CHAPTER 2:

Theories underlying the Study of Political

Economy
1. Value Theory

 What determines the price of a good or in the language of modern economics?

 What determines prices?

a. Relative prices are determined by supply or costs of production and the role of demand.
b. Market or short-run prices are determined by both supply and demand, while natural or long run
equilibrium prices generally depend upon costs of production.
c. For the agricultural sector, natural price depends upon supply and demand, since the long run supply
curve is upward sloping, which indicating increase in costs. But for the manufacturing sector, the long
run supply curve is at times assumed to be perfectly elastic, representing horizontal or constant costs,
and in other parts of the analysis, the supply curve is downward sloping, indicating decrease in profit.
d. The scholastics became interested in the question of relative prices because they were concerned with
the ethical aspects of exchange and the mercantilists considered it because they thought wealth was
created in the process of exchange.

The meaning of value:

 Value in use or the utility of some particular objects, and;

 Value in exchange or the power of purchasing other goods.

a. The things which have the greatest value in use have frequently little or no value in exchange, and on the
contrary, those which have the greatest value in exchange have frequently little or no value in use.
b. Example: water. Nothing is more useful than water, but it will purchase scarce anything. A diamond on
the contrary has scarce any value in use, but a very great quantity of other goods may frequently be had
in exchange for it.

2. Smith’s Three Theories of Relative Prices

 Labor cost theory
 Labor command theory
 Cost of production theory

a. Labor cost theory

 The units of measuring time are clock hours, but the units of measuring ingenuity and hardship
are not given.
b. Labor command theory
 The value of the good to those who possess it and who want to exchange it for some new
productions, is precisely equal to the quantity of labor which it can enable them to purchase or
command.
 Example: a beaver will command two hours of labor and a deer one, so that their relative price will
be 1B=2D.
c. Cost of production theory
 The value of a commodity depends on the payments to all the factors of production : land, and capital
in addition to labor.
 A. Distribution Theory

The personal distribution of income depends on the prices and quantities of factors of production sold by
individuals.

a. Labor is the only factor of production owned by most households, so a household income generally
depends upon the wage rate and the number of hours worked.
b. The amount of property income received by households that own property depends on the quantity
of capital and land held by the household and the prices of these factors.

Prices in Economy:

1. Wages

 Labor is a disadvantage in the wage-bargaining process. Since there are fewer employers than
employees, employers can more easily group together to strengthen their position. The law permits these
employer- combinations but prohibits employees from forming unions.
 Employers have ample resources that make it possible for them to live even if they employ no labor
during a strike or lockout.

2. Profits

 These are payments to the capitalist for performing a socially useful function, namely to provide labor
with the necessities of life and with materials and machinery with which to work during the time-
consuming production process.
 Labor permits deduction of profits because it has no materials to work with and no independent means
of support.
 Laborers received the whole of the product but in his own time labor had to share the product with the
capitalist and landlord.

3. Rent

 It means price determining and later, after anticipating that of Ricardo, he termed it as price-determined.
 “Landlords who love to reap where they never sowed”.
 The origins of rent are:
a. demands by the landlord
b. Monopoly
c. Differential advantages
d. Bounty of nature

RICARDO AND MALTHUS

 David Ricardo’s “ Principles of Political Economy and Taxation” in 1817

 Thomas Robert Malthus’ book on Population in 1803

B. Population Theory of Malthus

a. The principal thesis is that; population tends to increase faster than the food supply.

b. Note: This principal thesis however was not original with him. It can be found in the writings of
Smith and Benjamin Franklin.
 c. Three circumstances on the formation of Malthus’ theory:

i. Pressure of population on England’s food supply.

ii. Perceived increasing poverty of the lower-income classes.
iii. The character of man is not inherited but is shaped by the environment in which he lives .
( based on the ideas of Marquis de Condorcet and William Godwin, as sometimes called
the father of anarchism, as accepted by Daniel Malthus, the father of Thomas Malthus )

N.B. Eventually, Robert Malthus wanted to show that his father was wrong. He then
tried to prove that poverty and misery were not the result of social and political institutions and that
changes in these institutions would not remove the evils of society.

1. Assumptions of Malthus’ principles:

a. Food is necessary for the existence of man;
b. Passion between sexes is necessary and will remain unchanged.

 Conclusion: Population tends to grow at a faster rate than the food supply.

 In the absence of checks on population, human beings will tend to increase geometrically, and
the food supply will only increase arithmetically. This is the cause of poverty and misery.

 Two types of checks: positive and negative. ( First edition )

a. Positive checks are increases in the death rate as a result of wars, famines, diseases
etc.
b. Negative check is the lowering of the births rate, which is accomplished by the
postponement of marriage. But he concluded that postponement of marriage could
only result in vice, misery and degradation of character, because premarital sex
relations would occur.

 New check under the second edition

a. Moral restraint or the postponement of marriage without premarital sexual activities.

Flaws in the Malthusian Population Theory

 He never discussed the feasibility of controlling population by contraception.

 He confused the instinctive desire for sexual relationships with the desire to have children.
 He has an arbitrary assumption that the food supply cannot increase faster than the population.
 He failed to consider the possibility that developments in agricultural technology might permit increases
in the supply of food sufficient to feed an increased population.

Beginning in the 1960’s, people have expressed concern over the growth of population not only
in underdeveloped economies but also in developed ones. This is not because of an inadequate food supply,
but because of the environmental damage that has been associated with increases in population density in
the past. Earth has been compared to a spaceship that may already have more than an optimum number
of passengers on board.

The relationship of population to increase wage of labor:

  Increase in the real wage of labor would resulting increases in population, which would
eventually bring the wage rate back to its former level. So while humanitarian feelings might call
for social measures to raise the income of the laboring poor, such efforts would be futile.
 Attempts to alleviate the economic plight of low-income groups in England be legislation began
around 1600, and they are called the “poor laws”.

DAVID RICARDO

 The Works and Correspondence of David Ricardo, published in 1951 became a monument to one of the
most gifted of economic theorists.
 His first pamphlet, “The High Price of Bullion”, was published in 1810.
 His essays on the Corn Law Controversy published around 1815 established him as one of England’s
most able economists.
 His major work, “Principles of Political Economy and Taxation”, published in 1817,soon replaced
Adam Smith’s Wealth of Nations.

The Scope of Economics According to Ricardo

 While Adam Smith maintained the mercantilist concern with the forces determining wealth of nations,
Ricardo held that that the principal purpose of economics is to determine the laws that regulate the
distribution of income between landlords, capitalists and laborers.
 Further concerns: functional distribution of income.
 A society is made up of three classes:
a. Capitalists receiving profits and interests.
b. Landlords receiving rent
c. Laborers receiving wages.

The problem of the times-the Corn Laws paved way for Ricardo, West, Torrens and Malthus to publish
pamphlets to explain the rising prices of grain and raising rents.

C. Ricardo’s Theory of Land Rent

According to him, rents exist because of;

a. scarcity of fertile land
b. Law of diminishing returns

Scarcity of fertile land:

 If good land existed in quantity much more abundant than the production of food for an increasing
population required, or if capital could be definitely employed without a diminished return on the old
land, there could be no rise of rent.
 Rent is a payment to the landlord that equalizes the rate of profits on land of differing fertilities.

2 kinds of margin:
1. Intensive margin
2. Extensive margin

Extensive margin

Intensive margin
 Plot A Plot B Plot C
100 90 80
Doses of labor 90 80
& capital 80

270 total product 170 total product 80 total product

The intensive margin reflects the principle of diminishing marginal returns, which is assumed to be
operative immediately. As the marginal product on grade A land diminishes, it becomes economically feasible
to use lands of lower fertility, and grade B land represents the extensive margin, moving to the hillside after the
more fertile valley is cultivated. If there were no diminishing returns, plot B would never be farmed, as plot A’s
initial marginal product is the largest that can be produced with a single dose of labor and capital. Similarly,
plot C would never be used in the absence of diminishing returns on A and B.

If rent is the payment to the landlord that will equalize the rate profits on different grades of land, the
rent on grade A land is 30 bushels, grade B is 10 bushels and there is no rent on grade C land.

Notes:

a. The marginal returns on Grade A land diminished as successive doses of labor and capital were
applied.
b. The marginal costs of producing grain increase as the land is more intensively farmed.
c. Marginal cost is defined as the increase in total cost required to produce an incremental amount of
final product.
d. As the intensive margin on grade A land is pushed down, the marginal cost of producing grain
increases.
Rent can be measured not in bushels of wheat but in money. To compute rent in dollars, we need to find
the total revenue from selling grain and the labor and capital costs of producing grain on each grade of land.

Example: For grade A land, the total revenue is $337.50 which is computed
by multiplying the output of 270 bushels times the price of grain of $1.25 per
bushel.

Total costs of labor and capital is $300 since three doses of labor
and capital were used at a cost of $100 per dose. Rent is the difference
between total revenue and cost or $37.50.

270 X $ 1.25 per bushel = $337.50

- $300 labor and capital

$37.50

Models revealed from the concept of rent and the workings of competitive markets:

 Competition between farmers in the market will force the price of grain to the marginal costs of
the highest cost unit of output
 Competition for land will resulting rents being paid to the landlord owning the most fertile land.
 Competition will result in a uniform rate of profit on all grades of land.

D. Ricardo’s Labor Cost Theory of Value

“The value of a commodity, or the quantity of any other commodity for which it will exchange, depends on the
relative quantity of labour for which is necessary for its production, and not on the greater or less compensation
which is paid for that labour.”

 Measuring the quantity of labor necessary to produce a commodity includes skill, hardship, and
ingenuity.
 Use value is essential for the existence of exchange value.
 Before a commodity will have positive price, a demand must exist, but demand is not the measure of
price. The price of commodities that yield utility derives from two sources:
a. Their scarcity
b. Quantity of labor required to produce them

Solutions to five fundamental problems on labor theory of value:

1. A measure of the quantity of labor

Problem: how to measure the quantity of labor:

Smith was unwilling to use clock hours or time as a measure of the quantity of labor necessary to
produce a good because he felt that the skill of the laborer and the hardship of the job were also relevant.
The wage rates paid to different laborers would reflect their skills and hardships of their jobs.

Ricardo’s solution is to measure the quantity of labor by the amount of time involved in producing a
good, that is, by clock hours.

2. The differing skills of labor

Problem: Skilled laborers vs. unskilled laborers

Ricardo’s solution to this problem was by using wages paid to laborers to measure their relative
productivities. If differences in wages paid to laborers because of differing skills remain constant over time,
changes in the prices of final products will not be a result of the wages paid to labor.

3. Capital Goods

Problem: How to compute the capital goods with labor, direct and indirect and the interest on the funds
paid involved

Ricardo’s solution to the capital goods problem is that; if labor has been applied in some past period to
produce a capital good, the price of a final good produced by using up this capital good must include an amount
necessary to pay the labor directly applied, the indirect labor used to produce the capital good, from the time of
payment until the final good is sold.

4. Land Rent

Problem: Fertile land vs. less fertile land

 Ricardo’s solution to the problem is his theory of land rent. For him, the price of the bushel of wheat
depends upon the marginal costs of the bushel of wheat produced less efficiently. Price is determined at the
margin, and at the margin there is no rent.

5. Profits

Problem: how to measure profit

Ricardo’s conclusion is that changes in relative prices overtime depend upon changes in the relative
quantities of labor embodied in commodities.

E. Ricardian Distribution Theory

 Laborers get wages

 Capitalists get profits
 Landowners get rents

Ricardo’s Comparative Advantage

Ricardo strengthened the case of free trade by extending Adam Smith’s analysis of the gains to be
achieved by the free movement of goods across international boundaries.

If nation A could produce a good at a lower cost than nation B, and nation B could produce another
good at lower cost than nation A, both nations would gain by practicing territorial specialization and trading.

Mercantilists’ view of aggregate demand

Most of the mercantilists believed that individual thrift and saving were beneficial to the nation. Some
however, argued, that saving caused unemployment and the greater consumption spending would increase
economic activity and thus benefit the economy.

The most forceful advocate of this view was Bernard Mandeville. He presented his views in an
allegorical poem and some prose commentaries under the title: “Fable of the Bees”. He held that prosperity and
employment were furthered by spending, particularly on luxurious consumption, and that saving was
detrimental to the economy because it led lower levels of output and employment.

Smith’s Views of aggregate demand

Smith praised frugality and saving, for according to him, it was capital accumulation that was the main
determinant of prosperity and growth.