Adam Smith: A Summation• Moral sentiments a first principle.• Market coordination of self – interested individuals

“Economic man” led by an “invisible hand”Competition Efficiency and Equity

» Guard against monopoly• Laissez – faire!

Restricted government trumps government restrictions• Labor theory of value• Progress through specialization and exchange

The division of labor is limited by the extent of the market.Spiraling progressImproved rule of lawProgress

Stagnation and decline in the futureEnter MalthusEnter Ricardo

Ricardo & Malthus: Welcome to the Dismal Science

David Ricardo, 1772 – 1823Stockbroker/Dealer/Pampleteer

Abstraction Economic Science• Championed capitalists

– Opposed Corn Law

• Advanced Say’s LawMajor contributions

– Differential rent– Labor theory of value– Theory of distribution– Comparative advantage– Quantity Theory

Thomas Malthus,1766 – 1834Parson/Professor of History&PolEcon

Intuitive approach/empiricist • Championed landlords

– Favored Corn Law

• Advanced Theory of Gluts– Macro failure Keynes– Capitalism needs

unproductive consumersMajor contribution• Law of population Darwin

Whoever wins, workers get dry crust…not quite, as we’ll see

Diminishing Returns Prevail

Malthus, An Essay on the Principle of Population, as it Affects the Future Improvement of Society with Remarks on the Speculations of Mr. Godwin,

M. Condorcet, and Other Writers, 1st ed., 1798

Malthus’ precursors:• Cantillon: men multiply like mice• Quesnay: propagation has no limit but subsistence• Franklin: American vs. European fertility/rural vs. urban fertility• Smith: Wage increase Population increase• Godwin/Condorcet: reason would restrain propagation

Malthus’ insight: Diminishing Returns

Malthus, An Essay on the Principle of Population, as it Affects the Future Improvement of Society with Remarks on the Speculations of Mr.

Godwin, M. Condorcet, and Other Writers, 1st ed., 1798 • First principles

– Food– Passion

• Population, when unchecked, increases in a geometric ratio

• 1, 2, 4, 8, …[25 year doubling time]• Subsistence increases in an

arithmetic ratio• 1, 2, 3, 4, …

• Subsistence checks population(“Subsistence” adjusts to experience)

– Positive checks: • Vice • Misery: War, pestilence, famine

– Preventive check: Moral restraintLaw of Diminishing Returns• in proportion as cultivation is

extended … additions to average produce must be gradually and regularly diminishing

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Hint of an externality in Malthus’ Law of Population:Your use of resources reduces my wellbeing

Today’s environmental movement

From An Essay in Population…Malthus as ogre• Famine seems to be the last, the most dreadful resource of

nature. The power of population is so superior to the power in the earth to produce subsistence for man, that premature death must in some shape or other visit the human race. The vices of mankind are active and able ministers of depopulation. They are the precursors in the great army of destruction. But should they fail in this war of extermination, sickly seasons, epidemics, pestilence, and plague, advance in terrific array, and sweep off their thousands and ten thousands. Should success be still incomplete, gigantic inevitable famine stalks in the rear, and with one mighty blow levels the population with the food of the world.

• … to better the condition of the laboring classes [we should cultivate] a spirit of independence, a decent pride, and a taste for cleanliness and comfort. The effect of a good government in increasing the prudential habits and personal respectability of the lower classes … will always be incomplete without a good system of education…The benefits derived from education are among those, which may be enjoyed without restriction of numbers; and, as it is in the power of governments to confer these benefits, it is … their duty to do it.

Why no apocalypse? What did Malthus miss?

The Dismal Science of David Ricardo… Ricardo offers us the supreme intellectual achievement, unattainable by weaker

spirits, of adopting a hypothetical world remote from experience as though it were the world of experience and then living in it consistently. With most of his successors, common sense cannot help breaking in – with injury to their logical consistency.

John Maynard Keynes, The General Theory of Employment, Interest, and Money• Prototypes, not people• Laws of behavior, not lives• Long-run equilibrium…Production cost Natural price

– Dismissed Supply-Demand as championed by Malthus: …ephemeral and transient • Ricardo, The High Price of Bullion, 1810

Paper money Wartime inflation– Regulate paper currency (so its value corresponds to its gold “content”)– Stick to metallic money…Private enterprise “controls” money supply

Ricardo Currency School Monetarism• Influence of a Low Price of Corn on the Profits of Stock, 1814

• Discussed with Malthus• Ricardo, Principles of Political Economy and Taxation, 1817

• Encouraged by James Mill (another East India functionary…and mutual friend)

Ricardo on Money:…put the mass of commodities (Y) on one side of the line and the

amount of money (M) multiplied by the rapidity of its turnover (V) on the other. Is not this in all cases the regulator of prices?

[P = MV/Y]…Money cannot call forth goods.…Productions are always bought by productions. Money is only

the medium by which exchange is effected.…To save is to spend … a general glut is evidently impossibleSay’s Law: Supply creates its own demand! …every part of the income, whether entirely consumed or

invested, will always produce an equal demand for goods, although not the same kind of goods.

• Ricardo’s preferred monetary regime: paper money freely convertible into gold at a fixed rate.

The economic way of thinking:Ricardo to Malthus:• Our differences may … be ascribed to your considering my book more

practical than I intended it to be. My object was to elucidate principles, and to do this I imagined strong cases that I might show the operation of those.

Comparative advantage international division of laborWhen there’s a bad harvest, gold becomes the cheapest commodity to export.

Validity of Say’s Law? If workers paid little, who buys?Malthus on gluts: focus on effectual demand (Smith also used term)Growing Supply

Satiation Excess Supply Decline in Profits

Stable Demand General Glut Stagnation (Why invest if demand is down?)

Ways out: – Redistribution? No! – Unproductive consumers: Clergy, landlords, public works…military-industrial complex– Create new demands

Malthus on Gluts: Anticipation of Keynes???We see in almost every part of the world vast powers of production which are not put into action…[F]rom the want of a proper distribution of the actual produce adequate motives are not furnished to continue production…the grand question is whether it is distributed in such a manner…as to occasion the most effective demand for future produce: and I distinctly maintain that an attempt to accumulate very rapidly which necessarily implies a diminution of unproductive consumption, by greatly impairing the usual motives to production must prematurely check the progress of wealth.

Letter from Malthus to Ricardo, July 7, 1821

• Too much investment Glut???...anti-Keynes• Need for “unproductive consumption” pro-Keynes

Ricardo defended Say’s Law: to save is to spend..but in an afterthought, unemployment could result from progress:

“On Machinery” (Principles, Chapter 31, 1821)• If machines substitute for labor rather than complement labor,

unemployment is possible with accumulation… Say’s Law.• When will technological advance result in unemployment?

If interest rate is highCapitalist expansion won’t offset reduced labor inputIf machines are long-lived Low replacement demand for machines Low demand for labor

Say’s Law: The Beat Goes On• Which Law? Baumol, 1977…The are really eight Say’s Laws.• The simple version, per James Mill (1808):The production of commodities creates…a market for the commodities produced…When goods are carried to market, what is wanted is someone to buy. But to buy one must have the wherewithal to pay…But wherein consist the collective means of payment of the whole nation? Do they not consist of its annual produce?...[So] the more you increase the annual produce, the more by that very act you extend the national market…and the actual purchases of the nation…[T]he demand of a nation is always equal to the produce of a nation.• A clearer version per John Stuart Mill (1844):[the proposition that supply is at the same time demand is]…evidently founded on the supposition of a state of barter…One [person] cannot sell without buying. If, however, we suppose that money is used, …, although he who sells, really sells only to buy, he need not buy at the same moment when he sells…[T]o render the argument for the impossibility of an excess of all commodities applicable to the case in which [money] is employed, money itself must be considered as a commodity. High demand for money Short-run glut.• J.S. Mill sketches a business cycle with fluctuations in Md

Ricardo’s Theory of DistributionDifferential rent: rent built up from zero-rent margin

• As push out to worse and worse land, owners of better land command bigger and bigger premiums (rents)

• Extensive margin / Intensive margingets rid of rent from distribution• Only scarcity of fertile land yields rent

» Rent is a sign of poverty, not prosperity» Interest of landlord is always opposed to interest of society» Only landlord could gain from progress

– Importing grain serves like a technological advance in agriculture» It makes as much sense to limit imports as to forbid

agricultural improvementsWages ~ Natural price of labor = what’s required for

(socially necessary) subsistence & reproduction: dry crust• Malthusian Law of Population Iron Law of Wages

» Poor Law (Speenhamland System) only increases number of poor but does not improve their well-being

» Dole (wage subsidy) Population growth Lower wage Dole» Malthus: the poor are themselves the cause of their own poverty

Population changes slowly “natural” wage adapts to market wage (high wagehabits)

Idea pickedup from Malthus

Ricardo’s Theory of DistributionProfits ~ equalized and eliminated by competition

…nothing can increase profits permanently …but a really cheaper mode of obtaining food profits depend inversely on wages

Class Conflict: Theme picked up my Marx

…profits of capitalist farmer regulate the profits of all other trades corn-ratio theory of profits (corn is capital stock…wage

fund)Diminishing returns Profit squeezed as economy grows

Wage Rate = Dry Crust? Profit Rate = “Zero”???• Hollander and Hicks: Ricardo not as dismal as you’d think

• In expanding economy (point A)– Profit exceeds bare minimum incentive to accumulate– Wage exceeds bare minimum

population growth to meet increased demand for labor• Ricardo “does not dispute Malthus’s view that the stationary state is remote.

Wage

Labor

subsistence wage

“subsistence” profit Curvature reflects diminishing returns.A

long-run equilibrium stationary state

Ricardo’s Labor Theory of Value• Assuming constant proportions• Abstracting from disutility of labor in different occupations• Abstracting from different inherent qualities/skills of labor• Abstracting from different qualities of land• Abstracting from different quantities of capital

» Assume (circulating) capital:labor ratio the same for all goods» Assume capital inputs relatively small

“Ricardo’s 93% labor theory of value” Stigler• Then Smith’s Beaver:Deer labor theory of value appliesRicardo’s Labor Theory of Value does not apply to

• Goods in inelastic supply (Old Masters/Positional Goods)• Paper money• Monopolized products• Goods in international trade

» Owing to immobile factors of production, can only speak of comparative labor costs, not absolute labor costs

The problem with the labor theory of value…• Competition equates profit rates across industries• Some industries more ‘capital intensive’ than others

– Costs of production, including normal rate of profit, in capital intensive industries are greater relative to labor inputs than costs of production relative to labor inputs in less capital intensive industries.

Higher prices relative to labor input costs in capital intensive industriesPrices not uniformly in proportion to “labor values”

• Berries (L1 labor input;T1 to ripen) – Berry Liqueur (L2 labor input;T2 to distill)P1 / P2 = {w L1 (1+i) T1 } / {w L2 (1+i) T2 } = {L1 / L2 } (1+i) (T1 – T2)

Relative prices independent of wage…but not of i … unless T1 = T2

• Ricardo: assumed equal ratios of fixed capital (machines) to working capital (wage fund) across all products

…not rigidly true, but I say it is the nearest approximation to the truth• Malthus: Ricardo’s rule may be considered as the exception,

and the exceptions the rule.

Ricardo: Value, Distribution, and Growth

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Price of product determines how far cultivation is pushed.Price Rent

More fertile/better situated land commands rent to extent output can be produced with less labor.

Rent measured in units of labor

Workers paid “price” of own production/reproduction. Subsistence wage

Product of worst land only divided betweencapitalist and labor…gets rid of rent Profit is a residual

Ricardo: Value, Distribution, and Growth• Marginal product declines as economy grows. • Profit is squeezed by increasing rent.

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Ricardo: Value, Distribution, and Growth

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Profit squeezed to zero Growth ceases

Malthus: Perhaps, butonly in the v e r y L o n g R u n

Ricardo: Value, Distribution, and Growth• Free trade effectively extends the margin of cultivation, reduces rent and

postpones the dismal stationary state.» Additional fertile land made available to economy• Agricultural & transportation technology also serve.

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Ricardo’s parting words to Malthus:• And now, my dear Malthus, I have done. Like other

disputants, after much discussion, we each retain our own opinion. These discussions, however, never influence our friendship; I should not like you more than I do if you agreed in opinion with me.

• Homage to Malthus: If only Malthus, instead of Ricardo, had been the

parent stem from which 19th century economics proceeded, what a much wiser and richer place the world would be today.

John Maynard Keynes