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David Ricardo
The First Economic Theorist
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 David Ricardo (1772-1823)
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A stockbroker considered the first rigorous economic
theorists
• Made major contributions building on Smith’s ideas
• Best known for theory of land rent and theory of comparative
advantage in international trade
• Frequent correspondent with Thomas Malthus
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 Ricardo’s Theory of Land Rent: The Assumptions
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Land is divided into “Farms” of different soil qualities,
ranging from “Best Farm” to “Worst Farm”
Farms produce corn which is used to pay the next season’s
workers (the “wages fund”) or to provide seed for planting
(“circulating capital”) or to keep as rent
Corn can be sold at national price (farms are price-takers)
Capital and Labor work together in “doses” with fixed
proportions; labor receives only a subsistence wage; capital
earns a normal rate of profit
On each farm there are diminishing returns to increased
doses; the average product (corn per dose) declines, so the
marginal product is less than average product and declines
even faster
Good farms will be cultivated first, then poorer farms. The
worst farm is the last to be cultivated
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 Ricardo’s Theory of Land Rent: The Results
• Each farm will add doses until the marginal product of a dose
equals the cost of a dose—the “intensive margin”
• Rent on each farm is the excess of total product over total
cost of doses
• The best farm will use the most doses, produce the most
corn, and receive the highest rent
• The worst farm produces just enough corn to pay for doses
used; it will produce the least corn and the landlord will
receive no rent—the “extensive margin”
• Rent is not a necessary cost of production—it is the residual
between output and costs; rent is price-determined, not price
determining
• Land is required for production, but it is not a”factor of
production,” that is, not a required cost of producing
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 Ricardo’s Theory of Land Rent: Policy Implications
• Ricardo argued for an end to the Corn Laws (1804-1846),
which levied a stiff tariff on imported corn,* because the Corn
laws raised the price of corn, benefiting landlords (who would
get increased rent) and harming manufacturers (who would
have to pay higher real wages and would suffer a fall in
profits).
• A confiscatory tax on rent could be introduced without
affecting corn production—the only effects would be on the
distribution of income—landlords would lose and the public
would gain via increased revenues. [On this same issue, see
Henry George and the Fabian Society]
*Note: In Britain corn was a generic term for cereal grains. What we call corn was called maize.
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David Ricardo's Theory of Differential Rent
Assumptions:
Corn price = $10 per bushel
Dose cost = $900 labor + $100 profit
Diminishing returns within farms (intensive margin)
Diminishing returns across farms (extensive margin)
The Intensive Margin
The Best Farm
Doses
(K+L)
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2
3
4
5
6
7
8
9
10
11
12
13
14
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Total
Gross Revenue
$10,000
$19,000
$27,000
$34,000
$40,000
$45,000
$49,000
$52,000
$54,000
$55,000
$55,000
$54,000
$53,000
$52,000
$51,000
Average
Gross Revenue
$10,000
$9,500
$9,000
$8,500
$8,000
$7,500
$7,000
$6,500
$6,000
$5,500
$5,000
$4,500
$4,077
$3,714
$3,400
Marginal
Gross Revenue
$10,000
$9,000
$8,000
$7,000
$6,000
$5,000
$4,000
$3,000
$2,000
$1,000
$0
-$1,000
-$1,000
-$1,000
-$1,000
Average
wage
Average
Profit
$900
$900
$900
$900
$900
$900
$900
$900
$900
$900
$900
$900
$900
$900
$900
$100
$100
$100
$100
$100
$100
$100
$100
$100
$100
$100
$100
$100
$100
$100
Marginal
Cost
$1,000
$1,000
$1,000
$1,000
$1,000
$1,000
$1,000
$1,000
$1,000
$1,000
$1,000
$1,000
$1,000
$1,000
$1,000
The Poor Farm
Total
Gross Revenue
$5,000
$9,000
$12,000
$14,000
$15,000
$15,000
$14,000
$13,000
$12,000
$11,000
$10,000
$9,000
$8,000
$7,000
$8,000
Average
Gross Revenue
$5,000
$4,500
$4,000
$3,500
$3,000
$2,500
$2,000
$1,625
$1,333
$1,100
$909
$750
$615
$500
$533
Marginal
Gross Revenue
$5,000
$4,000
$3,000
$2,000
$1,000
$0
-$1,000
-$1,000
-$1,000
-$1,000
-$1,000
-$1,000
-$1,000
-$1,000
-$1,000
Average
wage
Average
Profit
$900
$900
$900
$900
$900
$900
$900
$900
$900
$900
$900
$900
$900
$900
$900
$100
$100
$100
$100
$100
$100
$100
$100
$100
$100
$100
$100
$100
$100
$100
Marginal
Cost
$1,000
$1,000
$1,000
$1,000
$1,000
$1,000
$1,000
$1,000
$1,000
$1,000
$1,000
$1,000
$1,000
$1,000
$1,000
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Ricardo's Extensive Margin
Forty Farms of Different Qualities
Percent of Total
Revenue
100
80
60
40
20
0
1
3
5
7
9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39
Farm
Wages + Profits
Rent
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Ricardo on the Direction of Int’l Trade
 Ricardo’s On International Trade: Comparative Advantage
• Smith proposed that a country would produce and export
a good if it was produced at a lower cost than in another
country (“Absolute Advantage”)
• Ricardo argued that this could only be a temporary
condition—suppose a country could produce all goods at
least cost. This would mean that the second country
would export no goods, paying for imports with specie,
driving prices down in the second country and up in the first.
• In the long run, imported goods must be paid for by
exported goods, so each country must have something to
export.
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 The Classic Example of Comparative Advantage
• England and France both produce corn and wine. France
produces 2 cases of wine for each bushel of corn (so the
French corn price of wine is 0.50); England produces 1
case of wine for each bushel of wheat (so the English
corn price of wine is 1.0).
• Question: Which Goods Will Each Country Export to the
other?
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Comparative Advantage and the Direction of Trade
Answer: England specializes in corn and trades with France for wine to (say) point e
France specializes in wine and trades with England for corn to (say) point f
Eventually, world corn price of wine settles between 0.5 and 1.0
Trade pattern is determined by comparative advantage
Cases of Wine
E’’
E
F
Bushels of Corn
F’
F’’
E’
Analysis: If France doesn’t trade it must consume along the line FF’; England will consume along EE’
if it doesn’t trade. Both countries can improve their consumption possibilities by specializing
in different products, then trading its surplus: France will specialize in wine and sell it to England
at England’s higher price—consuming along F’F’’. England will specialize in corn and sell it to
France at France’s higher price. The trade pattern is determined by comparative advantage, 10
not by absolute advantage
 General Gluts: Ricardo vs. Malthus
• Malthus argued that an economy could suffer protracted
periods of depression—periods with excess capacity,
including high unemployment
• Ricardo responded with Say;’s Law: Jean-Baptiste Say had
argued that general gluts were impossible because “goods
trade for goods.” By this he meant that the act of producing
$100 worth of goods was simultaneously an act of creating
$100 of income (wages and profits) to buy the goods.
Thus, “Supply creates its own Demand.”
• Ricardo believed that what looked like a general glut was
simply a transitional period when resources were shifting
from declining industries to growing industries (buggy
whips to auto horns).
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 Why Might Gluts Occur?
• One proposed source of gluts was excess saving: Instead
of spending the income received from producing goods,
workers and capitalists could save (abstain from
consuming)
• Saving (consumers’ abstaining from consumption)
could generate offsetting demand only if it led to investing
(business capital expenditures).
• In the early 19th century almost all saving was by
businesses in the form of retained earnings that were
intended to buy investment goods. So there was a strong
link between saving and investment
• The subsequent development of financial institutions
weakened the saving-investment link, making general gluts
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more likely
 Gold Exports and Note Depreciation in the Napoleonic Wars
• England ran large international deficits to buy war goods,
borrowing heavily to finance the wars. Poor wheat harvests
compounded the deficit by raising imports of foodstuffs.
• The demand for foreign exchange increased sharply, leading
to a price of gold, at the gold export point. Gold began
flowing out of the Exchequer.
• To prevent the loss of gold, the Exchequer and the Bank of
England suspended convertibility of notes into gold. As a
consequence, the price of gold (in notes) rose to a premium
above the mint parity; stated in language of the day, “notes
depreciated.”
• The reason for the note depreciation was hotly debated in
“The Bullionist Controversy,” in which Ricardo played an
important role.
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 The Bullionist Controversy:
• Ricardo argued that the premium on notes was due to the
suspension of convertibility; the Bank of England had
weakened the currency, thereby inducing inflation in the note
price of gold and other goods. This became known as “The
Currency School.”
• The Bank of England responded that it could not cause
inflation because it adhered to the “real bills doctrine,”
creating notes by discounting “real bills” (self-liquidating
commercial notes created by trade). This became known as
“The Banking School.”
• Who was right? Ricardo had the upper hand because the real
bills doctrine was a fallacy [see Adam Smith]
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 Ricardo’s “Invariable Measure of Value”
• Ricardo’s Invariable Measure of Value was designed to serve
two goals
 Provide a price index to compute real national output
 Determine the source of variation in relative prices
• Ricardo proposed using the commodity with average capital
and labor per unit produced, and with average durability of
capital. Its price (average cost of production) would be the
average of all prices, against which both relative prices and
the price level could be measured
• Ricardo arbitrarily chose gold as the average commodity, so
the price of gold was his price index—
 By dividing the value of national product in pounds sterling
by the sterling price of gold the real value of national
could be calculated
 If the price of a good is rising (falling) relative to gold, the
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cost of producing that good is rising (falling) relative to all goods
 Ricardo’s View of the Dynamics of Economic Growth
• As an economy grows its labor and capital both grow
• As labor increases, the demand for food (“corn”) rises, the
price of corn increases relative to the price of manufactured
goods (“cloth”)
• As the price of corn rises, less fertile land is brought into
production, and total land rent increases
• The increasing price of corn relative to cloth raises wage
rates relative to the price of cloth and the profit rate
declines
• In summary, as an economy grows the share of output
going to rent increases, the profit rate on capital falls, and
the real wage rate rises
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