UNIT X David Ricardo I: David Ricardo’s principles of political economy and Taxation
By the end of this unit, and having completed the recommended reading, you should know:
? The origin of David Ricardo’s contribution to economic theory
? David Ricardo’s principles of political economy and Taxation
? The major contributors of the classical school of thought.
The Period between Smith’s Wealth of Nations and Ricardo’s Principles of political economy and taxation
David Ricardo (1772-1823), a stock dealer turned economist, made significant contributions to a number of areas of economic theory, including methodology, theories of value, international trade, public finance, diminishing returns, and rent. He began his study of economics sometime around 1799, when he was twenty-eight years old, and in 1810 published his first pamphlet, The High Price of Bullion. His essays on the Corn Law controversy, published around 1815, established him as one of England’s most talented economists. His major work, Principles of Political Economy and Taxation, published in 1817, quickly replaced Adam Smith’s Wealth of Nations as the accepted book on economic questions. It is the third and final edition of this work.
Till the appearance of Ricardo’s Principles of Political Economy and Taxation in 1817, Adam Smith’s Wealth of Nations, published in 1776, dominated English economic thought. In the four decades that intervened, no major new economic theory appeared, although several significant contributions to economic analysis were made. Thomas Robert Malthus (1766-1834) published an essay in 1798 and a book in 1803 on population; in 1815 Edward West, Robert Torrens, Malthus, and Ricardo published essays discussing the concept and economic significance of rent. Ideas on both these subjects came to be embodied in classical economics.
Ricardo’s interest in economics was sparked by a chance reading of Adam Smith’s Wealth of Nations (1776) when he was in his late twenties. Bright and talkative, Ricardo discussed his own economic ideas with his friends, particularly James Mill. But it was only after the persistent urging of the eager Mill that Ricardo actually decided to write them down. He began in 1809, authoring newspaper articles on currency questions which drew him into the great Bullionist Controversy that was raging at the time. In that affair, he was a partisan of the Bullionist position, which argued for the resumption of the convertibility of paper money into gold. He wrote a pair of article in 1810 and 1811 articulating their arguments and outlining what has since become known as the “classical approach” to the theory of money.
Many of the fundamental concepts and principles of classical economics were set forth in Smith’s An Inquiry into the Nature and Causes of the Wealth of Nations (1776). Strongly opposed to the mercantilist theory and policy that had prevailed in Britain since the 16th century, Smith argued that free competition and free trade, neither hampered nor coddled by government, would best promote a nation’s economic growth. As he saw it, the entire community benefits most when each of its members follows his or her own self-interest. In a free-enterprise system, individuals make a profit by producing goods that other people are willing to buy. By the same token, individuals spend money for goods that they want or need most. Smith demonstrated how the apparent chaos of competitive buying and selling is transmuted into an orderly system of economic cooperation that can meet individuals’ needs and increase their wealth. He also observed that this cooperative system occurs through the process of individual choice as opposed to central direction.
In analyzing the workings of free enterprise, Smith introduced the rudiments of a labour theory of value and a theory of distribution. Ricardo expanded upon both ideas in Principles of Political Economy and Taxation (1817). In his labour theory of value, Ricardo emphasized that the value (price) of goods produced and sold under competitive conditions tends to be proportionate to the labour costs incurred in producing them. Ricardo fully recognized, however, that over short periods price depends on supply and demand. This notion became central to classical economics, as did Ricardo’s theory of distribution, which divided national product between three social classes: wages for labourers, profits for owners of capital, and rents for landlords. Taking the limited growth potential of any national economy as a given, Ricardo concluded that a particular social class could gain a larger share of the total product only at the expense of another.
These are some of the Ricardian theories which were restated by Mill in Principles of Political Economy (1848), an essay that marked the conclusion of classical economics. Mill’s work related abstract economic principles to real-world social conditions and thereby lent new authority to economic concepts. The teachings of the classical economists attracted much attention during the mid-19th century. The labour theory of value, for example, was adopted by Karl Marx, who worked out all of its logical implications and combined it with the theory of surplus value, which was founded on the assumption that human labour alone creates all value and thus constitutes the sole source of profits.
More significant were the effects of classical economic thought on free-trade doctrine. The most influential was Ricardo’s principle of comparative advantage, which states that every nation should specialize in the production of those commodities it can produce most efficiently; everything else should be imported. This idea implies that if all nations were to take full advantage of the territorial division of labour, total world output would invariably be larger than it would be if nations tried to be self-sufficient. Ricardo’s comparative-advantage principle became the cornerstone of 19th-century international-trade theory.
Question for review
1. Briefly explain the origin of David Ricardo’s contribution to economic theory
2. What are the major theories brought forth by David Ricardo?
UNIT XX: David Ricardo II: Ricardo’s income distribution theory and labour theory of Value
By the end of this unit, and having completed the recommended reading, you should know:
? David Ricardo’s theory of rent.
? David Ricardo’s Labour Theory of Value
? Some major critics of the modern economics to Ricardo’s theories.
David Ricardo’s Theory of Rent
Ricardo’s theory of rent in the doctrine was a consistent elaboration of the view contained in his essay. He defined rent as “that portion of the produce is paid to the landlord for the use of the original and indestructible powers of the soil. His theory of the determination of rent was based on two assumptions: first, that land differed in its fertility and that all lands could be arrayed along a spectrum from the most fertile to the least fertile; and second, that competition always equalized the rate of profit among the capitalist farmers who rented land from the landlords. His theory of rent cannot be summarized better than he himself summarized it. His discussion ofthe determination of rent shall therefore be quoted at length. Before readingthis quotation, however, it is necessary for the reader to understand Ricardo ‘sdefinition of net produce . Net produce was the total quantity produced minusall of the necessary costs of production, including the replacement of capitalused up in production and the w ages of workers. Net produce was therefore the total of the surplus value, created by labor, which could go to either profit or rent.
According to Ricardo, the quantity of land is limited, and so is its productiveness, and it is not uniform in quality. If the superior land will not support the population, recourse must be made to inferior lands and the produce is, thus, raised at different costs. The differential advantage of the superior land over the inferior gives rise to economic rent. It is plain that the farmer may just as well pay for the superior land as get the inferior land rent free. Thus, rent arises out of the difference existing in the productiveness of different soils under cultivation at the time for the purpose of supplying the same market, and the amount of rent is determined by the degree of those differences. This is known as Ricardo’s Theory of Rent.Rent is that portion of the produce of the earth, which is paid to the landlord for the original and indestructible powers of the soil. It is a surplus enjoyed by the super marginal land over the marginal land arising due to the operation of the law of diminishing returns. Productiveness depends on fertility and convenience of situation. Therefore, Economic Rent in its simplest form is the differential profit that arises in the case of production, owing to differences in natural conditions due to Fertility of the soil and advantages of situation.
The land margin is made the central point in the Ricardian theory of rent. In Ricardo’s law of rent, we have resort to inferior lands leading to extensive margin and the law of diminishing returns leading to an intensive margin. The land of the second quality is now said to be land on the margin of cultivation. Land on the margin just pays for the expenses of cultivation, viz., wages and profit on capital, and it yields on surplus for rent. Rent is measured from this point for rent is always the difference between the produce obtained by the employment of the two equal portions of capital and labour upon the land. Obviously, cost of transportation must be first deducted. The margin of cultivation is determined by the price of agricultural produce. As the price of this rises, lands of inferior quality will pay for cultivation and, similarly, if the price falls, those lands will fall out of cultivation.
The Implications are that Land according to Ricardo is limited in supply and of different grades of fertility. Rent arises as differential advantage which superior lands possess over the inferior lands apart from the operation of the Law of Dimin¬ishing Returns and a surplus over and above no rent land. Some critics of Ricardian Theory of rent according to the Morden theory of rent are that Ricardo restricted rent to land and his theory is simply based on the natural variation of the fertility of different pieces of land. Moreover, he took no account of the fact that there are competing uses for some land, and as a result it is not necessarily the least fertile land that will first go out of cultivation.
David Ricardo’s Labour Theory of Value
According to the labour theory of value, developed by David Ricardo and advanced and improved by Karl Marx theory, the value of anything depends on the amount of labour required to produce it. Therefore, in the opinion of Adam Smith, if one thing requires twice as much labour to produce as another thing, it would be twice as valuable. The labour theory was employed by the classical economists to explain the purpose of relative prices on the basis of quantities of labour, instantly and accumulated, embodied in goods. By instantly labour we mean the current effort of a worker and by accumulated labour we mean the services of capital which represent the past input of labour. It was argued that prices would be proportional to the quantities of embodied labour in goods. Ricardo also recognised that the theory broke down when production of different goods required different time periods or capital to labour ratios differed among them. If two goods had identical labour inputs but one was produced with more capital, then the producer of the capital-intensive good would need to be compensated for the large volume of capital out of the market price of the commodity. If the prices were the same his rate of profit must be lower; if he is to earn an equal rate of profit, his price must be higher. Embodied labour then fails to explain prices. A similar argument holds for different periods of production, if rates of profit are to be equalised.
The importance of the labour theory of value is that in as much as it draws attention to the grievances of labour and to the exploitation which the labourers suffer at the hands of the capitalists. For Ricardo, the labour theory was more than just a theory of relative prices and was in effect the key to understanding capitalism. In his system, only labour can create value, but it is unable to keep to itself all the value created, for the capitalist is able to extract a surplus value, or economic profit, which is then reinvested in machinery, which leads to growth of the capitalist economic system and its eventual collapse. Karl Max modified the labour theory by introducing the qualifications that different grades of labour should be reduced to simple labour, i.e., a unit of standard efficiency, and that the labour should be socially necessary one labour.Socially necessary labour is that required by the average technology of the time and which makes a product for which there is a demand. Without demand labour is not treated as socially necessary and so no value can be created. This latter qualification substantially weakens the claim of the labour theory that it can explain prices.
The labour theory of value has also not been exempted from the critics of the modern economics. One of the arguments against it is that labour alone does not create a product and its value. The other factors like risk-taking, capital, are as much necessary as labour. It also fails to explain the values of non-reproducible goods. Moreover, owing to the existence of various kinds of labour and owing to the differences in the ability and skill of different categories of labour, the term ‘labour’ cannot be properly defined and so cannot be reduced to a common measure. Finally, it also ignores the role of demand or utility which plays an important part in determining the value of anything in the very short period.
Questions for review
UNIT XXX : David Ricardo III: Low of Comparative advantage and Richardian equivalence
By the end of this unit, and having completed the recommended reading, you should know:
? The origin of the law of comparative advantage
? How the law of comparative advantage has influenced trade among countries
? The Ricardian equivalence theorem.
? criticism of the Ricardian equivalence theorem
The Ricardian Law of Comparative Advantage
Even the utmost objections of the Ricardian system have granted that at least David Ricardo made a vital influence to economic thought and to the case for freedom of trade which is the law of comparative advantage. In emphasizing the great importance of the voluntary interplay of the international division of labor, free traders of the 18th century, including Adam Smith, based his doctrine on the law of absolute advantage. The law of absolute advantage states that, countries should specialize in what they are best or most efficient at, and then exchange these products, for in that case the people of both countries will be better off. The law of comparative advantage tackles such hard cases, and is therefore indispensable to the case for free trade. It shows that even if, for example, Country X is more efficient than Country Y at producing both commodities A and B, it will pay the citizens of Country X to specialize in producing A, which it is most best at producing, and buy all of commodity B from Country Y, which it is better at producing but does not have as great a comparative advantage as in making commodity A. In other words, each country should produce not just what it has an absolute advantage in making, but what it is most best at, or even least worst at, i.e. what it has a comparative advantage in producing.
An Importantrepercussion of the law of comparative advantage is that no country or region of the earth is going to be left out of the international division of labor under free trade. For the law means that even if a country is in such poor shape that it has no absolute advantage in producing anything, it still pays for its trading partners, the people of other countries, to allow it to produce what it is least worst at.In this way, the citizens of every country benefit from international trade. No country is too poor or inefficient to be left out of international trade, and everyone benefits from countries specializing in what they are best or least bad at producing.
Until recently, it has been generally believed by historians of economic thought that David Ricardo first set forth the law of comparative advantage in his Principles of Political Economy in 1817. Recent researches by Professor Thweatt, however, have demonstrated, not only that Ricardo did not originate this law, but that he did not understand and had little interest in the law, and that it played virtually no part in his system. Ricardo devoted only a few paragraphs to the law in his Principles, the discussion was meager, and it was unrelated to the rest of his work and to the rest of his discussion of international trade.
The discovery of the law of comparative advantage came considerably earlier. The problem of international trade sprang into public consciousness in Britain when Napoleon imposed his Berlin decrees in 1806, ordering the blockade of his enemy England from all trade with the continent of Europe. Immediately, young William Spence (1783–1860), an English Physiocrat and underconsumptionist who detested industry, published his Britain Independent of Commerce in 1807, advising Englishmen not to worry about the blockade, since only agriculture was economically important; and if English landlords would only spend all their incomes on consumption all would be well.Ricardo’s views on foreign trade received almost no comment at that time. Mainly because writers concentrated on his labor theory of value, and his view that wage rates and profits always move inversely, with the former determining the latter.
The term Ricardian equivalence was brought by the American economist Robert Barro in the 1970s and later became a regularsubject matter in public finance and macroeconomic theory. The Ricardian equivalence theorem attributes to David Ricardo (1772–1823), the English economist, the view that taxation and public borrowing comprise equivalent means of financing public expenditure. The rationale behind this view is that the government is expected at some future time to redeem its debt. If one now supposes a closed economy, the repayment of debt will take place via increased future taxation, which means that, on the basis of the rational expectations hypothesis, individuals increase their savings through buying the bonds that have been issued by the government. The amount of savings, in other words, matches the size of the public deficit and therefore the interest-rate remains the same. This means that there is no crowding-out effect of private investment from public expenditure and the overall demand remains the same together with the other real variables of the economy. A similar mechanism operates in the case of an open economy, where the redemption of public debt takes place via the sale of assets to international institutional agents. Such a possibility raises, once again, the question of limited future government income, hence the inevitable future increase of taxation. Consequently, Robert Barro in the early 1970s and the new classical economists argued that either method of financing public expenditure, that is, through taxation or borrowing, leads to the same final results. The theorem has been used to argue against government intervention in the economy through fiscal policy because it suggests that the government cannot achieve anything quite different from the free operation of market forces. Monetary policy has similar effects; for example, if government expands the money supply, the public does not increase its expenditures but rather its savings in order to meet the future tax obligations. In short, Ricardian equivalence became a necessary weapon in the armory of the new classical economics in their defense of “free market.” The truth, however, is that Ricardo, to whom this theorem is attributed, repudiated the notion of equivalence between the two ways of financing government expenditure. He reasoned that taxation falls on current incomes and primarily reduces current consumption and only secondarily saving. By contrast, borrowing falls entirely on savings, which for Ricardo and classical economists are identical to investment. As a consequence, public borrowing diminishes the investable product and has detrimental effects on the economy’s capacity to accumulate capital. The empirical evidence from various countries does not lend support to the Ricardian equivalence in its pure form, although there is some evidence that saving rates follow government spending—that is, it has been observed that the personal saving rate increases in the case of deficit spending and decreases in the case of government surpluses. It is very hard, however, to show a direct one-to-one relationship here. A usual criticism of the Ricardian equivalence theorem is that real-life situations are characterized by uncertainty regarding future income and also tax liability, which prevents individuals from behaving in accordance to rational expectations. Furthermore, Ricardian equivalence does not hold in cases where the growth rate of the economy exceeds the rate of interest.