History of economic thought



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HISTORY OF ECONOMIC THOUGHT

LECTURE 3
Robert Thomas Malthus and David Ricardo
Adam Smith’s economic discourse established the framework within which economic/social issues were addressed within the context of natural laws of the market by the economists who succeeded him. However, while Smith arrived at an optimistic conclusion about future outcome of a free market system, Malthus and Ricardo, both adhering to the same natural laws, arrived at a fundamentally different, much less sanguine conclusions.



  1. Robert Thomas Malthus (1766-1834)




    1. Population Theory

Malthus’ fame rests upon his main thesis, the theory of population. To recognize the implications of Malthus’ population theory, first consider what Adam Smith had to say about population growth. For Smith, population growth was a positive social phenomenon. It was essential for economic growth. Population growth allowed for the expansion of markets, increased division of labor and increased productivity. But for both Malthus and Ricardo, population growth had negative consequences, although much less for Ricardo than for Malthus. Malthus, particularly, saw population growth as the impediment to economic growth and social improvement. Furthermore, based on natural laws, he argued, there is no practical public policy that would alleviate the dire impact of population growth.





      1. Geometric versus Arithmetic Ratio

Malthus’ theory is compactly presented in following statement in the first edition of his book (published 1798) An Essay on the Principle of Population as it affects the future Improvement of Society.


“Population, when unchecked, increases in a geometrical ratio. Subsistence [food production] increases only in an arithmetical ratio. A slight acquaintance with numbers will show the immensity of the first power in comparison to the second.”
The following table shows what Malthus meant by geometric versus arithmetical ratios:


Years

Population

Food

-

1

1

25

2

2

50

4

3

75

8

4

100

16

5

125

32

6

150

64

7

175

128

8

200

256

9

225

512

10

250

1,024

11

275

2,048

12

300

4,096

13

According to this scheme, every 25 years, while population doubles, food increases only by one unit. Thus, within one century, the ratio of population to food (the inverse of food production per capita) will increase to 16/5, in two centuries, 256/9, in three centuries, 4,096/13, and in six centuries, to 16,777,216/25.


Why this tension between population and food? The theoretical justification for the geometric growth assumption is biological, as Malthus expresses it, it arises from “the passion between the sexes”, or, as one contemporary writer called it, “the delights of domestic society”. However, Malthus has no clear theoretical justification for the arithmetic series describing food production. Malthus’ argument stems from his attempt to show the rapid divergence of the two time series.

Malthus wants to warn us that the tension between population and food is inevitable and permanent:


“By the law of our nature which makes food necessary to the life of man, the effects of these two unequal powers must be kept equal. This implies a strong and constantly operating check on population [emphasis added] from the difficulty of subsistence. This difficulty must fall somewhere; and must necessarily be severely felt by a large portion of mankind.”



      1. Constantly Operating Check on Population

What is this “constantly operating check”? Malthus mentions two distinct checks or mechanisms: “misery and vice.” A clear example of the misery is famine or scarcity of food. By “vice” Malthus actually meant, according to his theological convictions, birth control. Without birth control, which he clearly disapproved, then misery is the lot of a large portion of mankind.


At the heart of the “misery” check is the mechanism that forces wages to the subsistence level, the so-called “iron law of wages”. If at any time wages rise above the subsistence level, the delights of domestic society would lead to more childbirth and, down the line, increased supply of labor. The result is the fall in wages back to the subsistence level.
What are the implications of this argument with respect to attempts for social and economic reforms to improve the working-class living standards? For Malthus any such attempts would be self-defeating. The result of any social improvement is increased population and the move back to the subsistence wage. In modern debates about social reforms, this punitive attitude toward the poor had, and still has, significant adherents.
As is explained below, based on his own population theory, in the debate about free trade and repeal of Corn Laws, Malthus and David Ricardo were on the opposite side of this debate. Corn Laws in effect then set high tariffs against imported grains, keeping the price of grains high to the benefit of the landowners. Malthus opposed the repeal, again arguing that a decrease in price of food would improve the lot of working class, which would cause population to rise, and then we are back to square one!



    1. General Glut”

Other than Marx, who is basically considered outside the sphere of “orthodox” economists, Malthus is the only well-known economist before Keynes who mentions the possibility of economic stagnation. Until John Maynard Keynes, practically all economists, including Malthus’ friend David Ricardo, denied the possibility of economic stagnation. This problem is variously referred to as, over-production, under-consumption, or, as Malthus termed it, general glut.


The argument against general glut goes as follows. In terms of modern national income accounting, the value of all goods produced in a given time period, that is, the cost of producing these goods are returned back into the economic flow as income to owners of factors of production. The recipients of the various categories of income, namely, wages to workers, rent to owners of the land, and profit to capitalist are plowed back into the economy. But what if people decide, rather than spending all their income, save part of it? Does this not take part of funds out of circulation and make the economy shrink? The answer is, no.
First of all, since workers receive only subsistence wages, they must spend all their income on necessities to maintain and reproduce the working class. Thus, all savings are done by capitalists and, to a lesser extent, landowners. But why would capitalists save? The answer is, to further accumulate capital. The capitalists urge to accumulate always finds a channel to invest the available savings.
Malthus’ argument was that the very fact that wages are stuck at the subsistence level keeps the working class from consuming the very goods that it produces. Therefore, there is always the tendency for the economy to over-produce, to experience a “general glut” of commodities. What alleviated this tendency to overproduction was the expenditure by the “landed gentry”, who demanded the excess products, in terms of luxury goods, without themselves contributing to total output of the economy.
In summary, in the conflict of interest among the three classes, workers, capitalist, and landowners, Malthus was firmly in the landowners’ camp. He opposed the repeal of Corn Laws because it would have lowered the price of grain, which would be harmful to the interests of landowners, and supported the landed gentry’s profligate consumption habits because it helped to prevent a general glut.


  1. David Ricardo (1772-1723)

In modern perspective, David Ricardo can be considered more of an economists’ economist than any of the other economists who populated the classical school, including Adam Smith. His contribution to economic theory are still taught in modern economic textbooks. These contributions are explained below.





    1. Use of Abstraction and Economic Models

Ricardo was the first economist who used models, abstracting from many details and peripheral aspects of the “real world”, by making simplifying assumptions, to effectively and persuasively expound his arguments about major economic issues of his time. He did not use graphs or mathematical functions. His arguments were stated in very precise language, interspersed with simple numerical examples.




    1. Labor Theory of Value

The labor theory of value is an essential aspect of the economic models Ricardo uses to explain his theory of rent, international trade, and his arguments for the repeal of Corn Laws.


Ricardo’s value theory is essentially the same as Smith’s, with some additional arguments with respect to the cost of capital used in the production process in determining the value of a good. To Ricardo, cost of capital can be reduced to the amount of labor time embodied in that part of capital that is used up in the production process. This embodied labor time plus the current “live” labor time necessary for production make up the cost, hence the value of the good.



    1. The Theory of Rent

Land, along with capital and labor, is a factor of production and its cost, counted as rent, is included in the total cost of production, or the price of the product. So it appears, and it sounds logical. But Ricardo, using a simple model showed that appearances are deceiving. He showed that price, rather than being determined by rent, in fact, determines the rent.


To explain rent, Ricardo also used a concept that is one of the foundations of modern economic theory--marginal analysis. To simplify the model, Ricardo assumes that the landowner does not cultivate his own land, he rents it to the tenant farmer. Land varies in quality and productivity. Thus, as population increases, to produce more food, land of decreasing quality is cultivated.
Given a tract of land, the tenant farmer, the farmer capitalist, uses his own capital and hires workers to cultivate the land. The value or price of “corn” is determined by how much it costs, expressed in the amount of actual and embodied labor (capital) required to produce a unit, say a bushel. This price is equal to the cost of production in the marginal land, the land with the lowest quality.
The following table shows how rent is generated. There are three tracts of land where has the highest productivity and the lowest. Therefore, the output of the same dosage of labor and capital, costing $600, diminishes from 400 bushels on tract A to 300 bushels on B, and to 240 on C. The price of a bushel of corn is determined by the cost per bushel on the marginal land C, which is . Total revenue accruing to each tract is obtained by multiplying output by $2.50. The difference between the total revenue of A and C is , is the rent accruing to A, and that for B is .





Output

Total

Average

Total




Land

(bushels)

cost

Cost

Revenue

Rent

A

400

$600

$1.50

$1,000

$400

B

300

600

2.00

750

150

C

240

600

2.50

600

0

This example illustrates Ricardo’s theory of rent, which implies that the chain of causation goes from the price of corn to rent. The price of corn determines how much rent is paid to the landowner. Rent is not a factor in the cost of production. According to Ricardo: “Corn is not high because a rent is paid, but a rent is paid because corn is high.”


Ricardo defines rent as the payment “to the landlord for the use of the original and indestructible powers of the soil.” Rent exists because of (1) the scarcity of fertile land and (2) the law of diminishing returns.
“If, then, good land existed in a quantity much more abundant than the production of food for an increasing population required, or if capital could be indefinitely employed without a diminished return on the old land, there could be no rise of rent; for rent invariably proceeds from employment of an additional quantity of labour with a proportionally less return.”


    1. Rent, Distribution of Income, and the Stationary State

Why has Heilbroner included Ricardo in the chapter titled “The Gloomy Presentiments”? This has to do with impact of the rise in the landowners’ share, rent, as a percentage of national income, and the consequent crowding out of the capitalists’ profits. The decreasing profits slows down capital accumulation, and in the final analysis, brings it to a standstill.


Ricardo’s stationary state model can be explained using the following diagram. The downward curve labeled MP is the marginal product. When capital and labor added in fixed proportions to the land, as the lower quality land is cultivated, marginal productivity of capital/labor decreases. When L₁ units of capital/labor is used on the available land, the total output (in bushels of corn) is shown as the area under the MP curve, OQ₀BL₁. The line W represents the subsistence wage.

Given the subsistence wage rate, workers’ share of total output is OQ₃EL₁. Since marginal product is OQ₁ = L₁B, then any output above this marginal product accrues to landowners as rent. This is shown as the area of the triangle Q₀BQ₁. What is left, the residual, is the capitalists’ profit—the area Q₁BEQ₃.
Now, as the population rises, and the economy is forced to produce more food on lower quality land using L₂ units of capital/labor, marginal productivity falls to OQ₂ = L₂C. Rent, in this situation, is increased to Q₀CQ₂. Wage rate remains at the subsistence level, using the Malthusian thesis. Thus, the decreasing rate of return, squeezes capitalists profit between the wages fund and rent. In the long-run, when marginal productivity falls to the subsistence level, all profits are squeezed out and rent takes it all, after covering the wages fund. This is the stationary state, where capital accumulation comes to a standstill.


    1. Comparative Advantage, Specialization, and the Benefits of International Trade

Ricardo’s theory of comparative advantage is now taught in every introductory course in microeconomics and international economics. The theory proves that in any economic transaction or trade, both parties to the trade would be better off if they specialized in the production of a good in which each has a relative or comparative advantage. That is, each is relatively more productive in the production of one good compared to the other good that are being traded. The comparison of productivity is not between the two parties, rather, it is between the production of the two goods subject to the trade.


To show how comparative advantage works, Ricardo uses the two countries England and Portugal as the trade partners, and cloth and wine as the two goods that are being traded. The following is a slightly altered example which Ricardo uses. In this two country/two commodity model, suppose both countries use equal amount of labor time to produce cloth and wine. The output of cloth and wine are shown in the two countries are shown in Table A.
Table A

 

England

Portugal

Cloth

90

100

Wine

80

120

The table shows that equal doses of labor and capital in England can produce either 90 units of cloth or 80 units of wine. In Portugal, the same dose of labor and capital can produce either 100 units of cloth or 120 units of wine. The figures indicate that Portugal has an absolute advantage in the production of both goods. Labor and capital or more productive in the production of both cloth and wine in Portugal than in England. The diagram below shows that Portugal can allocate its resources and produce any combination of cloth and wine along its production possibilities line (PPL), which would be greater than any combination that England can produce along its production possibilities line.


The question is, however, which country has a comparative advantage in the production of either cloth or wine. Consider cloth first. In the diagram below, Portugal’s PPL is steeper, where the slope is , than England’s PPL, with a slope of . This tells us that in Portugal the relative cost of producing each additional cloth is 1.2 wine, while in England the relative cost of cloth is 0.89 wine. This means that, in terms of relative costs, it is cheaper to produce cloth in England than in Portugal. England has a comparative advantage in producing cloth
Regarding Wine, the cost of each additional wine in Portugal is cloth, while in England each additional wine costs cloth. The relative cost of wine is lower in Portugal. Portugal has a comparative advantage in producing wine.


Suppose both countries pursue a policy of autarky, being self-sufficient in cloth and wine both, and each chooses the following combinations of cloth and wine. The combined international output is Cloth = 95 and Wine = 100.
Table B

 

England

Portugal

Total

Cloth

45

50

95

Wine

40

60

100

On the other hand, if each country specializes in the good according to its comparative advantage, one of the possibilities is shown below.1 Note that now the international total output of cloth and wine with specialization is greater than that under autarky: Cloth = 100, Wine = 108.


Table C

 

England

Portugal

Total

Cloth

90

10

100

Wine

0

108

108

Finally, if both countries trade in a way that makes them both better off than under autarky, one of the possible outcomes would be the following,


Table D

 

England

Portugal

Total

Cloth

48

52

100

Wine

43

65

108

The diagram below shows that with specialization and trade both countries can produces and consume combinations of both goods that goes beyond each individual PPL.





1 You can obtain these numbers by simply using the linear PPL equations:

Portugal:



England:

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