## Ricardo Final Lecture

• I. What he is trying to do:
• A. Price Theory: Explain relative prices
• B. Growth Theory: Explain how an economy will change over time.

• II. The Problem:
• A. An economy is a complicated interdependent system
• B. When you change one part of it, other parts change in response.
• C. Consider Smith's cost of production theory of price.
• 1. Price is the sum of wages, profits, and rent
• 2. So if wages go up, all prices go up
• 3. But what about the price of money?
• 4. That must be one, so if all prices are the sum of input costs
• 5. A rise in the wage rate must somehow force down rent or profit
• a. measured in money.
• b. Whether a fall in profit represents a fall in the profit rate depends on what happens to the amount of capital the profit is on--measured in the same money the profit is measured in.
• c. Since the profit rate is the ratio of the amount of profit to the amount of capital.

• III. Ricardo's solution
• A. Everything except agriculture is produced under conditions of constant cost, meaning
• 1. that quantity produced is proportional to input of labor and capital
• 2. Double labor and capital, double output
• 3. Possibly with time lags.

B. Agriculture is produced under conditions of rising cost

• 1. Land is of variable fertility, and you use the best land first--meaning the land that gives the highest ratio of output to input.
• 2. You can increase output either by using inferior land--which means that the amount produced for a given input of labor and capital is less, or ...
• 3. By using more labor and capital on the existing land--again with the additional inputs providing less additional output.
• 4. The former is the extensive margin, the latter the intensive margin
• 5. Since neither Ricardo nor his readers know calculus, they are thinking in discontinuous terms:
• a. A particular amount of labor plus the associated capital is one dose of labor and capital.
• b. You increase output on land under cultivated by using two doses, or three doses, but not 1.47 doses.

C. Labor is effectively a produced good.

• 1. There is some wage rate and price of corn and necessaries at which the working population just reproduces itself; holding prices constant, this is the natural wage.
• 2. If demand for labor is constant, the wage rate will be driven to the natural wage.
• 3. If it is increasing, the wage rate will be above, if decreasing below the natural wage.

D. Price (for most goods, in equilibrium) equals long run cost of production, equals the sum of profits and wages on the capital and labor used to produce them.

• E. Strictly speaking, this is marginal cost--the cost per unit of producing a little more output.
• 1. In the case of manufactured goods, marginal cost equals average cost, because of A above.
• 2. In the case of agriculture, marginal cost is the cost of producing on marginal land--whether on the intensive or extensive margin.
• 3. So rent is not a cost of production.
• a. No rent for producing manufactured goods
• b. No rent on marginal land for producing agricultural goods.

F. All prices are measured in terms of an imaginary money which is itself a manufactured good, produced domestically under conditions of constant cost like other manufactured goods. Price defined in this way is what Ricardo means by "value."

• G. So a change in wages and profits that applies equally to all manufactured goods does not affect their price.
• 1. After all, the price of a good is the ratio of its cost of production to the cost of production of a unit of money
• 2. And both are affected equally by such a change.

H. And the value of a good is simply proportional to the inputs used to produce it.

• I. So value, and price, only changes when there is some technological change--i.e. some change in what inputs are needed to produce an output.
• 1. This includes both technological change in our sense--new inventions and the like, and ...
• 2. The change in the inputs needed to produce agricultural outputs on marginal land as we change what land is marginal.

IV. Problems with this

• A. We have two different inputs--labor and capital--with different prices.
• B. So "proportional to inputs" is not well defined--which input?
• C. If we define value as proportional to labor input
• 1. it will understate the cost of production, hence the price, of capital intensive goods.
• 2. But this effect remains the same as long as the technology of production remains the same--the goods that were capital intensive last year are capital intensive this year, so relative prices stay the same, except that ...
• 3. If the relation between wages and profits change, then the amount by which capital intensive goods are being undervalued changes, so relative prices change even though technology, and labor used to produce the goods, stay constant.

V. Ricardo's Solution

• A. Ricardo calculates that this final effect is not very large, and trying to include it makes his problem intolerably difficult, so ...
• B. His fundamental model is one in which all goods, including money and agricultural commodities, are produced with the same ratio of capital to labor.
• 1. Which makes some sense if you are thinking in terms of circulating capital with a one year period--the total amount of capital is simply enough to pay a year's wages, plus paying for raw materials.
• 2. If capital accumulates, the short run effect is to bid up wages--and value of capital is again equal to one year's value of wages.
• 3. The long run effect is that the labor force rises until wages are again at the natural wage.

C. This gives us a tidy, soluble, although unrealistic first approximation picture of the economy at one instant and through time.

• 1. At any instant, in long term equilibrium, all prices are proportional to labor input, and profit is equal to what is left from output after paying the natural wage to the workers.
• 2. Over time, capital accumulates, bidding up wages, driving up population.
• 3. This would scale up forever with no change save size, except that ...
• 4. You run into declining returns in agriculture.
• 5. So over time, the price of corn goes up, the wage rate goes up, profits go down.
• 6. Note that "profits go down" might mean either that the share of value of profit or the profit rate--ratio of value of profit to value of capital--goes down.
• 7. And in fact both happen
• a. Share to profit goes down because share to labor goes up
• b. And value of capital goes up, because it is largely advanced wages, hence amount of capital to support a given amount of labor goes up.
• c. The value of total profit might go up, however, since capital is accumulating, hence labor is increasing, hence total value produced is increasing. So a smaller share could still be a larger amount.

8. At any instant, rent measured in corn is the excess of the corn output of the more fertile land over that of the marginal land--since all corn, labor, and capital gets the same price, and marginal land must just cover its costs.

• 9. With progress, the margin moves farther out, raising rent in two senses
• a. Corn rent goes up, because the difference between a given piece of land and the marginal piece goes up as we move to worse and worse marginal land.
• b. Money rent goes up even farther, because the value of corn is determined by the inputs needed to produce it on marginal land--which are increasing as we move to worse and worse marginal land.

D. Ricardo runs through the logic of this model by looking at the effect of various possible taxes

• 1. Tax labor, wage rate rises accordingly, the tax gets paid out of profit
• 2. Tax necessaries, wage rate rises accordingly, tax paid out of profit and out of necessaries bought by rich consumers
• 3. Tax corn, its price rises accordingly
• a. Wages rise, profits fall
• b. After tax rents, measured in corn, fall, since the excess production on the more fertile land is being taxed too, but ...
• c. The price of corn is rising proportionally, so money rents stay the same.
• d. Tax is paid by capitalists and non-poor consumers of food.

4. Tax the farmer's profits

• a. Price of corn rises enough to bring agricultural profits back up to other profits
• b. Rent comes from additional corn produced with the same amount of labor and capital, so corn rent remains the same
• c. So money rent goes up.

5. Tax agricultural rent.

• a. If you can really tax rent in Ricardo's sense, the tax will be paid entirely by the landowners, but ...
• b. Part of what looks like rent is really profit on the landowners (frequently sunk) capital investment on the land.
• c. So you are in part taxing the profits of a particular sort of capital.
• d. If investing that capital is important at the margin (i.e. if output is expanding, so that the marginal cost of corn includes the profit on the sunk capital used to bring new land into production, or raise output in old land) then this tax raises the price of corn.
• e. Note that he discusses this issue in two chapters, one on taxes on rent and one on Poor Rates.

6. Land tax.

• a. If proportional to rent, then a rent tax, see above.
• b. If a fixed tax per acre on cultivated land, it increases marginal cost of production, leaves corn rent unaffected, raises money rent.

7. Gold tax: Could be a burden free tax.

E. One oddity of the discussion is that at this point he ignores both substitution of inputs in production (labor for capital or vice versa) and substitution in consumption.

• 1. So in figuring out the effect of a tax, Ricardo asks who has less money as a result, and how that person would have spent his money, but usually not ...
• 2. What actions result in your paying more or less of the tax, hence what activities are discouraged or encouraged by the tax.
• 3. In particular, he seems to regard demand for agricultural output as entirely price-inelastic.
• 4. And he usually ignores the effect of the profit rate on the accumulation of capital, except when the rate gets so low that accumulation stops.

• VI. Beyond the basic solution.
• A. Ricardo knows that his model departs from reality in a variety of important ways, and discusses how including the features he has ignored would change the predictions.
• B. Technological progress in agriculture can reduce the value of corn, thus reverse the normal effect of growing population--for a while.
• C. The natural wage depends on the tastes of the workers, which could change.
• D. Technological change in our sense can change relative prices of manufactured goods.
• E. Goods are not all produced with the same labor/capital ratio. In particular, goods may use more or less fixed capital.
• 1. A change towards fixed capital tends to reduce the demand for labor, total capital held constant, making workers worse off.
• 2. Note that, given his natural wage assumption, a decrease in the demand for labor hurts workers, and the fact that consumer goods are getting cheaper doesn't matter--the wage will eventually fall far enough so that even at the new prices, workers are worse off.
• 3. On the other hand, if we ignore advances in technological knowledge, the only reason why producers shift to more fixed capital is the falling profit rate and rising wage rate, as capital accumulates,
• 4. So this effect slows those changes but does not reduce them. Newly saved capital goes partly into fixed, partly into circulating, so increases demand for labor but by less than it would have if fixed capital was not an option.
• 5. And at the same time, since this slows the fall of the profit rate, and makes living cheaper for capitalists, it results in more accumulation than would otherwise happen.
• 6. So net effect on the workers cannot be predicted.
• 7. It is worth remembering that the iron law has not held, in practice, on our society, from about Ricardo's time to ours, so although he is correctly working through the logic of his system, he is not accurately explaining the logic of the effect of real technological change as it actually happened.

F. Real money is not the same as his imaginary money,

• 1. so his statements about price and value may not describe what happens to market prices, but ...
• 2. They are closer than one might think, since the real way England "produces" money is by producing goods to export in exchange for money
• 3. So money is, in effect, being produced with the same technology as produced goods.

G. Population could be out of equilibrium, in a growing society, for an indefinite length of time (and has been!).

•

• A. I have left foreign trade out of this summary because it is not essential to the logic of his model.
• B. And because his picture of foreign trade is essentially correct--a modern, comparative advantage theory of trade ...
• C. Odd to us only because equilibrium is through specie flow mechanism rather than shifts in exchange rates.

• VIII: Oddities to watch out for:
• A. Value. Ricardo clearly distinguishes between value and riches--and the latter is roughly what we mean by "value."
• 1. Value is simply cost of production, thought of as labor input, at least when we hold labor/capital ratios constant.
• 2. So technological progress increases the production of riches but not of value--if we produce more units of output from a given amount of input, each unit is of lower value.
• 3. As it would be, if we imagine that prices are measured in a money whose production technology is not changing.
• 4. And the increasing value of corn due to economic growth is a bad thing--it means it takes more labor to produce additional corn.
• 5. So "wages increasing" means that a larger share of output goes to workers--and hence that profit is decreasing.

B. What equilibrates how fast

• 1. Implicitly, and sometimes explicitly, Ricardo assumes that prices go to equilibrium very fast, wages go to equilibrium fast, sometimes through a population mechanism (although he realizes that actually is slow). Capital accumulates towards its equilibrium more slowly.
• 2. But technological change in our sense is slow, so we can imagine either
• a. Population goes to equilibrium, capital is still accumulating, new invention, repeat or ...
• b. Population goes to equilibrium, capital goes to equilibrium, new invention, repeat.

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