David Ricardo

History of Economic Thought

 • Son of a wealthy English capitalist
• Became Quaker, then Independent
• Wealthy (£600,000 pounds in 1823)
• Regarded as the most rigorous theoretician of the
classical economists.
• His style of abstract deductive economic models
dominates economic theory to present.
• Purchased a seat at the British parliament
• Friend of Malthus, J.S. Mill, and Jeremy Bentham
• Accepted Malthus’s Population Theory & his theories
about the nature and causes of worker’s poverty.
• Malthus’s theory of rent complemented Ricardo’s
later theory of profits
• Developed a Theory of distribution in An Essay on the
David Influence of a Low Price of Corn on Profits of Stock
• Died from an infection of the middle ear that spread into
Ricardo (1772- the brain
 Ricardo’s Theory of Rent

Ricardo’s Principles of Political Economy & Taxation

Rent: “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.”
Two Assumptions:
1. Land differed in its fertility with land being arranged in a spectrum from most fertile to least fertile.

2. Competition always equalized the rate of profit among capitalist farmers who rented land from the landlords.

• Net produce is therefore the total surplus value (created by labor), which goes to either profits or rent.

Chapter 5 - 1
 Ricardo’s Theory of Rent: A Summary
• Land is not unlimited and land quality varies.
• Because of population growth, we will at some point have to start cultivating land of inferior
quality.
• When we begin cultivating land of secondary fertility/quality, we start charging rent on the
higher quality (“first” quality) land.
• The rent charged on the most fertile land depends on the difference in fertility/quality
between the two plots of land.
• When we start to cultivate on land of the third quality (even less fertile), we will start charging
rent on the secondary land.
• At the same time, rent on the first-quality land will increase, since the most fertile land should
always be more than rent on land of secondary quality.
• As population increases, we will have to cultivate land of lesser and lesser quality in order to
continue increasing the supply of food. rent on the most fertile land will rise.
𝑒𝑡𝑃𝑟𝑜𝑑𝑢𝑐𝑒=𝑇𝑜𝑡𝑎𝑙𝑄−𝑁𝑒𝑐𝑒𝑠𝑠𝑎𝑟𝑦𝐶𝑜𝑠𝑡𝑠𝑜𝑓 𝑃𝑟𝑜𝑑𝑢𝑐𝑡𝑖
The rate of profit received by capitalist farmers will be the same for each plot of land.
Theory of Rent II
Competition would equalize the rate of profit for all capitalists.
• “To quit a less profitable [business] for a more advantageous business has a strong
tendency to equalize the rate of profits of all.”
Suppose the capitalist farmer on No 1 paid only 15 units of corn as rent to No 1’s
landlord after No 3 was brought into cultivation.
• His profit would be 85 units of corn, while farmers on No 2 and No 3 each only make
80.
• Gives farmers on No 2 and No 3 an incentive to offer the landlord of No 1, say 18 units of corn to
let them farm his land.
• As long as the rent on No 1 is below 20 units of corn, capitalist farmers would continue to have an
incentive to bid the rent up.
• When the rent is bid up to 20, they no longer have this incentive, because the rate of profit would
then be the same for all capitalist farmers.
This downward sloping line (NP) shows
the diminishing fertility of land.
• Net produce per small unit of land
diminishes as the quantity of land
under cultivation increases.
• NP (Net Produce)= Profits + rents
 Assuming the wage is the only cost of production,
We can add the wages paid per unit of land farmed
to line NP to show Total Produce (line P)
• P= profits + rents + wages
• If x units of land are under cultivation, then y
will be the total produce on the last unit of land
brought into cultivation (no-rent or “marginal”
land).
• So Profit on the last unit of land cultivated
is what is left over after paying wages.

Triangle a : the total amount of rent received by the landlord class

Triangle b : the total amount of profit received by the capitalist class
 Ricardo’s Corn Theory of Profits
Ricardo accepted Malthus’s population theory and its most important corollary: population growth
would tend to force the wages of laborers to subsistence level.
• Therefore, the level of profit on the no-rent land was the total produce of that land minus the
subsistence of the labor working on the land

• There’s no rent on marginal land, so TP on the last unit of land cultivated is just profits+ rents, so Profits= total produce-wages
• i.e., profit was simply what was left over after paying wages.
Ricardo’s simple model:
• Only one commodity is produced (corn)
• Wages are paid in corn

• Since the net produce will decrease with each less fertile plot of land cultivated…
• …assuming the corn-wage remains the same…
• The rate of profit must decrease.
 Ricardo and the Relationship between Profits,
Rent and Prosperity.

“the interest of the landlord is always opposed to the interest of every

other class in the community”
Economic well being is tied to Capital Accumulation:
1. Capital Accumulation → 2. Rising Labor Demand → 3. Rising Market Wages → 4. Rising Population
• As long as the capitalists continue to make profits, this sequence can repeat itself over and over again , the economy is growing and there would
be general prosperity...
• However, diminishing productivity in agriculture would cause rents to squeeze profits, which would hurt the economy.

→ 5. Increased Food Demands → 6. Less Fertile Land Use → 7. Rising Food Production Cost → 8. Rising Rents →
9. Falling Profits →10. Declining Capital Accumulation

~Rising Rents are an Economic and Social Constraint.

Chapter 5 -3
• As we bring less fertile land into cultivation ( ), wages remain the same, profits get lower, and rent expands.
• ( ), wages get pushed back down to subsistence, rent expands, and there will be no profits!

Ricardo believed that diminishing productivity in agriculture would steadily squeeze out profits because of higher and
higher rents.
 Ricardo: Landlords vs Capitalists
Diminishing productivity in agriculture would cause profits to be squeezed out steadily
by higher and higher rents.
• Rent is not, per Ricardo, directly responsible for squeezing out profit.
• Ricardo blames the increase in the cost of labor, resulting from the increase in the
cost of corn (which workers require for subsistence).
• Assuming the purchasing power of money is constant
• If competition equalizes all rates of profit when the price of corn and labor increase,
prices would have to adjust in all sectors to equalize the rate of profit in those sectors.
• Corn’s price now embodies more labor, since labor is less productive on each new plot
of land under cultivation lower profits.
a decline in the profit rate a decline in the rate of accumulation, which slows
economic growth and decreases general social welfare.
 Ricardo and Exchange Value (Labor Theory of Value)

Commodities have exchange value because they possess Utility.

I. Two Sources of Exchange Value:
1. “Scarcity” – Regulates the price of those goods perceived as non-reproducible luxuries, such as
paintings, wine, statues, etc.
• These can have value “wholly independent of the quantity of labour originally necessary to produce them…
and varies with the varying wealth and inclinations of those who are desirous to possess them.”
• Ricardo dismisses this view of pricing as being the exception rather than the rule. If a nation’s production of freely
reproducible commodities were to decline, then regardless of the existence of non-reproducible luxuries, the nation would
decline economically.

2. “Quantity of Labour Required to Obtain Them” – Implying that the more labor embodied in a
commodity necessitates that the purchase of that commodity requires the sale of something of
containing an equal amount of labor.
• Ricardo accepts this view as capturing the exchange value of freely reproducible commodities which are the
lifeblood of a healthy economy and the source of wealth within any given economy.
Chapter 5 -7
Price Determinations with Different
Combinations of Capital
• Recall that Smith’s theory of prices was circular
• Ricardo (and Marx) realized the labor embodied in commodities
served as a factor that is not a price.
• To prove this, Ricardo had to show that even with differing ratios of capital to
labor, we can derive exchange value (price) from the labor embodied in a
commodity.
 Example set-up
• two capitalist firms.
• Firm 1 spends almost all of its funds paying workers’ wages,
• Firm 2 uses mostly expensive machines, only spending a little on wages
• If in the first period of production each firm employs 100 workers, the price of the first
firm’s commodity will have to be equal to the wages of those workers plus profits (let’s
say 10% of the surplus goes to capitalists as profits).
• The price of the firm 2’s commodity will be higher;
• the second firm’s commodity contains the labor of 100 workers, plus some of the labor of the
workers who produced expensive machines.
• The second firm’s price will include the wages of 100 workers, plus 10% of the surplus that goes
to wages, plus the cost of machines that are used in production.
• Let’s assume when the costs are totaled, the price of the second commodity is twice
that of the first.
 Example set-up II
Assume in the next production period, the wage rate increases.
• higher wages will result in decreases in profits.
• But if the labor embodied in the commodities is the only determinant of their prices, the relative prices
should remain the same because the labor embodied didn’t change.
Let’s consider those new prices
• Firm 1 produces good 1 and 90% of the surplus goes to wages, 10% to profits.
• The increase in the wage will have a big effect on the new price, which will have to go up substantially
and in doing so, profit wont really be affected too much.
• Firm 2 produces good 2 and they pay 10% of the surplus to wages and 90% to capital
(profit they can reinvest).
• Wages are but a small percent of good 2’s costs, so the impact of increased wages on total costs will
be small.
• Cost of machinery might go up or down, depending on the impact the wage increase has on the
companies who make the machines, but we include the profits on both the labor and machinery
used in production,
• so technically the effect of the new lower rate of profit will be a greater cost for firm 2 than it is firm 1.
Given: Two Firms (Firm 1 and Firm 2)
Differing K/N Ratios K1/N1 < K2/N2

~With respect to the Firm 2, What is the Price Effect

Associated with an Increase in the Wage Rate?
1. If the wage increase causes wage costs to rise by more than the resulting profit cost reduction
associated with the profit rate reduction, then the price of Good 2 will rise.

2. If the wage increase causes wage costs to rise by an amount equal to the decrease in profit costs
associated with the reduction in profit rates, then the price of Good 2 will remain the same.

3. If the wage increase causes wage costs to rise by an amount less than the decrease in profit
costs associated with the reduction in profit rates, then the price of Good 2 will fall.
*Regardless of what happens to the price of Good 2, given the
circumstance, the price of Good 1 will rise (relative) by more than the
price of Good 2.
Most important point: The price ratio has changed while the quantities of labor
embodied in the two commodities has remained unchanged.

Chapter 5 - 9
Ricardo’s Three Circumstances in Which a Changing Wage Rate
Changes Relative Prices

1. Differing K/N Ratios

2. Comparable K/N Ratios, however, some Firm’s K is more
Durable than other Firm’s K.
3. Comparable K/N Ratios, however, some Firm’s K is held
longer than other Firm’s K until receiving a return.
Summary,
i. If Capital is actually Past Labor, then each of the above
circumstances represent instances of differing K/N ratios.

ii. Because Past Labor implies a time element, every production

process entails different time sequence of labor inputs.

Chapter 5 - 10
 3 Observations: Summarized
1.Changing the wage rate substantially alters the relative prices of x and y. In the first
table, the price of x is more than double the price of y, but its only slightly higher in
the second table.
• This shows that it is the difference in profits that causes prices not to be proportional to labor
embodied.
2.An increase in the wage rate can only be achieved through a decrease in the profit
rate.
• The price of x is lower in the second case than in the first (15.21 compared to 10.62) as, per
Ricardo, a consequence of doubling the wage rate.
• This is why Ricardo rejected Smith’s assertion that increasing wages always increases prices.
Smith made this assertion using an example where he didn’t vary the technique of production
as Ricardo did to make his point.
3.As long as the profit rate is positive, x will always have a higher price than y because
x’s K/L ratio is higher than y’s.
Ricardo’s Response to Criticisms of the
Labor Theory of Value
I. Two Criticisms:

1. ~Criticism: The LTV cannot account for the combination of different types of labor with
different skills and differing wage rates
~Response: In general and across generations it takes the same amount of time for any
one person to develop a more productive set of skills. This implies that if any one
person can acquire a skill set any other person is also likely to be able to acquire the
same skill set. Therefore the time necessary, and labor time embodied, in the
development of the skill set can be generalized as a multiple of any type of unskilled
labor.

2. ~Criticism: The LTV cannot account for the increased productivity of labor associated
with the use of land and capital.
~Response: Tools (capital) are merely the embodiment of past labor exertions, while
land is itself inert until human labor is expended in its transformation. Therefore,
whether tools or land, production is always a series of labor exertions.

Chapter 5- 8
Malthus Regarding Market Disequilibrium: The
Theory of Gluts
I. In Times of Prosperity Capitalists will Invest in either
(1) New Capital of the same Technology or (2) New Capital
which embodies New Technology.
1. In the case of New Capital of the same Technology, the sudden
increase in Capital would outstrip the existing labor supply causing a.)
some Capital to lay idle and b.) wages to rise. Whether Capital is idle
or wage increases cause profits to decline, both circumstances cause
the capitalist to not reinvest (hoard cash).

2. In the case of New Capital which embodies New Technology, the

same quantity of output can be produced using less labor. The
displacement of labor then reduces demand causing a glut.

Chapter 5- 4
 Malthus’s Solution for the Problem of Gluts

~Because Gluts are caused by excessive

profits thereby driving the excessive
accumulation of K and the subsequent glut
induced economic downturn

*As a result, Malthus suggests a redistribution policy to

encourage an increase in income for landlords. Malthus’s
policy of choice being the Corn Laws

Chapter 5 -5
 Ricardo’s Response to Malthus’s Theory of
Gluts

1. The idea of landlord’s being necessary to offset the appearance of gluts is

considered an absurdity. The position essentially advocates that capitalists
subsidize the unproductive consumption of the landlord. The capitalist may
as well advocate a fire in her warehouse thereby destroying the available
commodities.

2. Supply will create its own demand, essentially Say’s law prior to Say.

Chapter 5- 6
The Theory of Comparative Advantage &
International Trade
Ricardo is the first economist to argue consistently that free
international trade could benefit two countries, even if one country
produces all of the trades commodities more efficiently than the other.
• a country doesn’t need absolute advantage in the production of a
commodity in order to engage in mutually beneficial trade
• Two countries could benefit from trade if each had a relative
advantage in production
• One of the first to argue that because capital was relatively immobile,
a separate theory of international trade is needed.
Machinery as a Source of Involuntary
Unemployment
“The substitution of machinery for human labor is often very injurious to the interests of the class of
labourers.”
• Workers would be made to produce capital goods instead of wage goods fewer wage goods and reduced
demand for labor.
• machinery is implemented to reduce the number of workers necessary to produce a given output (i.e., to
reduce the capitalist’s wage costs and increase profits).
• Net income (profits and rents) of society increases
• while gross income (profits, rents, and wages) is being reduced.
He concludes, " the opinion entertained by the labouring class, that the employment of machinery is
frequently detrimental to their interests, is not founded on prejudice and error, but is conformable to the
correct principles of political economy.“
• Technical admission that the market may not be effective in reallocating resources when a change in the
conditions of production takes place.
• His faith that the accumulation of capital  economic welfare for society is unfounded.
Ends the chapter still in favor of the use of machinery and his main sympathy still with the capitalist class.
• "wages should be left to the fair and free competition of the market, and should never be controlled by the
interference of the legislature."