handout5.doc

David Ricardo (1772-1823)

During the review of Ricardo’s economic ideas we will also present some economic views of Thomas Malthus (1766-1834), who was not exactly a classical economist. But some of his views were shared by classical economists particularly by David Ricardo.

Ricardo and Malthus were close friends constantly debating economic issue; they differed on many points.

Some of Malthus’ economic insights were debated heavily by Ricardo and other classical economics - particularly his view that there is a serious possibility of lasting economic depressions in capitalist economy. This view is in a clear opposition to the most fundamental propositions of classical economists, who stated that capitalism is a self-adjusting system and that depressions are short-lived and not very frequent in capitalism.

We will talk about the debate between Malthus and Ricardo on this issue, because this was one of the liveliest, hotly debated, controversies in the development of economic ideas, in history.

We turn to Ricardo.

David Ricardo was a son of a stockbroker and he came from a Jewish family. At the age of 21, he married a Quaker and was subsequently disowned by his father, deprived of the family property.

He started his own business as a stockbroker and soon he became successful. At 26, he was wealthy and independent, in his early 40s he owned a fortune on the order of magnitude of half a million pounds and was an influential financier.

He is a rare example of a famous economist who was also successful in business; other example would be John Maynard Keynes.

He was not a professional scholar, but autodidact; he taught himself business and economics.

Later he became a Member of Parliament, member of the House of Commons,

He was there an authority of finance and was engaged actively in debating many issues in economic policy.

He made significant contributions to a number of areas of economic theory, including methodology, theories of value, international trade, public finance, the concepts of diminishing returns and economic rent.

His major work is Principles of Political Economy and Taxation, published in 1817. This book soon replaced Adam Smith’s Wealth of Nations as the accepted book on economic questions.

He was one of the most gifted economic theorist of all times, the quantity of material written about Ricardo and his theories is equaled only by that on Smith, Marx and Keynes.

Before we will discuss Ricardo’s views, we have first to deal with some views of Thomas Malthus, mainly with his population theory.

Malthus in 1798 published an essay, transformed in 1803 in a book, called Essay on the Principle of Population, where he presented a theory of population growth, which has significant implication for classical economics. This theory is essential to an understanding of certain parts of Ricardo’s economic theory, so we have to consider it first.

The basic thesis Malthus defended about population is that population (the number of the members of society) tends to increase faster than the food supply. This is Malthus population principle, or population thesis.

This principle was formulated earlier by many, for example by Adam Smith, but Malthus discussed in detail and his account of it influenced existing and subsequent economic thinking.

This population principle was founded on two assumptions:

- that food is necessary for the existence of humankind (not controversial);

- that passion between the sexes is necessary and will remain unchanged.

He concluded from the assumptions that the population tends to grow at a faster rate than the food supply.

Malthus stated that human beings in the absence of checks on population would tend to increase their numbers geometrically (1, 2, 4, 8, 16 …) in geometric progression.

But that the supply of food can only increase arithmetically (1, 2, 3, 4, 5), like in arithmetic progression.

So, there is a potential shortage of food.

He concluded that check on population would develop in society to keep the rate of population growth in line with the rate of growth of the food supply. He postulated two types of these checks, positive and preventive.

Positive checks are increases in the death rate because of wars, famines, disease and similar disasters.

Preventive checks lower the birth rate – like postponement of marriage, prostitution, contraception, moral restraint even (he was a clergyman) and the like.

Therefore, in the presence of these checks, in fact population grows in line with the growth of food supply, not faster.

What is the economic implication of the Malthus’s thesis? You cannot help the misery, hardship and poverty in the society, especially in the working class. In the early 19th century, in early capitalism, poverty of lower-income class was increasing rapidly, when people were moving to towns and started to work in urban factories. Therefore, the working class was in real poverty in early 19th century (we will see this in detail when discussing Marx’s views).

And the implication of Malthus’s thesis is that the government cannot help the poor, because if their welfare is increased above the subsistence level (above the level at which their basic needs, like hunger and thirst, are fulfilled), they start to reproduce at a higher rate then the grow of their welfare. In the end the welfare of their families returns to the subsistence level.

This is a very sad consequence of Malthus’s thesis.

This reasoning is connected to the so-called iron law of wages.

The iron law of wages declares that wages can never rise above the minimum level that will enable the laborer to survive. Because it wages rise above the subsistence level, laborers start to reproduce, the number of the working class members is increasing, there is an increased competition for labor and wages tend to decrease to the subsistence level.

Ricardo and other classical economists generally accepted this view.

The prospects of laborers, the working class, for classical economists were bad, dismal, their welfare cannot be improved even in the long run. Any effort to improve the welfare of lower-income class is futile, the governments should abolish any pro-poor legislation because it can not help them.

Malthus’s population principle caused considerable controversy. It has some obvious flaws.

He did not take into account that sexual desires do change and that thanks to increasing levels of affluence and education members of the working class started to realize that the decision to have children is costly, so they finally limited the number of children.

In addition, Malthus failed to consider the possibility that developments in agricultural technology might permit sufficient increases in the supply of food to feed an increased population.

Malthus’s thesis is not correct from the modern point of view, but nevertheless we have to remember that all classical economists thought that it was true and used it in their theories – for example to formulate the iron law of wages.

Now we turn to Ricardo.

First, his views on methodology to be used in economics, later about his views on economic policy and the proper subject of economic science, and finally we will discuss his contributions to the economic theory

We start with the methodology Ricardo proposed for economics.

As I said while discussing A. Smith, Smith used the so-called contextual economic policy, while he formulated prescriptions for policy

This means that his conclusions in economic policy were not only based on abstract, non-contextual, theoretical arguments, but that they were contextual, that is, they are based also on Smith’s observations of the existing historical, political and institutional circumstances.

Ricardo on the other hand, represents the pure theorist. He abstracted from the economy of his time and built an analysis based on the deductive, logical, purely theoretical method.

His skill in this approach was so great that pure theorists admire him even today, though he did not used any mathematics.

Although he was a pure theorist, his economics was not impractical, he was strongly oriented toward policy issues – he just wanted to resolve practical issues in policy only by the means of economic theories, which are possible to apply in any country at any given time.

The existing historical, political and institutional context in economy did not matter for Ricardo.

His policy recommendations were non-contextual; they were based only on purely theoretical considerations.

Ricardo’s method is thus highly abstract modeling, he postulated that economists abstract from nonessential factors and build a highly theoretical model that will reveal the casual relationships between economic variables (that is relationships identifying which economic causes produce certain economic effects).

Ricardo’s method (building highly abstract models) and his approach to economic policy (non-contextual) ultimately became the path followed by mainstream economics, especially in late 19th century and in 20th century with the rise of mathematical economics.

Most economists today argue that this is the important contribution of Ricardo, introducing abstract modeling and non-contextual economic policy. But there are of course minority that this is a dubious heritage from Ricardo – as I said in one of the previous classes, they regard today’s highly abstract economics as unrealistic and irrelevant for policy matters and they name this feature of modern economics as ‘Ricardian vice’, evil, badness in modern economics.

Whoever is right, it is Ricardo, who introduced abstract modeling and non-contextual policy in the history of our discipline.

The problem of what is the proper subject of economics.

Ricardo represents a turning point in the conception of the basic task of economics. Adam Smith, mercantilists, and others were striving for discovering the forced determining the wealth of nations, so they thought that the investigations into the nature of economic growth are most important in economics.

Whereas Ricardo maintained that the principle purpose of economics is to determine the laws, the principles that regulate the distribution of national income among social classes in the society, that is the distr. of income among landlords, capitalists and laborers.

He was preoccupied with what is now called the functional distribution of national income, the relative shares of output, of national income, going to labor, capital and land. What is the share of national income going to the working class, capitalists and landowners?

He was particularly interested in changes in the functional distribution of national income over time, over the long run.

He considered this problem in the context of society made up of three classes: capitalists receiving profits, landlords receiving rents and laborers receiving wages.

In order to explain changes in the shares of National income receiving by these three classes he found it necessary to develop theories explaining profits, rents and wages.

He was primarily concerned with the effects of the changes in relative income distribution on the rate of capital accumulation and the rate of economic growth. His theoretical conclusion was that in the long run the rate of economic growth would be zero, so this maybe explains why he was not interested in growth in the first place.

He was not very interested in microeconomics, but he developed a theory of value, theory of relative prices, but this served almost only as a tool to discover the forces governing the changes in the distribution, functional distribution of income among social classes.

Before discussing his theories, let’s consider one practical problem in English economic policy in early 19th century. Many of his theoretical arguments are designed especially as arguments in the debate on this problem.

This is the problem of the so-called Corn Laws. Corn is grain, right, like wheat, rice or rye.

The Corn Laws were regulations placing tariffs on the importation of grain into England. In late 18th and early 19th century, during the period of Napoleonic wars, the prices of grain were very high, because the import was not possible during the wars and because of the fact that Britain was not agriculturally self-sufficient after the year of 1790.

After the wars, English landlords and farmers were afraid of falling prices of grain, so they went to Parliament to get increased protection.

The Corn Laws then in effect had been passed in 1791; they placed a floor on the price of grain at 50 shillings per quarter, which was substantially increased later. The import of grain was only possible when the domestic price was higher then this floor level.

In early 19th century there was a constant discussion in Britain whether to increase or decrease the price-floor in corn laws, or even whether to abolish the corn laws or not.

Of course, landowners and farmers were the supporters of the Corn Laws. Ricardo was the most prominent critic of these regulations. He introduced into discussion new economic ideas, based on his theories of land rent and distribution of income. We will get back to the problem of Corn Laws while discussing these theories.

Now we turn to theoretical contributions of Ricardo.

First I will discuss his theory of land rent, that is how he explained the payment for the use of land as a factor of production.

Later, we will review his value theory, theory of relative prices

Next we will turn to his most important theory explaining the distribution of income in time.

And later I will shortly present his comparative advantage theory in international trade. We will finish the discussion of Ricardo’s views with the debate between Ricardo and Malthus on the problem of stability of capitalist economies.

OK, so we start with his theory of land rent.

In this theory Ricardo formulated the principle of diminishing return, which has become an important economic concept.

Actually, the principle of diminishing returns appears to have been discovered in 18th century, but Ricardo and other British economists in the early 19th century formulated it very clearly and brought it back to economics.

The principle of diminishing returns, as you know, states that if one factor of production is steadily increased while the others are held constant, the rate at which the total product increases will eventually diminish.

Ricardo in his model, for simplicity of analysis, assumed that only one combination of labor and capital inputs can be used to produce a given output – that is he combined labor and capital – two factors of production into one – doses of labor and capital. It is as if production process in his economy would be some kind of row digging, for example, where the factor of production is a person with a spade.

To increase output, you need another unit of labor (worker) and another unit of capital (spade). Increasing only labor or only capital will be useless. It is the assumption of Ricardo’s model. Capital and labor are used in doses, one dose of labor and capital, two doses… and the like.

He also assumed that the principle of diminishing returns begins immediately, so that the marginal product of the second dose of capital and labor used in the production process is less than that of the first dose.

Ricardo maintained that land rent, payment to land used as a factor of production, exist because of 1) the scarcity of fertile land and 2) the law of diminishing returns.

Let’s discuss the model with the help of a diagram.

Let there be an economy, which produces only one good – wheat.

Let there also be 3 plots of land, plots or areas or parcels or locations of land, of different fertility. Plot A is the most fertile, while plot type C is the worst, the least fertile.

Assuming that 3 doses of labor and capital are applied to type A land, 2 doses to type B land, and 1 dose to type C land, suppose that marginal product of three separate plots of land are as in the diagram.

Successive doses of capital and labor applied on any given type of land give us diminishing marginal product, because there operates the law of diminishing returns. First dose of capital and labor on land type A gives MP of 100 bushels of wheat. Second one gives 90 bushels, third only 80. And the same principle applies to land of different types.

Also because of the difference in natural fertility MP of the first dose of capital and labor on the land C is smaller that MP of the first dose of capital and labor on the land of type B, and the latter is smaller then MP of the first dose of capital and labor used on land type A.

There are two sources of the land rent...