THE CLASSICAL SCHOOL 2

Value, distribution & trade

 Contents
• David Ricardo
• The labor theory of value
• Ricardo’s theory of distribution (the model of
land rent)
– Distribution in John Stuart Mill
• Theory of international trade

Roncaglia, sec. 7.2, 7.3, 7.4 & 7.6

 David Ricardo
• An analytical economist, developing Adam Smith’s system to its highest
degree of analytical depth and consistency.
• Profits of capital are the engine for economic growth (the laws of
distribution are the essential part of economics). His works supported
economic policies aimed at favouring capital accumulation.
• A pure theoretician (non-contextual), who elaborates theoretical models
grounded on simplified assumptions and elimination of variables. His
highly abstract methodology will prevail in economic science in the 20th
century.
• Main contributions:
– Labour theory of value
– Theory of distribution (model of land rent)
– Theory of international trade (comparative advantages)
Biography
• Born in London, 1772, in a Sephardic family of Portuguese origins.

• Broker in the London stock market, quickly making a big fortune.

• A friend of James Mill, Bentham and Malthus.

• A reputed specialist in topics on money, taxation and public debt. In

1817 he published his Principles of political economy and taxation.

• 1819: Member of the House of Commons, one of the most engaged

MPs in the discussions on the Corn Laws.

• Died in 1823.

• Disregarded by marginalists and neoclassicals, his ideas were

rediscovered in the decade of 1950 (neo-Ricardian and Marxists)
David Ricardo
(1772-1823)
 Labour theory of value
• As Smith, Ricardo distinguishes between:
– Use value: Utility (non measurable, necessary for exchange value)
– Exchange value: The amount of any other commodity for which a
commodity can be exchanged. There is no quantitative relation
between them.
• Commodities derive their exchange value from:
– Scarcity: Only in the case of non-reproducible goods (v.g. an art
masterpiece)
– Cost of production: The amount of labour required to obtain them
(unlimitedly reproducible commodities). Ricardo built his labour
theory of value for these goods.

“Cost of production must regulate the price of commodities, and not, as

it has been often said, the proportion between supply and demand, the
influence of which is transitory” (Ricardo, 1817)
Ricardo reduces all costs of production to wages and profits, as raw
materials and capital goods are constituted by labour exerted and
financed in the past, representing a certain amount of wages and profits.
The “natural price” (exchange value) of a commodity is the addition of the
remuneration of labour (direct and incorporated in the other factors of
production) and the profit (capitalist’s remuneration), which Ricardo
considers a fix percentage (r) of total labour cost (L·S).

Pi = Li·S + Li·S·r ⇒ Pi = Li·S (1+r)

Li: the amount of labour (direct or incorporated) used in production; Li =
Li1+Li2+···+Lin (capital is viewed as accumulated labour, the productive
power of which would be transferred to the output)
S: salary (equal in the whole economy, and close to subsistence level)
r: profit rate (equal in the whole economy, due to capitalists’ competition)
LiS: “advanced capital”, by the capitalist (the amount paid in salaries,
including salaries of labour accumulated in the capital)
LiSr: capitalist’s remuneration
The relative price of a commodity “depends on the relative amount of
labour required for its production, and not on the remuneration paid
to that labour”:
P1/P2=L1/L2
Labour “embedded” in raw materials and machines is taken into
account:
P1/P2=L1/L2=(L11+L12+L13+…)/(L21+L22+L23+…)

P1/P2= L1S(1+r)/L2S(1+r)= L1/L2

⇒ Relative prices are independent from the level of salaries or profits.

⇒ Profits depend on the level of salaries: An increase (or reduction) in
salaries will cause a reduction (or increase) in profits, but will not
affect relative natural prices. Land rent will not be affected either.
But this theory had problems when dynamic considerations were introduced,
especially regarding capital. Relative prices of commodities (the ratio between
the amounts of labour used) do not always fulfil the condition of equal rate of
profits. This happens for instance with goods whose productive processes do
not have the same duration.

Example: Two commodities with different time structure of production (1 year –

good 1 and 2 years – good 2). Capital invested on good 2 must be remunerated
through the rate of profits.

P1/P2 = L1S(1+r) / [L21S(1+r)2 + L22S(1+r)]=

= L1S(1+r) / [L21(1+r)+ L22] S(1+r) =

= L1 / [L21(1+r)+ L22]

⇒ Profit rates in both productive processes should be different so that relative

prices depended only on the amount of labour incorporated in both
commodities (they are equal only when profit = 0). → Inconsistence of
Ricardian labour theory of value.
In any case, Ricardo held that discrepancies in value were limited.
• Summing up, Ricardian labour theory of value states that in the calculation of
value it must be considered labour immediately applied to a commodity, and
labour embedded in tools, materials or buildings which aids that labour
(“fresh labour” of the day + “frozen labour” of the past, that constitutes
capital, fix and circulating).
• The exchange value of a commodity is the addition of hours of labour (“fresh”
and “frozen”). But “frozen” labour (capital) must be funded: its remuneration
is the interest of capital. Actualization of this advanced capital is done through
compound interest. This posed problems to the theory.
• In order to solve them, Ricardo suggested searching a commodity standard of
value (an invariable measure of value), so that the value of all goods could
compared to it, and therefore monitor variations in real prices. But “there is no
commodity which is not itself exposed to the same variations as the things the
value of which is to be ascertained”: Even if there exists one good which
always contains the same amount of labour (an absolute measure of the
“effort of production”), other circumstances would make its value shift. The
problem remained unsolved.
 Theory of distribution
• To Ricardo, the core problem of political economy is to unveil the
laws of the distribution: Distribution of surplus between profits
and rents is the key to explain economic growth (profits →
capital accumulation)
• Distribution is made among three social classes (Smith):
Landowners, capitalists and workers.
– Wages correspond to the consumption of workers: They are a part of
the costs of production. Natural wages are those which allow labour
to subsist and reproduce.
– Land rent and profits form the surplus (that part of the output left
after rebuilding the initial stocks of means of production and means of
subsistence for the workers).
– Landowners use all their income (rent) for consumption (of luxuries);
capitalists, forced by competition, must re-invest all their profits.
A) Profit rate: Is the same in all sectors, due to competition
among capitalists. It is a percentage of costs.
Pi=LiS (1+r) = LiS + LiSr

B) Wages:
– Theory of the “wage fund”.
– Malthus’ theory of population.
⇒ Real wages will fluctuate around subsistence level
(“minimum consumption required”, or “the conveniences
that are indispensable, as it has become customary”):
Natural wages.
C) Land rent: The theory of differential land rent
Why does land rent exist? Because there is scarcity of land of good quality.
→ Let’s suppose that there are lands of two different qualities and corn is
cultivated in both, using the same techniques.
→ The “natural price” of corn reflects the amount of labour necessary to produce
it in the land of worst quality, the marginal land (the last to be cultivated).
Otherwise, this land would not be used.
→ Differences in quality among lands result in differences in profits:
Assuming lands of quality 1 and 2:
r1 = (P-L1S)/L1S and r2 = (P-L2S)/L2S
r1 > r2 because L1 < L2

However, profits must be the same: Competition between capitalists make

them bid for the land of best quality, until rates of profit are equal in all lands (r1
= r2) →
→ Differences in surplus between lands 1 and 2 turn into rent of land 1.

Land rent is, therefore, the payment to landowners which equal the rates of profit
of lands of different fertility.
Ricardo’s model of distribution
• The assumptions of the model:
1) Land can be classified from more to less fertile.
2) The principle of diminishing returns rule: Increasing a factor of production
results, from a certain point, in diminishing average returns.
3) Competition makes capital profit rates equal.
4) Malthus’ theory of population rules

• Ricardo thinks that productive conditions in agriculture can represent

those of the whole economy. Agriculture was special because:
– It was the only sector in which the same commodity (corn) figured both as
input and output.
– Corn, being the basic component of subsistence, was also crucial to the
other indispensable input: labour (wages could be reduced to advances in
corn, so all inputs could be expressed in corn).
How does the model work?
In a country there is an increase in population (the consequence of salaries over
the level of subsistence, or a flow of profits which makes capital
accumulation increase and the wage fund grow)
⇒ Land of worse quality is cultivated ⇒
⇒ Increase in the rent of all lands ⇒
⇒ Increase in relative prices of food (corn) ⇒
⇒ Increase in monetary wages ⇒
⇒ Reduction in rate of profits (the residual of the system). A fall in the rate of
profits is transmitted from agriculture to other sectors through an increase in
agrarian prices and therefore wages.

⇒ Eventually, society arrives to a stop in the process of capital accumulation

and then in economic growth: The stationary state.

The dynamics of economic growth: An increase in landowners’ share in national

income, and a reduction in the possibilities of capital accumulation.
• In the stationary state:
– Wages: Subsistence level.
– Profits. Tend to 0.
– Land rent: Highest.
– Population stagnates.

• Capital accumulation is the base for economic growth. Countries

must enlarge the period of high profits as much as possible, as this
will allow more capital accumulation and technological innovations.
• This can postpone the emergence of diminishing returns and
therefore the stationary state.
• In any case, the process of increase in land rent is unstoppable.
“In all countries, and all times, profits depend on the quantity of
labour requisite to provide necessaries for the labourer on that land
which yields no rent”. Ricardo (1817)
• Ricardo’s theory of distribution opens a conflict between
landowners and the rest of society:
– “Landowners’ interests are opposed to those of the rest of society”
(Ricardo)
– “The system devised by Mr. Ricardo is a system of discords (…) as a whole,
it tends to create hostility between classes and nations” (Henry Carey).
• In order to enlarge the period of high profits and postpone the
stationary state, it is necessary to lower salaries. How? Removing
restrictions to imports of cheap food from overseas, this is,
liberalising international trade.
• Ricardo held two arguments to support free trade:
– The theory of differential land rent → Free trade of food will reduce
wages and postpone the arrival of Britain to the stationary state.
– The theory of comparative advantages → International trade will be
(globally) profitable, if the structure of relative costs is different among
countries.
 Distribution in J.S. Mill
• John Stuat Mill (1806-1873), the culmination of the classical school, a
progressive liberal and social reformer, interested in the application of
economics to improve society’s welfare.
• Distribution is the object of political economy in advanced countries.
“It is only in the backward countries of the world that increased production is still an important
object; in those most advanced, what is economically needed is a better distribution.”

• His views are optimistic. Mill separates the laws of production

(immutable) and the laws of distribution (mutable: the outcome of
institutions, uses, culture,...)
– Mill objects the “Iron law” of wages; they may increase if there is a change in
the reproductive mechanisms of the working class.
– Workers might influence capitalists’ decisions on consumption and investment
through union bargaining.
“Far from being a hindrance to a free market for labour, [trade unions] are the necessary
instrumentality of that free market; the indispensable means of enabling the sellers of
labour to take due care of their own interests under a system of competition”.
• However, an improvement in the life conditions of workers (an
alteration in the laws of distribution) may accelerate the arrival
of the stationary state (by reducing profit rates).
• But, the stationary state may not be an undesirable
circumstance, if society attains an acceptable standard of living
to all. It is in fact an opportunity for social reform: A fairer
income distribution, leading to higher standards of living.
Attached to this, there will be a moral and cultural
development.
In the stationary state “while no one is poor, no one desires to be
richer, nor has any reason to fear being thrust back by the efforts
of others to push themselves forward”. On the contrary, present
society is characterised by “trampling, crushing, elbowing and
treading on each other’s heels”.
• A better distribution should make its way in society through education
and opinion, so that individuals arrive to link personal happiness to
collective (utilitarianism).
“(…) education and opinion, which have a considerable power on human character, should be used
so that they instil in every individual’s mind the indissoluble association between his own
happiness and general welfare.”

• Mill’s objective was to make capitalism “human” capitalism. He promoted

cooperatives as a way to reorganise production and involve workers in
business’ management.
“If, therefore, the choice were to be made between Communism with all its chances, and the
present state of society with all its sufferings and injustices; if the institution of private property
necessarily carried with it as a consequence, that the produce of labour should be apportioned
as we now see it, almost in an inverse ratio to the labour - the largest portions to those who
have never worked at all, the next largest to those whose work is almost nominal, and so in a
descending scale, the remuneration dwindling as the work grows harder and more
disagreeable, until the most fatiguing and exhausting bodily labour cannot count with certainty
on being able to earn even the necessaries of life; if this or Communism were the alternative,
all the difficulties, great or small, of Communism would be but as dust in the balance.”
J.S. Mill, Principles of Political Economy, 1848)
 The theory of international trade
• “Under a system of perfectly free commerce, each country naturally devotes its
capital and labour to such employments as are most beneficial to each. This
pursuit of individual advantage is admirably connected with the universal good
of the whole. By stimulating industry, by regarding ingenuity, and by using most
efficaciously the peculiar powers bestowed by nature, it distributes labour most
effectively and most economically” (Ricardo, Principles, 1817)
• The example of England and Portugal:
Cloth Wine
England 100 120
Portugal 90 80

• Both countries become specialized in those commodities in which their

industries are more productive, this is, that product for which they have a
relative advantage (Theory of Comparative Advantages)
• The essential criticism to TCA has been its static character: Comparative
advantages are not granted; they are created and transformed along the
process of economic growth, either as a consequence of trade (Smith) or
protectionism (Friedrich List).
The framework: The Corn Laws debate
• Beginning of 19th c.: An increase in population pushes corn
prices. Corn is imported into UK → Conflict between landowners
(high corn prices) and capitalists (corn is too expensive).
• Napoleonic Wars and blockade. New land is cultivated. When the
war is over, it is feared that increases in national production and
imports will bring corn prices down.
• Landowners go to the Parliament: Corn Laws passed, 1815.
• The Corn Laws debate:
– Landowners: With prices down, much land will be idle and shortage
may occur (Malthus). Britain will depend on foreigners’ exports of
food, which might be dangerous.
– Capitalists: High prices of corn due to diminishing returns of land
make wages increase, hindering capital accumulation and economic
growth (Ricardo).
Falling prices of bread after Napoleonic Wars
Capitalists struggled to lift Corn Laws. It would not
happen until 1846.

A “monument” to Sir Robert

Peel, the British Prime
Minister who abolished
Corn Laws in 1846