History of Economic Thought

Lecture 7
Giorgi Bakradze
 Thomas Robert Malthus (1766-1834)
• Known for the population theory
– Won’t dwell much on it
• Other contributions:
– GDP accounting
– Value theory
– Diminishing returns
– Land rent
– Aggregate demand
 Malthus – Historical Setting
• Two major controversies:
– Increase in poverty and how to deal with it
• Negative effects of the industrial revolution
• Growing urbanization
• Poor laws – minimum income irrespective of their earnings (linked to the
price of bread)
– Corn laws
• Tariffs on imported grain
• Favoured landlords
 Malthus – Intellectual Setting
• Godwin and Condorcet
• Godwin: Perfectibility of the human race
– Advance towards higher rationality and increased well-being
– Major obstacles: private property, inequality, coercive state
• Not the population growth
• Condorcet: social progress
– Equality among nations
– Equality of individuals within nations
– Perfectibility of humanity
– Universal suffrage
– Also didn’t see the population growth as a problem
 Malthus – Population Theory
• Answer to Godwin and Condorcet
• Vices and misery are due to the prolific fertility
– We need them
– Welfare programs would counter hunger, pacifism will remove war
• Preventive checks – reduce birth rates
• Positive checks – increase death rates
 Malthus – Policy Implications
• The Poor Laws are wrong (initial claim)
– Giving the poor aid will cause more children to survive – worsening
the problem of hunger
• Modified in later editions
– Reducing the number of eligible poor
• Some ideas adopted in the amendment of 1834
– Workhouses – harsh and horrible stigma
 Malthus – Market Gluts
• Potential insufficiency of demand
– Workers receive subsistence wage
– Employers hire them because of profit (output>wages)
– Workers cannot buy back the total output – others must
– Wages cannot be increased – profit is an important incentive
– Who buys the extra output?
• Some is bought as capital goods
• Capitalists have high propensity to save – they don’t spend all of the profit
– Spending/unproductive consumption is essential to avoid the glut of goods
 Malthus – Market Gluts
• Policy implications:
– Retain corn laws – they enrich the landlord and promote
unproductive consumption
– Malthus opposed unproductive consumption by the government
• Taxes bad
• Debt bad
– For acute economic distress – government spending on public work
 Malthus - Assessment
• Was wrong on significance of rents/landlords
• Theory of glut – precursor to aggregate demand explanation of
unemployment
• Was wrong on the overpopulation/regression to subsistence
levels
– Technological progress helped
– Some Malthusians exist even today
• Value theory was based on both demand and supply
 David Ricardo (1772-1823)
• Major step in establishing economics as science (dubious, I
know)
• One of very few economists who actually made some money
• Stock broker and landlord
– One could use his money making principles
– Advocated policies that conflicted with his own personal interests
• Argued against excessive gains of the BoE (was its stockholder)
• Was the landowner – but his theories could ruin the class
• Advocated the levy on capital being one of the richest people in England
 David Ricardo (1772-1823)
• Important topics:
– Income Distribution
– Theory of Value
– Law of Comparative Advantage
– Ricardian Equivalence
– Deductive Analysis
– But also – Ricardian vice
 Ricardo – the Currency Question
• England moved to paper standard in 1797
– Price of gold rose (mint price 3.17 – market price 5.10 per ounce)
– General inflation
• Ricardo’s conclusion – overissuing
• Remedy – return to gold standard (redeeming paper for gold)
– Correct, if paper changed value
– Wrong, if gold did
• Gold standard worked until 1914
 Ricardo – Diminishing Returns and Rent
• Debate over the corn laws
• Diminishing returns first developed by Turgot
– Ricardo used the notion to formulate a marginal principle
– Important for marginalist school

• “Rent, is 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.”
• Ricardo modified this definition by including as rent the return on long-run capital
investments that are amalgamated with the land and increase its productivity.
 Rent at the Extensive Margin of Cultivation
• If fertile soil is abundant – no one pays rent
• But once the land of the second degree of fertility is taken into
cultivation – rent appears
– We talked about this in “Topics in Economics”
• Introduce third degree – second degree land gets rent too, etc.
• Produce from marginal (last degree) land will bring revenue to
cover costs+profit
– Anything above brings rent
Rent at the Extensive Margin of Cultivation
 Rent at the Intensive Margin of Cultivation
• Law of diminishing returns
– Successive units of labour and capital are added to the piece of land –
returns drop
– The last unit of labour and capital must pay for itself
– Earlier units earn a surplus return = rent
Rent at the Intensive Margin of Cultivation
 Rent
• Every increase in price of wheat raises rents
– Tariffs
– Population growth
• Rent is a differential return and surplus above costs
• Rent is price-determined but not price determining
• High rents cannot explain high prices
 Theory of Exchange Value and Relative Prices
• In order for a commodity to have exchange value, it must have
use value
• Two sources of exchange value
– Scarcity (only source if nonreproducible commodity)
– Quantity of labour necessary to obtain them
• Labour theory of value only relevant for reproducible goods
 Labor Theory of Value
• For simple economic activities such as hunting and
fishing, the Labor Theory of Value was fine according to
Ricardo
– Smith had the same view
• This is an illustration of the classical idea that in the long
run demand has no influence on (relative) prices.
 Labor Theory of Value
• But now consider a case where production takes time.
• Consider a ton of wheat and a ton of rice available for sale today.
• Suppose both require five hours of labor to produce.
• However, suppose wheat takes two years to mature after cultivation whereas rice is produced
instantaneously.
– In this case, the rice purchased today was made today whereas the wheat purchased today was made two
years ago.
• So whereas the rice farmer would simply have to pay for five hours of labor upon the sale of the rice,
the wheat farmer would have to pay for five hours of labor plus two years’ interest to the workers
whom he has kept waiting for two years.
• As a result, the wheat would cost more than the rice even though both wheat and rice require the
same amount of labor to produce.
• This is another way of saying that for complex cases the Labor Theory of Value is not valid.
 Labor Theory of Value
• Ricardo was also aware that even if wheat and rice took the same
amount of time to be produced, the LTV would still be in trouble if
the fertility of land varied from one place to another.
• When fertility varied from one plot of land to another, the amount
of labor needed to produce a ton of wheat (or rice) would not be
fixed but would instead depend on the fertility of the land being
used.
• As a result the LTV could not be readily applied.
 Labor Theory of Value
• Suppose a ton of rice grown on less fertile Type B land requires 4
hours of labor whereas a ton of rice grown on more fertile Type A
land requires 2 hours of labor.
• Would we then say that the price of the first ton of rice would be
twice the price of the second ton of rice?
• Clearly such an application of the Labor Theory of Value would
make no sense because the price of a ton of rice must necessarily
be the same irrespective of what type of land it was produced on.
 Labor Theory of Value
• To restore the applicability of the LTV, Ricardo used the zero-rent land—land that
farmers could use without paying any rent.
• The cost—and, therefore, the price—of a ton of rice on such zero-rent land would
be only the wages for the labor needed to make a ton of rice on zero-rent land.
• Therefore, one could say if a ton of wheat grown on zero-rent land required twice as
much labor as a ton of rice grown on zero-rent land, then the price of a ton of wheat
would be twice the price of a ton of rice.
 Labor Theory of Value
• Thus the LTV could be applied even when the fertility of
land varies from plot to plot provided it is understood that
what mattered was the labor needed for production of a
good on zero-rent land.
 Labor Theory of Value
• What if agriculture requires workers and shovels?
• No problem. Simply calculate the labor needed to make shovels,
measure the labor needed to make a ton of rice on zero-rent land
as the sum of farm labor plus the labor needed to make the
shovels and then apply the LTV as before.
– Of course, I am using ‘shovels’ as a stand-in for all capital goods.
 Theory of Exchange Value and Relative Prices
• Unlike Smith, Ricardo applied his LTV to an advanced economy
• EV of a commodity depends on the labour time necessary to
produce it
– Work done in making it
– Work embodied in the raw materials and capital goods used up in the
production process
– This approach allows to determine the cause of changes in EV over
time
 Theory of Exchange Value and Relative Prices
• Problem: differing capital-labour ratios
– If all commodities are sold at their labour value, rates of return to
capital would differ across sectors
– Cannot happen in a competitive economy
• Ricardo: cause of variation in the value is slight in its effect
– Commodity will sell at more than its LTV if more-than-average capital
is invested and vice versa
– Labour time is much more important
 Theory of Exchange Value and Relative Prices
• Differences in labour quality
– High-skilled workers can produce more per hour than low-skilled
– Wide variation in the combinations of grades of labor
– Problem?
• Ricardo’s answer: if labour of type A is twice productive – hour
of A is twice hour of B
 Theory of Exchange Value and Relative Prices
• Wages, profits and rents
– EV doesn’t depend on wages (just on quantity of labour)
– Wages and profits vary inversely (more details later)
– Change in the wage rates affects only profits/wages, not the EV
– Same goes for changes in profits
– Rents do not include prices of goods at all
 Relative Prices
• Market price can deviate from natural price (value)
– Fluctuations in demand and supply
– Regulated by flows of capital in and out of industry
– Rates of profit are equalized
• Long-run prices depend on the real costs of production
• Relative real costs are proportional to the total quantity of
labour
 Functional Distribution of Income
• Ricardo considered a world with
– three factors of production
• land,
• labor, and
• capital goods
– and three classes of people:
• landlords,
• workers, and
• capitalists.
• Ricardo focused on income distribution among the three classes
 Functional Distribution of Income
• Landlords earn rent,
• workers earn wages, and
• capitalists earn profits.
• Ricardo wanted to show how the total output of a society is
distributed among wages, rent, and profits.
 Wages
• Labour has its natural price and market price
• Natural price of labour is a subsistence wage
– Depends on the price of bare necessities
– Costs rise – real wage stays the same
• Market price of labour fluctuates around the natural price
– Depends on demand/supply
• In the long run natural price of labour and nominal wages
tend to rise when the cost of food rises due to larger
population
 Wages
• Ricardo used the Iron Law of Wages
– This idea argued that the wage would in the long run equal the subsistence
wage, which is the bare minimum necessary for survival (Malthus)
– Population changes will drive the long run wages to subsistence level
• However
– With expanding capital the wages fund may rise faster than population
– Natural wage is not biologically subsistence wage, rather depends on the habits
and customs of the people
 Profits
• Profits are the main source of capital accumulation.
• If the current rate of profit is higher than the minimum rate of
profit that is acceptable to capitalists, more capital will be
accumulated.
• Price movements influence rates of profits, which direct the
flow of capital
• Rates of profit are thus equalized across sectors
• Rate of profit on the marginal land (rent=zero) governs the rate
of profit for the whole economy
 Profits
• Profits and wages vary inversely
– Why not pass higher wages to higher prices?
– BoP – money will flow out because of cheaper imports
– Hence prices cannot rise (money supply goes down)
– Employers have to bear higher costs of production
• In the long run profits will fall (because wages must rise
because population grows)
• Ending up in stationary state
 Stationary State
• The falling rate of profit leads to a slowdown in capital
accumulation.
• Ultimately growth stops altogether; a steady state is
reached.
– Ricardo assumed that only the profit income of the capitalists is
used for the accumulation of new capital goods.
– The landlords are parasites who blow their rent earnings on
consumer goods.
• Adam Smith had a similar view of landlords
 Rents
• Rent as Residual: Ricardo assumed that each landlord
hires labor and capital—at the prevailing market-wide
prices of these two resources—and keeps as rent
whatever output is left.
– Recall that Adam Smith too thought of rent as a residual
 Rents
• Population grows – food demand grows – prices grow –
marginal land extends further – rents rise
• Nominal wages also rise
• Only profits/share of profit in incomes fall
Rents
 Policy Implications
• Wages should not be regulated
• No relief to the poor
• Introduce tax on rent, since it cannot be shifted to anyone else
– Rent cannot increase
– Prices cannot rise
• Criticism of corn laws
– Again, against landlords
 Main Issue in Economics
• The inevitability of the steady state is why Ricardo came to the conclusion
that it was a waste of time to worry about long-run economic growth.
• More important was the issue of how the steady state output is distributed
among the different classes.
• Ricardo’s belief that total output will ultimately stop growing convinced him
that the main issue in economics was not to figure out how economies grow
richer but to figure out how the limited output in the economy’s stationary
state is distributed or shared among the various sectors of the economy.
 Main Issue in Economics
• “Political Economy, you think, is an enquiry into the nature and
causes of wealth -- I think it should rather be called an enquiry
into the laws which determine the division of produce of industry
amongst the classes that concur in its formation. No law can be
laid down respecting quantity, but a tolerably correct one can be
laid down respecting proportions. Every day I am more satisfied
that the former enquiry is vain and delusive, and the latter the only
true object of the science.”
– David Ricardo, “Letter to T. R. Malthus, October 9, 1820”, in Collected
Works, Vol. VIII: p.278-9.
 Trade: Law of Comparative Advantage
• Ricardo’s Law of Comparative Advantage improved upon the
earlier Law of Absolute Advantage. How?
• If A (Advancedland) is more productive than B (Backwardland) in
every productive activity, would both countries benefit from trade?
• The law of absolute advantage has no answer to this question.
• Ricardo's law of comparative advantage showed that the answer
is yes.
 Comparative Advantage
• Ricardo's disagreement with Malthus on the import tariffs
embedded in the Corn Laws—Ricardo was against the
tariffs, of course—was rooted in his theory of trade.
 Public Finance: Ricardian Equivalence
• This idea says that, under certain conditions, it does not
matter whether a government pays for its expenditures
through taxes or through debt.
– This idea of Ricardo on public finance has, under the name of
Ricardian Equivalence, become an important player even in
contemporary debates on how governments should pay for
their expenditures.
 Tax-Financed Government Spending
• Suppose the government spends one dollar this year and
charges Ms. Citizen a tax of one dollar to pay for the
spending.
• The dollar leaves Ms. Citizen’s purse, never to return.
• Saving decreases.
 Debt-Financed Government Spending
• The government pays for its expenditures by borrowing one dollar.
• Ms. Citizen breathes a sigh of relief at not having to pay taxes.
• But she quickly realizes that next year the government will have to pay the borrowed money
back with interest.
• As the interest rate is 10%, the government will need $1.10 next year.
– As it can’t keep incurring new debts to repay old debts, there will come a time when the government will have to
raise taxes to repay its debts.
• Let’s say the government will be forced to raise taxes by $1.10 to repay the debt it incurred
this year.
• Ms. Citizen sees the tax coming. She puts one dollar in her bank account today. That way
she will have $1.10 in her account a year later, and that will be just enough to pay next
year’s anticipated tax.
• Ms. Citizen’s initial relief at having escaped the tax this year is, therefore, replaced with the
realization that even in this case a dollar has left her purse, never to return.
• Saving decreases.
 Ricardian Equivalence
• Equivalence: Tax-financed government spending
therefore has the same effect on Ms. Citizen as debt-
financed government spending.
• Therefore, both the government and Ms. Citizen behave
the same in the two regimes and the economic outcome
is identical.
 Deductive Analysis
• Ricardo’s analytical style was deductive.
• In deductive analysis, one first imagines a model economy (as it is usually
much simpler to think about than an actual economy) and then figures out
how that model economy would behave under alternative economic policies.
• If the model economy is essentially similar to actual economies, policies that
are effective in the model economy will also be effective in actual economies.
• Ricardo’s analytical style is very modern in the sense that it is similar to the
way an economic theorist today may think through a problem.
• Too many simplifying assumptions – Ricardian vice
 Assessment
• Plus side
– Comparative advantage
– Use of abstract reasoning
– Marginal analysis
– Law of diminishing returns
– Distribution of income
• Minus side
– No mention of technological advance
– Land having single use – it doesn’t and rent is a cost of production
– Labour theory of value
 Readings
• Brue, Grant – Chapters 6-7

• Optional:
– Backhouse, pages 137-141
– The Worldly Philosophers by Robert Heilbroner, Chapter IV (The Gloomy
Presentiments of Parson Malthus and David Ricardo)
– New Ideas from Dead Economists by Todd Buchholz, Chapter IV (David Ricardo
and the Cry for Free Trade)