RICARDIAN THEORIES

DAVID RICARDO

David Ricardo (1772–1823) was a classical

economist best known for his theory on wages
and profit, labor theory of value, theory of
comparative advantage, and theory of rents.
David Ricardo and several other economists
also simultaneously and independently
discovered the law of diminishing marginal
returns. His most well-known work is the
Principles of Political Economy and Taxation (1817).
• David Ricardo was a classical economist who
developed several key theories that remain
influential in economics.
• Ricardo was a successful investor and member of
Parliament who took up writing about economics
after retiring young on his fortunes.
• Ricardo is best known for his theories of
comparative advantage, economic rents, and
labor theory of value.
RICARDIAN THEORY OF VALUE
David Ricardo (1772-1823) who adopted Smith's abandoned felt that value
depended upon the quantity of labour necessary for production which would
be calculated by time. More precise and clearer than Smith, Ricardo stated that
'Possessing utility, commodities derive their exchangeable value from two
sources : from their scarcity and from the quantity of labour required to obtain
them.'
Discarding Smith's labour command and cost of production theories of value,
Ricardo attempted to prove his labour theory of value against its inherent
difficulties. To bolster his hypothesis, he used time as a measure of labour
quantity, accommodated the different skills of labour by comparing wages to
productivity and also assumed that capital influence on value was neutralised
since it was merely stored up in labour. Despite these attempts, Ricardo in the
end was forced to accept that there were other forces affecting value which
prevented a pure theoretical labour theory of value.
The labor theory of value suggested that two commodities will trade for the
same price if they embody the same amount of labor time, or else they will
exchange at a ratio fixed by the relative differences in the two labor times. For
instance, if it takes 20 hours to hunt a deer and 10 hours to trap a beaver, then
the exchange ratio would be two beavers for one deer.

If it takes 20 labor hours to produce one beaver and 10 labor hours to produce
one deer, then one beaver would exchange for two deer, both equal to 20 units
of labor time. The cost of production not only involves the direct costs of going
out and hunting but also the indirect costs in the production of the necessary
implements—the trap to catch the beaver or the bow and arrow to hunt the
deer. The total quantity of labor time is vertically integrated—including both
direct and indirect labor time. So, if it requires 12 hours to make a beaver trap
and eight hours to catch the beaver, that equals 20 total hours of labor time.
Here is an example where beaver production, initially, is more
profitable than that of deer:

It's more profitable to produce beaver, so people will move out of deer
production and choose instead to produce beaver. The labor time embodied
indicates that there should be an equilibrium ratio of 2:1. So now the income
of beaver producers will tend to drop to $10 an hour while the income of deer
producers will tend to rise to $10 an hour as the cost of production drops in
beaver and rises in deer, bringing back the 2:1 ratio so that the new costs of
production would be $200 and $100.
RICARDIAN THEORY OF TRADE
Theory of trade was first described by David Ricardo in his 1817 book
“On the Principles of Political Economy and Taxation”. Ricardo noted
Portugal could produce both wine and cloth with less labour than
England. However, England was relatively better at producing cloth.
Therefore, it made sense for England to export cloth and import wine
from Portugal.
Example
Assume two countries, UK and India.
They both produce textiles and books.
For the UK to produce 1 unit of textiles it has an opportunity cost of 4 books.
However for India to produce 1 unit of textiles it has an opportunity cost of 1.5
books. Therefore India has a comparative advantage in producing textiles
because it has a lower opportunity cost.The UK has a comparative advantage in
producing books. This is because it has a lower opportunity cost of 0.25
 Output without trade Output after trade

Specialisation and trade

• If each country now specializes in one good then, assuming
constant returns to scale, output will double.
• Therefore the total output of both goods has increased –
illustrating the potential gains from exploiting comparative
advantage. • By trading the surplus books and textiles,
India and UK can enjoy higher quantities of the goods.
Criticism of Theory of Trade
•Cost of trade - To export goods to India imposes transport costs.
•External costs of trade - Exporting goods leads to increased pollution from
‘air-freight’ and can contribute to environmental costs not included in models.
•Diminishing returns/diseconomies of scale - Specialisation means a
country will increase the output of one particular good. However, for some
industries increasing output may lead to diminishing returns.
•Static comparative advantage - In case of products having a low-income
elasticity of demand, and it can hold back an economy from diversifying into
more profitable industries, such as manufacturing.
•Dutch disease - Dutch disease is a phenomenon where countries specialise
in producing primary products (oil/natural gas) but doing this can harm the long-
term performance of the economy.
•Trade – Trade can lead to an increase in net economic welfare. However, it
doesn’t mean that everyone will become better off. Some workers in
uncompetitive industries may lose out and struggle to gain employment in new
industries.
•Gravity theory - Proposed by Jan Tinbergen, in 1962, this states that
international trade is influenced by two factors – the relative size of economies
and economic distance. The model suggests that countries of similar size will be
attracted to trade with each other. Economic distance depends on geographical
distance and trade barriers. The implication is that countries economically close
and of similar size will engage in similar levels of bilateral trade. It also suggests
trade is more likely between countries which are geographically close.
•Complexity of global trade - Models of comparative advantage usually focus on
two countries and two goods, but in the real world, there are multiple goods and
countries. Increasingly there is growing demand for a variety of goods and choice
– rather than competing on simple price.
Ricardian distribution theory
The importance of David Ricardo's model is that it was one of the first models
used in Economics, aimed at explaining how income is distributed in society.

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Assumptions:
-there is only one industry, agriculture; only one good, grain;
-there are three kinds of people:
Capitalists: they start the economic growth process by saving and investing.
In return, they receive profits.Capital can be divided into fixed capital
(machines, for example) and working capital (wage fund, WF).
Workers: they represent the labour force, in return for wages (w).
Landlords: they allow production(y) to take place in their lands in return for
rent (R).
law of diminishing returns: affects labour (variable factor of production) and
land (fixed factor).
-principle of margin: marginal product of labour, which, along with the average
product of land, is decreasing.
-principle of economic surplus: profits are determined as a surplus of
production.
Analysis:
At a given initial situation, production is at a y0 level, which we can divide into
wages, w0, and profits, P0. Rent paid to landlords corresponds to R0. From w0
and the level of labour, L0, we determine the wage fund at the initial situation,
WF0.
In the long term, wages will arrive at a subsistence level, ws, which can be
defined as the wage a worker needs in order to survive. From this, and the level
of labour being employed, we determine the wage fund in the long run, WF*.
As this level is the same as labour’s marginal product, the capitalist will not
obtain any profits. On the other hand, landlords will get higher rents, R*.
Steady state:
Real wages will stagnate at subsistence level, the interest rate of capital
will stay at 0 and rents will reach its maximum level.

Ricardo explains how this steady state is painful, especially for the working
class. However, this steady state can be delayed with technological
progress or international trade, as is shown in Ricardian trade theory.
THANKS