David Ricardo1772-1823

Biographical DetailsRicardo was the third son of a Dutch Jew who had made a fortune on the London Stock Exchange. Entered his father's business at age 14. By age 21 he had broken with his father over religion, become a Unitarian, and married a Quaker. Continued as a member of the stock exchange. His acumen won him support of an eminent banking house. Acquired a fortune in a few years.Used it to indulge his tastes in literature and science, specially in mathematics, chemistry, and geology.

Arrival as an EconomistInterest in economic issues started in 1799 upon reading Adam Smith's Wealth of Nations. Studies economics for 10 years with increasing interest. First published work was in 1810: The High Price of Bullion, a Proof of the Depreciation of Bank Notes 1810.It stemmed from Ricardos letters in the Morning Chronicle the previous year. He reconfirmed Hume and Smith in the Quantity Theory of Money.Provided fresh stimulus to a controversy over a specific policy of the Bank of England with regard to the supply of money: The Currency Question.

The Currency Question 1The wars with France had cause a very large outflow of gold.The government prohibits Bank of England (BoE) from paying for its notes in gold under the Bank Restriction Act of 1797. Thus it did not have to issue notes against its holdings of gold.Without this anchor, it substantially increased the notes issued and the amount of lending.By 1813, the price of gold had increased to 5.10 from 3.17 in 1799.

The Currency Question 2Directors of BoE did not acknowledge any link between increase in credit, the increase in gold prices and the deprecation of the sterling.Ricardo argued the reverse: Increase in bank notes caused the price level to increase. This in turn depreciated the exchange rate, andLed to an outflow of gold.

The Currency Question 3Thus, the de-linking from the gold standard because of gold outflows was worsening the problem: leading to more of the same.Ricardo argued BoEs lending policy must be consistent with general economic conditions.It must manage the volume of money and credit.

The Currency Question 4The Currency Question was pivotal in the development of the theory of central banking. The Bullion Committee, appointed by the House of Commons, agreed with Ricardo.It recommended the repeal of the Bank Restriction Actrepealed in 1819.The debate sealed Ricardos position of pre-eminence as an Economist.

Company of Good FriendsRicardo had the company of influential people whose views went of to shape his thoughts:James Mill, father of John Stuart Mill, and a friend of his own father, a leading philosopher and economist, became his political and editorial adviser.Jeremy Bentham, the Utilitarian philosopher. Thomas Malthus, whose theory of population was accepted by Ricardo.

Corn Laws ControversyIn 1815 a controversy arose over the Corn Laws. Falling wheat prices had led Parliament, under Lord Liverpool, to raise the tariff on imported wheat. A popular outcry ensued. In response, Ricardo published his Essay on the Influence of a Low Price of Corn on the Profits of Stock (1815).He argued that raising the tariff on grain imports increased the rents of landowners and decreased the profits of manufacturers.

Coup de Grace In addition to: Essay on the Influence of a Low Price of Corn on the Profits of Stock (1815)

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

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

Principles of Political Economy and Taxation 1In this book, he:Examined the principles by which the social product was distributed among the "three classes of the community: the landlords, the workers, and the capital owners.

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

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

Principles of Political Economy and Taxation 2Whereas Malthus fretted about gluts Ricardo assumed full-employment. Thus, the only real economic issue to clarify, which was the overarching theme of Principles, was how national income was distributed between the three groups. He wrote to Malthus:

Theory of RentA summary of the Ricardian view of RentThe increase in the price of grain, whether due to tariffs or due to increased demand through population growth, increase the Rent on land.High prices cause high rents, not the other way round.Rent is both a differential return on differential fertility, and the surplus over labor and normal capital costs.

Definition of RentTo Ricardo, rent was that portion of the produce of the earth, which is paid to the landlord for the use of the original and indestructible powers of the soil.

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

Differential Rent 1Ricardos ideas on rent developed in the context of the Corn Laws. The consequent high price of corn provided the incentive of increased cultivation of corn. As the most fertile lands were being used up, in many places, corn cultivation was moving to land higher up on the slopes. These lands were less fertile in that their ability to retain water was limited. These new, least fertile, lands were brought under cultivation as long as the addition to the value of output would cover the costs of cultivation on the least fertile acreage cultivated.

Differential Rent 2On the intra-marginal land, that of higher fertility, the cost of cultivation per unit of output would be below that price. This difference between cost and price accrued to the owners of land, who benefited in this way from the fertility of the soil, a "free gift of nature."The least fertile, newest sown, marginal land, what Ricardo called the extensive margin of cultivation, received no rent; the rent was zero. It was, thus, the differences in fertility that brought about the surplus for landowners the return to them. Hence, it was called differential rent.According to Ricardo, land begins to earn rent when less fertile land is brought under cultivation. Ricardo used the Law of Diminishing Returns in the most effectively to his analysis of the determination of rent.

Differential Rent 3As Ricardo put it:

Differential Rent 4

Competition would force farmers to pay landowners this Rent.

Scarcity Rent 1If all land is of the same fertility, would there be any rent, or would it necessarily be zero?Ricardo answered that Rent will be positive even if the fertility is uniform if land is scarce. He observed that rent emerged also as cultivation was pushed to the "intensive margin" through more intensive use of land.

Scarcity Rent 2The intensive margin would exist even if all land were of equal fertility, if land were in scarce supply.

This is scarcity rent, as against differential rent.

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

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

Scarcity Rent 3

Rent: Further DevelopmentsSince return to any factor of production can be similarly determined, why should the return to land be separately considered? Unlike other factors of production, the supply of land is fixed; a higher price will not call forth more land. In essence, its supply price is zero. However, the supply of labor or capital is responsive to the factor price. Hence, rent was redefined as the return to any factor of production above its supply price.The entire return to land is rent since its supply price is zero.Rent may be a component of return to any other factor; if the return exceeds the opportunity cost of the factor. For instance, a singer may earn much less in employment outside the opera; i.e., her opportunity cost is much less than her earning. The portion above the alternative earning possibility constitutes rent.

Theory of Value 1Stressed the importance of relative, not absolute prices or nominal price.Nominal price is dependent on Money in circulation, as per the discussion on the Currency question.

For most goods, exchange value (relative price) came from:Scarcity; and amount of labor used in its production.Dependent on objective cost factors, not subjective factors such as tastes and preferences.

Theory of Value 2For non-reproducible goods, exchange value was determined only by scarcity. These goods are in fixed supply. [Quote, p.118]

Labor Theory of Value Did take into account the use of capital.But since capital is a produced good, the exchange value of the good depended on the labor time used in the production of capital that is used.

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

Theory of Value 3Labor Theory of Value not accurate if:Differing Capital-Labor ratios are used in Industries. This would lead to wrong assessment of true value if one looked at labor time as the method to value. He argued that this was not an empirically significant issue since the amount of capital used was small relative to that of labor used.Workers have different skills. Then simply adding labor time does not work. Adjustment for labor quality would be needed.

Theory of Value 4: WagesWages do not affect the exchange value (relative prices), only the amount of labor used does. Assumes that:Labor market is competitive; then,Relative price Px/Py = WLx/WLy = Ly/Lx No differences in K/L ratio.Labor is of uniform quality; homogeneous.

When the wage changes, the profit changes, but not the relative price of the good. Since price is given by (international) competition, higher wage implies lower profit. But relative price does not change (see above)

Theory of Value 5: ProfitRicardo had a pessimistic view of profit:Wage and Profit are inversely related Profit rate is guided by the profit on marginal land.Eventually, profit rate would decline to zero.

Theory of Value 6: ProfitWage and Profit are inversely related Goods price set by international competitionIf wage rises and profit does not change, domestic price of good increasesBOP deficit ensues, gold outflow occurs, money supply and, therefore, prices fall to original levelSo profit must have fallen

Theory of Value 7: ProfitProfit rate is guided by the profit on marginal land.On such land, revenue only covers labor cost and normal profit and there is no rent.If profit of industry increases above normal, capital moves from marginal land to industryAgriculture output falls, industrial output risesProcess of reallocation continues until, in the new equilibrium, the profit on marginal land is again equal to the profit in industry

Theory of Value 8: ProfitEventually, Diminishing Returns will cause the profit rate to decline to zero.

Theory of Value 9: ProfitDiminishing Returns causes profit to decline to zero.Capital accumulation occurs and arable land is used up. K/L increases from A B C.Population expands, the demand for food increases, causing an increase in food prices. This causes increase in land use and Rent increases: R R.The rising price of food in turn this increases the Wage: W W.Because of diminishing returns, the additions to output become smaller. These additions are swallowed by the rising Wages and Rent, so the Profit gets squeezed.Ultimately, the profit falls to zero.

Policy Implications: WageHe did not recommend a Wage policy. In later writings he argued against the Poor Laws. Argued that increasing the Wage would reduce employable workers and Profit. This would make both the rich and the poor worse off.

Policy Implications: TaxTaxes on Rent were not shiftable. [Harks back to the Physiocratsthey argued that final burden of tax was on landlords]. Why?Productivity differentials on land were constant.Since rent was a residual, the tax would not raise the price of corn.Marginal land would have zero rent, so would pay zero tax.

Policy Implications: Corn LawsElimination of Corn Laws would reduce domestic corn production and, therefore, the demand for land.As corn price fell, so would rent fall.Capital would shift to manufactures as corn price fell.Wage would be governed by the Iron Law of Wagesfall in food price fall in nominal Wage.Profit would thus increase.

Law of Comparative Advantage 1Labor/Output Labor = 1000

Absolute Advantage: US has absolute advantage; its labor productivity is higher in both goodsComparative Advantage: Japan has comparative advantage in TV. Its opportunity cost in terms of corn is that in the US. Free trade price bounded between and 1.

Law of Comparative Advantage 2Labor Theory of Value technology opportunity cost C.A.Specialization in production; allocative efficiencyIncrease in world productionPartners share gains from trade; mutual benefitCA sets pattern of trade

5050CornTVUSProductionConsumption4010CornTVJapanProductionConsumption

Law of Comparative Advantage 3

Unemployment 1Strong belief in full employmentlater embodied in Says Law: Supply creates its own demand.Combined income of factors equals combined value of output.Now, do people have the will to spend?If some do not, there is saving.But this saving is consumed by borrowers who buy capital goods.So the product mix C+I will vary but always will equal C+S.

Unemployment 2There could be excess production (glut) of individual goods.If so, their price will decline, so will profit.Capital will shift to other uses, where there is greater demand.But there would not be a general glut or general unemployment.Though, there could be technological unemployment.