David Ricardo

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David Ricardo

David Ricardo (April 18, 1772 – September 11, 1823), was a British economist, a successful businessman, financier, and speculator, and amassed a considerable fortune. He is credited with systematizing economics in the nineteenth century, and was one of the most influential of the classical economists. Despite his relatively short career, Ricardo's work in economics was foundational to many later developments in the field. Both those who favored his laissez-faire capitalism, and those who opposed it, drew on his work despite their abstract formulation. As a politician, albeit briefly, Ricardo was able to present his opinions regarding various issues, and his stature in the newly emerging field of economics caused them to be received with respect and acted upon. His promotion of free trade supported the growth of British industry. While Ricardo's theories have been modified and superseded, his foundational role in the development of economics remains, as does much of Britain's economic success and influence in the world during the nineteenth century.

Contents

Biography

Born in London, 'David Ricardo was the third of 17 children in a Sephardic Jewish family (from Portugal) that emigrated from the Netherlands to England just prior to his birth. At age 14, Ricardo joined his father at the London Stock Exchange, where he began to learn about the workings of finance. This beginning set the stage for Ricardo's later success in the stock market and real estate.

Ricardo rejected the orthodox Jewish beliefs of his family and eloped with a Quakeress, Priscilla Anne Wilkinson, when he was 21. He later became a Unitarian, and was disinherited by his family. It is likely that his mother never spoke to him again.

Ricardo became interested in economics after reading Adam Smith's The Wealth of Nations in 1799 on a vacation to the English resort of Bath.

His work with the stock exchange made Ricardo quite wealthy, which allowed him to retire from business in 1814 at the age of 42. He then purchased and moved to Gatcombe Park, an estate in Gloucestershire.

In 1819, Ricardo purchased a seat in the British parliament as a representative of Portarlington, a borough in Ireland. He held the post until the year of his death in 1823. As a member of parliament, Ricardo advocated free trade and the repeal of the Corn Laws.

Ricardo was a close friend of James Mill, who encouraged him in his political ambitions and writings about economics. Other notable friends included Jeremy Bentham and Thomas Robert Malthus, with whom Ricardo had a considerable debate (in correspondence) over such things as the role of land owners in society. He also was a member of London's intellectuals, later becoming a member of Malthus' Political Economy Club, and a member of the King of Clubs.

He died at Gatcombe Park at 51 years-of-age.

Work

Ricardo first gained notice among economists over the "bullion controversy." In 1809 he wrote that England's inflation was the result of the Bank of England's propensity to issue excess bank notes. In short, Ricardo was an early believer in the quantity theory of money, or what is known today as monetarism.

His law of rent was probably Ricardo's most notable and influential discovery. It was based on the observation that the differing fertility of land yielded unequal profits compared to the capital and labor applied to it. His other great contribution, the law of comparative cost, or comparative advantage, demonstrated the benefits of international specialization of the commodity composition of international trade.

Law of Rent

Ricardo formulate the "law of rent" around 1809. It was the first clear exposition of the source and magnitude of land rents, and is among the most important and firmly established principles of economics. The Law of Rent states that the rent of a land site is equal to the economic advantage obtained by using the site in its most productive use, relative to the advantage obtained by using marginal (the best rent-free) land for the same purpose, given the same inputs of labor and capital.

To see how competition generates rent and, therefore, determines the magnitudes of the two remaining shares, we follow Ricardo's original logic. He began by noting that if land is not scarce, then it generates no rent.

If all land had the same properties, if it were unlimited in quantity, and uniform in quality, no charge could be made for its use. (Ricardo 1821, 71)

But, of course, land is scarce and of differing qualities. As population increases, it becomes necessary to cultivate less quality land. Given competition among farmers, and assuming, for example, that there is a difference of ten units of corn in profits between the highest quality land and a low quality land, the farmer on the lower quality land would bid up to ten units in order to farm on the highest quality land. As Ricardo tells the story, the landowner of the higher quality land would insist on a ten unit rent

... and if the original tenant refused, some other person would be found willing to give all which exceeded that rate of profit to the owner of the land from which he derived it. (Ricardo 1821, 72)

With this simple model, Ricardo could explain how the two remaining shares, rent and profits, were determined. The logic is crystal clear:

  1. A given population requires a certain amount of food.
  2. The lowest quality land called into cultivation generates some profit (total revenue—wages).
  3. This profit becomes the prevailing profit through competition among farmers—any difference between the profit generated by higher quality land and the profit generated by the lowest quality land accrues to the landowner as rent.

This law has a number of important implications, perhaps the most important being its implication for wages. The law of rent implies that wages bear no systematic relationship to the productivity of labor, and are instead determined solely by its productivity "on marginal land,"[1][2] as all production in excess of that amount will be appropriated by landowners in rent.

The law of rent makes it clear that the landowner has no role in setting land rents: he simply appropriates the additional production his more advantageous site makes possible, compared to marginal sites. The law also implies that the landowner cannot pass on the burden of any cost such as land taxes to his tenants, as long as such costs do not affect the relative productivity of his land and marginal land.

Theory of Comparative Advantage

In his 1815 work, Essay on the Influence of a Low Price of Corn on the Profits of Stock, Ricardo articulated what came to be known as the "law of diminishing returns." One of the most famous laws of economics, it holds that as more and more resources are combined in production with a fixed resource—for example, as more labor and machinery are used on a fixed amount of land—the additions to output will diminish.

Ricardo also opposed the protectionist Corn Laws, which restricted imports of wheat. In arguing for free trade, Ricardo formulated the idea of comparative costs, today called "comparative advantage." Comparative advantage, a very subtle idea, is the main basis for most economists' belief in free trade today. The idea is this: A country that trades for products that it can get at lower cost from another country is better off than if it had made the products at home.

Ricardo illustrated this by means of a comparison of the productivity of two imaginary countries, "Richland" and "Poorland." The gains in foreign trade for both of his imaginary countries come, Ricardo observed, because each country specializes in producing the goods for which its comparative cost is lower (Ricardo 1815). In his example, both countries produce wine and bread, but "Richland's" workers are more productive, requiring fewer hours of labor to produce each item:

One might think at first that because Richland requires fewer labor hours to produce either of the goods, it has nothing to gain from trade. Think again. ... If they exchange wine and bread one-for-one, Poorland can specialize in producing wine and trading some of it to Richland, and Richland can specialize in producing bread. Both Richland and Poorland will be better off than if they hadn't traded. (Ricardo 1815)

Analyzing this in more detail, the following table considers England and Portugal as producers of wheat and wine.

COUNTRY WHEAT WINE
Cost per Unit in Man Hours Cost per Unit in Man Hours
England 15 30
Portugal 10 15

It can be seen that Portugal can produce both wheat and wine more cheaply than England (it has an absolute advantage in both commodities). What David Ricardo saw was that it could still be mutually beneficial for both countries to specialize and trade. In Table 1, a unit of wine in England costs the same amount to produce as two units of wheat. Production of an extra unit of wine means foregoing production of two units of wheat—thus, the "opportunity cost" of a unit of wine is two units of wheat. In Portugal, a unit of wine costs one and a half units of wheat to produce—thus, the "opportunity cost" of a unit of wine is 1.5 units of wheat in Portugal. Because relative or comparative costs differ, it will still be mutually advantageous for both countries to trade, even though Portugal has an absolute advantage in both commodities. Portugal is relatively better at producing wine than wheat: so Portugal is said to have a comparative advantage in the production of wine. England is relatively better at producing wheat than wine: so England is said to have a comparative advantage in the production of wheat.

When both countries specialize and trade their products, both countries gain. These gains come, Ricardo observed, because each country specializes in producing the goods for which its comparative cost is lower.

Writing a century before Paul Samuelson and other modern economists popularized the use of equations, Ricardo is still esteemed for his uncanny ability to arrive at complex conclusions without any of the mathematical tools now deemed essential. As economist David Friedman (1992) put it in his textbook, Price Theory, "The modern economist reading Ricardo's Principles feels rather as a member of one of the Mount Everest expeditions would feel if, arriving at the top of the mountain, he encountered a hiker clad in T-shirt and tennis shoes."

Principles of Political Economy and Taxation

The fundamental doctrine of Ricardo's work Principles of Political Economy and Taxation is that, on the hypothesis of free competition, exchange value is determined by the labor expended in production. Ricardo's theory of distribution can been briefly enunciated as follows:

  1. The demand for food determines the margin of cultivation;
  2. this margin determines rent;
  3. the amount necessary to maintain the laborer determines wages;
  4. the difference between the amount produced by a given quantity of labor at the margin and the wages of that labor determines profit.

The produce of the earth - all that is derived from its surface by the united application of labor, machinery, and capital, is divided among three classes of the community; namely, the proprietor of the land, the owner of the stock or capital necessary for its cultivation, and the laborers by whose industry it is cultivated. But in different stages of society, the proportions of the whole produce of the earth which will be allotted to each of these classes, under the names of rent, profit, and wages, will be essentially different; depending mainly on the actual fertility of the soil, on the accumulation of capital and population, and on the skill, ingenuity, and instruments employed in agriculture. (Ricardo 1817, Preface)

A considerable portion of the work is devoted to a study of taxation, which requires to be considered as a part of the problem of distribution. A tax is not always paid by those on whom it is imposed; it is therefore necessary to determine the ultimate, as distinguished from the immediate, incidence of every form of taxation. Adam Smith had already dealt with this question; Ricardo criticized and developed his results:

In 1815, Mr. Malthus ... presented to the world the true doctrine of rent; without a knowledge of which, it is impossible to understand the effect of the progress of wealth on profits and wages, or to trace satisfactorily the influence of taxation on different classes of the community; particularly when the commodities taxed are the productions immediately derived from the surface of the earth. ... Adam Smith ... not having viewed correctly the principles of rent, have, it appears to me, overlooked many important truths, which can only be discovered after the subject of rent is thoroughly understood. To supply this deficiency, abilities are required of a far superior cast to any possessed by the writer of the following pages; yet, after having given to this subject his best consideration ... opinions on the laws of profits and wages, and on the operation of taxes are presented. (Ricardo, 1817)

The conclusions at which he arrived can be summarized as follows:

  • a tax on raw produce falls on the consumer, but will also diminish profits;
  • a tax on rents falls on the landlord;
  • taxes on houses will be divided between the occupier and the ground landlord;
  • taxes on profits will be paid by the consumer, and taxes on wages by the capitalist.

Ricardo also developed a theory of foreign trade, which has been embodied in the two propositions:

  1. International values are not determined in the same way as domestic values;
  2. the medium of exchange is distributed so as to bring trade to the condition it would be in if it were conducted by barter.

Ricardo’s model of macro-economic relations

Ricardo’s approach to economics differed markedly from that of Adam Smith. Ricardo was a pure theoretician, an architect of a simple, highly abstract model from which he drew policy conclusions. His most important assumption was that economic growth must decline and end due to the scarcity of land and its falling marginal productivity. In this, we see the origin of John Stuart Mill’s later contention that economic stagnation would flow from the working out of the capitalist productive process. It also is very suggestive of later arguments by John Maynard Keynes of the continuing potential macro-stagnation that, according to Keynes and many of his followers, flows from a chronic insufficiency of aggregate demand in any relatively closed-market economy.

Ricardo’s foremost contemporary critic was Malthus, author of the famous pamphlet An Essay on the Principle of Population. It was from Malthus that Ricardo took the argument of an ever-growing population that pressed against all economic expansions, an assumption that lay at the heart of Ricardo’s model. His central consideration in his Principles was to show how distributional changes between wages, rent, interest, and profit affected the prospects for long-run capital accumulation and economic growth.

Because his model produced a falling rate of profit and an ever-rising price for corn (grains), Ricardo favored an end to the Corn Laws, arguing that Britain ought to import corn from countries better equipped to produce it at lower cost. He was opposed to the rising rents he attributed to the laws, since they came, in his view, at the expense of the driving force of the economy—profits (Formaini 2000).

Ricardo’s theory of rent was tied directly to the marginal productivity of land, his theory of value was tied directly to labor costs, and his theory of distribution stood atop both concepts, with Malthusian economic stagnation as a major assumption. Ricardo was not as naive as to attempt to explain all market prices by labor costs. He recognized the importance of “non-reproducible” commodities whose value was solely determined by their rarity in the market. However, he considered such things as rare paintings and fine wines to be a small portion of overall market consumption. He also allowed a role for capital in determining value and argued that an increase in fixed (more permanent) capital as opposed to circulating (perishable) capital would increase value. By allowing value to be influenced by capital, Ricardo indirectly suggested that time played a major role in value, a discovery later generally attributed to other economists (Formaini 2000).

Another major contribution Ricardo made to economics was the doctrine of fiscal equivalence, or, as it has come to be known today, Ricardian equivalence. His argument, as put forth in Chapter 17 of his Principles is as follows: It matters not whether government finances itself through taxes or debt. They are equivalent and have no appreciable effect on household consumption or capital formation. This is because either the public sector will save or run a deficit, or households will do likewise and at the same rate. Further, expectantly, taxpayers view a deficit as a future tax increase and will save to pay for it, while a surplus is viewed as a future tax cut with an opposite result (Formaini 2000).

Legacy

Ricardo’s international free trade agenda became one with British public policy. Ricardo had provided an answer to Britain’s long-term growth problems, and Britain became the “workshop of the world,” importing most of its food and “outsourcing” most of its agricultural employment. Ricardo’s ideas became “the fountainhead of all nineteenth-century free trade doctrine!” (Formaini 2000).

Ricardo’s abstract model became the means by which he advocated public policy. A free trade enthusiast, he also was not a fan of public expenditure, believing most such spending to be at worst wasteful or at best incapable of changing aggregate well-being and output. Ricardo also believed that the Corn Laws, in particular, constituted a burden to the agricultural economy. He believed that these trade barriers kept food prices artificially high and encouraged a bloated rent rate. In Parliament, Ricardo actively campaigned against the Corn Laws as well as other government interventions.

Essentially this economic stance mirrored Adam Smith's teachings: the market, although imperfect, is best left untouched. Government action only prevents the economy from righting itself. Although Ricardo did not share Smith's complete confidence in the market he recognized that tampering with the system would only result in further economic stagnation.

Ricardo's influence, especially in Great Britain, was great. As Keynes wrote, “Ricardo conquered England as completely as the Holy Inquisition conquered Spain” (Formaini 2000).

Ricardo also maintained that England's inflation was the result of the Bank of England's propensity to issue excess bank notes. Thus, Ricardo was an early believer in the quantity theory of money, or what became known as monetarism.

Publications

  • Ricardo, D. 1810. The High Price of Bullion, a Proof of the Depreciation of Bank Notes.
  • Ricardo, D. 1815. Essay on the Influence of a Low Price of Corn on the Profits of Stock.
  • Ricardo, D. 1821. (original 1817) Principles of Political Economy and Taxation. Dover Publications. ISBN 0486434613

Notes

  1. Henry George extended the Law of Rent by recognizing that marginal productivity of labor on intramarginal land (the "intensive" marginal product) would equalize the "extensive" productivity of labor on marginal land: "the process will not stop until, either by the extension of cultivation to inferior lands or to inferior points on the same land, or by an increase in the relative value of manufactured products ... the yield to labor and capital [has] been brought again to the same level. ... And thus to say that rent will be the excess in productiveness over the yield at the margin or lowest point of cultivation is the same thing as to say that it will be the excess of produce over what the same amount of labor and capital obtains in the least remunerative occupation."
  2. Henry George, 2005, "Progress and Poverty," Rent and the Law of Rent. Cosimo. ISBN 1596051507

References

  • Case, Karl E. and Ray C. Fair. 1999. Principles of Economics (5th edition). Prentice-Hall. ISBN 0139619054.
  • Formaini, R. L. 2000. "David Ricardo: Theory of Free International Trade." Economic Insights. Dallas, TX: Federal Reserve Bank of Dallas.
  • Friedman, David D. 1992. Price Theory. South-Western Educational Publishing. ISBN 0538805641
  • Hollander, Samuel. 1979. The Economics of David Ricardo. Toronto: University of Toronto Press.
  • McCulloch, J. R. 1881. The Works of David Ricardo. London: John Murray. 31, 50-58. Reprinted 2000 by The Lawbook Exchange. ISBN 1584770287


External links

All links retrieved April 17, 2008.

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