002 $19,000 $9,500 $9,000 $900 $100 $1,000 $9,000 $4,500 $4,000 $900 $100 $1,0003 $27,000 $9,000 $8,000 $900 $100 $1,000 $12,000 $4,000 $3,000 $900 $100 $1,0004 $34,000 $8,500 $7,000 $900 $100 $1,000 $14,000 $3,500 $2,000 $900 $100 $1,0005 $40,000 $8,000 $6,000 $900 $100 $1,000 $15,000 $3,000 $1,000 $900 $100 $1,0006 $45,000 $7,500 $5,000 $900 $100 $1,000 $15,000 $2,500 $0 $900 $100 $1,0007 $49,000 $7,000 $4,000 $900 $100 $1,000 $14,000 $2,000 -$1,000 $900 $100 $1,0008 $52,000 $6,500 $3,000 $900 $100 $1,000 $13,000 $1,625 -$1,000 $900 $100 $1,0009 $54,000 $6,000 $2,000 $900 $100 $1,000 $12,000 $1,333 -$1,000 $900 $100 $1,000

10 $55,000 $5,500 $1,000 $900 $100 $1,000 $11,000 $1,100 -$1,000 $900 $100 $1,00011 $55,000 $5,000 $0 $900 $100 $1,000 $10,000 $909 -$1,000 $900 $100 $1,00012 $54,000 $4,500 -$1,000 $900 $100 $1,000 $9,000 $750 -$1,000 $900 $100 $1,00013 $53,000 $4,077 -$1,000 $900 $100 $1,000 $8,000 $615 -$1,000 $900 $100 $1,00014 $52,000 $3,714 -$1,000 $900 $100 $1,000 $7,000 $500 -$1,000 $900 $100 $1,00015 $51,000 $3,400 -$1,000 $900 $100 $1,000 $8,000 $533 -$1,000 $900 $100 $1,000

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Ricardo's Extensive MarginForty Farms of Different Qualities

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20

40

60

80

100

1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39

Farm

Per

cent

of T

otal

R

even

ue

Wages + Profits Rent

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Ricardo on the Direction of Int’l Trade

Ricardo’s On International Trade: Comparative Advantage

• Smith proposed that a country would produce and export a good if it was produced at a lower cost than in another country (“Absolute Advantage”) • Ricardo argued that this could only be a temporary condition—suppose a country could produce all goods at least cost. This would mean that the second country would export no goods, paying for imports with specie, driving prices down in the second country and up in the first. • In the long run, imported goods must be paid for by exported goods, so each country must have something to export.

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The Classic Example of Comparative Advantage

• England and France both produce corn and wine. France produces 2 cases of wine for each bushel of corn (so the French corn price of wine is 0.50); England produces 1 case of wine for each bushel of wheat (so the English corn price of wine is 1.0).

• Question: Which Goods Will Each Country Export to the other?

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Comparative Advantage and the Direction of Trade

Answer: England specializes in corn and trades with France for wine to (say) point e France specializes in wine and trades with England for corn to (say) point f Eventually, world corn price of wine settles between 0.5 and 1.0 Trade pattern is determined by comparative advantage

Analysis: If France doesn’t trade it must consume along the line FF’; England will consume along EE’ if it doesn’t trade. Both countries can improve their consumption possibilities by specializing in different products, then trading its surplus: France will specialize in wine and sell it to England at England’s higher price—consuming along F’F’’. England will specialize in corn and sell it to France at France’s higher price. The trade pattern is determined by comparative advantage, not by absolute advantage

Cases of Wine

Bushels of Corn

F

F’ F’’

E’’

E

E’

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General Gluts: Ricardo vs. Malthus

• Malthus argued that an economy could suffer protracted periods of depression—periods with excess capacity, including high unemployment • Ricardo responded with Say;’s Law: Jean-Baptiste Say had argued that general gluts were impossible because “goods trade for goods.” By this he meant that the act of producing $100 worth of goods was simultaneously an act of creating $100 of income (wages and profits) to buy the goods. Thus, “Supply creates its own Demand.” • Ricardo believed that what looked like a general glut was simply a transitional period when resources were shifting from declining industries to growing industries (buggy whips to auto horns).

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Why Might Gluts Occur?

• One proposed source of gluts was excess saving: Instead of spending the income received from producing goods, workers and capitalists could save (abstain from consuming) • Saving (consumers’ abstaining from consumption) could generate offsetting demand only if it led to investing (business capital expenditures). • In the early 19th century almost all saving was by businesses in the form of retained earnings that were intended to buy investment goods. So there was a strong link between saving and investment • The subsequent development of financial institutions weakened the saving-investment link, making general gluts more likely

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Gold Exports and Note Depreciation in the Napoleonic Wars

• England ran large international deficits to buy war goods, borrowing heavily to finance the wars. Poor wheat harvests compounded the deficit by raising imports of foodstuffs. • The demand for foreign exchange increased sharply, leading to a price of gold, at the gold export point. Gold began flowing out of the Exchequer. • To prevent the loss of gold, the Exchequer and the Bank of England suspended convertibility of notes into gold. As a consequence, the price of gold (in notes) rose to a premium above the mint parity; stated in language of the day, “notes depreciated.” • The reason for the note depreciation was hotly debated in “The Bullionist Controversy,” in which Ricardo played an important role.

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The Bullionist Controversy:

• Ricardo argued that the premium on notes was due to the suspension of convertibility; the Bank of England had weakened the currency, thereby inducing inflation in the note price of gold and other goods. This became known as “The Currency School.” • The Bank of England responded that it could not cause inflation because it adhered to the “real bills doctrine,” creating notes by discounting “real bills” (self-liquidating commercial notes created by trade). This became known as “The Banking School.” • Who was right? Ricardo had the upper hand because the real bills doctrine was a fallacy [see Adam Smith]

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Ricardo’s “Invariable Measure of Value” • Ricardo’s Invariable Measure of Value was designed to serve two goals Provide a price index to compute real national output Determine the source of variation in relative prices • Ricardo proposed using the commodity with average capital and labor per unit produced, and with average durability of capital. Its price (average cost of production) would be the average of all prices, against which both relative prices and the price level could be measured • Ricardo arbitrarily chose gold as the average commodity, so the price of gold was his price index— By dividing the value of national product in pounds sterling by the sterling price of gold the real value of national could be calculated If the price of a good is rising (falling) relative to gold, the cost of producing that good is rising (falling) relative to all goods

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Ricardo’s View of the Dynamics of Economic Growth

• As an economy grows its labor and capital both grow • As labor increases, the demand for food (“corn”) rises, the price of corn increases relative to the price of manufactured goods (“cloth”) • As the price of corn rises, less fertile land is brought into production, and total land rent increases • The increasing price of corn relative to cloth raises wage rates relative to the price of cloth and the profit rate declines • In summary, as an economy grows the share of output going to rent increases, the profit rate on capital falls, and the real wage rate rises