CHAPTER

10
Ricardian Theory The Ricardian Theory
INTRODUCTION
Like Smith, David Ricardo also presented his views on economic development in an unsystematic manner in his book The Principles of Political Economy and Taxation. This book was published in 1917. It was its third edition of 1921 and Ricardos correspondence with a number of economists that contain his ideas on which his model of development has been built.

RICARDOS THEORY
Ricardo never propounded any theory of development. He simply discussed the theory of distribution. Therefore, Ricardos analysis is a detour. The Ricardian theory is based on the marginal and the surplus principles. The marginal principle explains the share of rent in the national output, and the surplus principle explains the division of the remaining share between wages and profits. Assumptions of the Theory. The Ricardian theory is based on the following assumptions: (i) All land is used for the production of corn and the working forces in agriculture help in

determining distribution in industry. (ii) The law of diminishing returns operates on land. (iii) The supply of land is fixed. (iv) The demand for corn is perfectly inelastic. (v) Labour and capital are variable inputs. (vi) Capital consists of circulating capital. (vii) There is capital homogeneity. (viii) The state of technical knowledge is given. (ix) All workers are paid a subsistence wage. (x) The supply price of labour is given and constant. (xi) The demand for labour depends upon the accumulation of capital, and both demand and supply price of labour are independent of the marginal productivity of labour. (xii) There is perfect competition. (xiii) Capital accumulation results from profits. THE THEORY Given these assumptions, the whole economy consists of one huge farm fixed in supply which is engaged in producing only corn by applying homogeneous units of labour and capital. It grows on the basis of interrelations of three groups in the economy, They are landlords, capitalists and labourers among whom the entire produce of land is distributed. The total national output is distributed among the three groups as rent, profits, and wages respectively. Division of Rent, Profits and Wages. Given the total output of corn, the share of each group can be determined. Rent per unit of labour is the difference between the average and marginal product. Or, total rent equals the difference between the average product and the marginal product of labour (multiplied by) the quantity of labour and capital applied on land. The wage rate is determined by wage fund (divided by) the number of workers employed at the subsistence level. Thus out of total corn produced and sold, rent has the first right and the residual (produce minus rent) is distributed between wages and profits, while interest is included in profits.1 Process of Capital Accumulation. According to Ricardo, capital accumulation is the outcome of profits because profits lead to saving of wealth which is used for capital formation. Capital accumulation depends on two factors: First, the capacity to save; and second, the will to save. The capacity to save is more important in capital accumulation. This depends upon the net income of society which is a surplus out of total output after meeting the cost of workers subsistence. The larger is the surplus, the larger will be the capacity to save. As Ricardo said, Out of two loaves I may save one, out of four I may save three. Landlords and capitalists invest through this surplus. The size of this surplus of net income depends on the rate of profit. (i) The Profit Rate. The rate of profit = profits/wages i.e., the rate to profit is equal to the ratio of profits to capital employed. But since capital consists only of working capital, it is equal to the wage bill. So long as the rate of profit is positive, capital accumulation will continue. The labour force will grow proportionately and the total wage fund will also increase. In reality, profits depend on wages, wages on the price of corn and the price of corn depends on the
1. See Fig. 1. for its clarity.

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fertility of the marginal land. In this way, there is an inverse relation between profits and wages, and wages rise or fall in keeping with the price of corn. When there are improvements in agriculture, the productive power of land increases, or by applying better machines less workers produce more output. This results in fall in the price of corn. As a result, the subsistence wage also falls, but profits increase and there is more capital accumulation. This will increase the demand for labour and the wage rate will rise. This, in turn, will increase population and the demand for corn and its price. Thus wages will rise and profits decline. (ii) Increase in Wages. Ricardo tried to show that it is only under different conditions that capital accumulation will reduce profits. In the Ricardian system, wages play an active role in determining income between capital and labour. The wage rate increases when the prices of commodities forming the subsistence of the workers increase. The commodities consumed by workers are primarily agricultural products. As the demand for food increases, less fertile land is brought under the plough. For this purpose, to produce a unit of the product more labourers are required. The demand for labour starts rising which raises wages. Moreover, to match the increasing cost of subsistence, money wages will also continue to rise. Thus wages rise with the increase in the price of corn and then profits decline. In such a situation, rent also increases which absorbs the rise in the price of corn. Since wages also increase, profits decline. These opposite tendencies ultimately retard capital accumulation. (iii) Declining Profits in Other Industries. According to Ricardo, The profits of the farmer regulate the profits of all other trades. Therefore, the money rate of profit earned on capital must be equal in equilibrium both in agriculture and industry. In manufacturing industry, corn is used as an input and the equality in the rate of profit comes through a definite relationship between the prices of industrial goods and the price of corn. Thus, when the profit rate declines in the agricultural sector, it also declines in the manufacturing industry. For with the rise in the price of corn, the industry will have to raise the wages of labourers, thereby reducing profits. Thus the price of corn determines the rate of profit in industry. When profits decline in the agricultural sector, profits of all trades also decline. Other Sources of Capital Accumulation. According to Ricardo, economic development depends on the difference between production and consumption. He, therefore, lays emphasis on increasing production and reducing unproductive consumption. However, the productivity of labour may be, increased through technological changes and better organisation. It is in this way that capital accumulation also can be increased. But the use of more machines will employ less workers. This will lead to unemployment and reduced wages. Since the economic condition of the workers worsens with the employment, of more machines, Ricardo regards technological conditions as given and constant. (i) Taxes are a source of capital accumulation in the hands of the government. According to Ricardo, taxes are to be levied only to reduce conspicuous consumption. Otherwise, the imposition of taxes on capitalists, landlords, and labourers will transfer resources from these groups to the government. But taxes adversely affect investment. Therefore, Ricardo does not favour the imposition of taxes because taxes reduce income, profits and capital accumulation. (ii) Ricardo is in favour of free trade. Free trade is an important factor for the economic development of the country. The profit rate can be saved from declining by importing corn. The capital accumulation will, therefore, continue to be high. In this way, the resources of the world can be used more efficiently through foreign trade. But the import of corn leads to fall in the demand

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for labour which deteriorates the economic condition of labourers. On the other hand, landlords and capitalists do not think it fit to import cheap corn from foreign countries, as a result their profits decline. Ricardos theory has been illustrated in Fig. 1 where quantities of corn are measured on the vertical axis and the amount of labour employed in agriculture on the horizontal axis. The curve AP represents the average product of labour and curve MP the marginal product of labour. With OM amount of labour, OQRM total corn is produced. Rent is shown by the rectangle PQRT, as the difference between AP and MP. At the subsistence wage rate OW, the supply curve of labour WL is infinitely elastic, and the total wage bill is OWLM. Total profits, WPTL, are the residue after deducting rent and wages from the total output: WPTL = OQRM (PQRT OWLM). Stationary State. According to Ricardo, there is a Fig. 1 natural tendency for the profit rate to fall in the economy so that the country ultimately reaches the stationary state. When capital accumulation rises with increase in profits, total output increases which raises the wages fund. With the increase in the wages fund, population increases which raises the demand for corn and its price. As population increases, inferior grade lands are cultivated to meet the increasing demand for corn. Rents on the superior grades of land rise and absorb a greater share of the output produced on these lands. This reduces the share of capitalists and labourers. Profits decline and wages tend to fall to the subsistence level. This process of rising rents and declining profits continues till output from the marginal land just covers the subsistence wage of the labour employed. Then profits are zero. This situation is explained in the above figure. During the course of capital accumulation, the amount of labour increases from OM to ON and the total output from OQRM to OABN. Of this, OWSN is the total wage bill (fund) and WABS is the rent. There are no profits at all. The stationary state arrives. In this state, capital acumulation stops, population does not grow, the wage rate is at the subsistence level and technical progress ceases. The basic causal force in this scheme is the fact of diminishing returns in agriculture, a grim tendency which can only be postponed temporarily by technical progress. But technical progress can not prevent the ultimate disappearance of profit and the onset of the stationary state.. The movement towards the stationary state in the Ricardian model is explained in terms of Fig. 2. Population is measured along the horizontal axis and total product minus rent on the vertical axis. The curve OP is the production function which shows total produc minus rent as the function of population. As population increases, the OP curve flattens out due to the operation of the law of diminishing returns. The ray through the origin OW measures the constant real wage rate. The vertical distance between the horizontal axis and the wage rate line OW measures the total wage bill at different levels of population. Thus W1N1, W2N2, and W3N3 are the total wage bills at ON1, ON2, and ON3 levels of population. When the wage bill is W1N1 the profits

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are P1W1 (Total product minus rent total wage bill, i.e., P1N1 W1N1 = P1W1). When profits are P1W1, investment is encouraged. The demand for labour increases to ON2 which pushes up the wage bill to W 2 N 2 but profits decline to P 2 W 2 . This will encourage further investment and technical progress and raise the demand for labour to ON3 and the wage bill will also increase to W3N3. But the profits will decline to P3W3. This process of capital accumulation, increase in population and the wage bill will continue till profits disappear altogether at point S from where the stationary state sets in. A CRITICAL APPRAISAL

P3 Total Product Minus Rent P2

S W3

W P

P1

W2 W1

N1

N2 Population Fig. 2

N3

Ricardo was the forerunner of modern economists and his ideas on economic development have been adopted by them. He emphasised the importance of raising savings and profit rate for capital accumulation. But it has certain flaws which are discussed below: 1. Neglects the Impact of Technology. Ricardo pointed out that improved technology in the industrial field leads to the displacement of labour and other adverse consequences. In the beginning, technological progress might counteract the action of diminishing returns. But ultimately when the impact of technological progress is exhausted, diminishing returns set in and the economy moves towards the stationary state. Thus, the Ricardian theory is primarily based on the law of diminishing returns. Rapid increase of farm produce in the advanced nations has proved that Ricardo underestimated the potentialities of technological progress in counteracting diminishing returns to land. Ricardo gave unnecessary importance to the law of diminishing returns and failed to visualize the important impact that science and technology had on the rapid economic development of the now developed nations. 2. Wrong Notion of Stationary State. The Ricardian view that the state reaches the stationary state automatically is baseless, because no economy attains the stationary state in which profits are increasing, production is rising and capital accumulation is taking place. 3. Baseless Notion Regarding Population. The Ricardian view that the wage rate does not increase with the rise in population has been disproved. First, the Malthusian theory of population has been proved wrong by population trends prevailing in the Western world. Second, wages have not tended to be at the subsistence level. Rather, there has been a continuous increase in money wages, and population has tended to decline. 4. Impracticable Laissez-Faire Policy. The Ricardian theory is based on the impracticable notion of laissez-faire. According to this policy, there is no government interference and the economy operates automatically through perfect competition. In reality, there is no economy which is free from government interference and in which perfect competition prevails. 5. Neglects Institutional Factors. One of the principal defects of the Ricardian theory is that it neglects the role of institutional factors. They have been assumed as given. But they are crucial in economic development and cannot be overlooked. 6. Distribution Rather than Growth Theory. According to Schumpeter, the Ricardian theory is

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not a growth theory but a theory of distribution which determines the shares of workers, landlords and capitalists. Even in this, he regards the share of land as primary, and the residual as the share of labour and capital. Ricardo failed to present a functional theory of distribution because he did not determine the share of each factor separately. 7. Land also Produces Goods other than Corn. Ricardo believed that only one product corn is produced on land. But this is an old notion because land produces a variety of products other than corn. This view appears to be still obsolete when Ricardo opined that the other factors of production are supported only by the produce of land. 8. Capital and Labour not Fixed Coefficients. The Ricardian assumption that capital and labour are fixed coefficients of production, is not correct. This assumption is invalid because labour and capital are independent variables. 9. Neglects the Interest Rate. The most serious defect of the Ricardian theory is the neglect of the rate of interest in economic growth. He does not regard the interest rate as an independent reward of capital but includes it in profits. This wrong notion stems from his inability to distinguish between the capitalist and the entrepreneur. 10. Static Model. According to Hicks, Ricardo uses the static method for the analysis of a dynamic process by confining himself to circulating capital and capital homogeneity. The Ricardian model is not one of a regularly progressive economy. It is confined to the comparison of static equilibria of even stationary states, and therefore cannot be extended to the analysis of a dynamic process.2 UNDERDEVELOPED COUNTRIES AND RICARDOS THEORY Despite these weaknesses, the Ricardian theory points toward the importance of capital accumulation through agricultural development, and increase in the various sources of savings and the profit rate. The Ricardian theory may not be fully applicable to underdeveloped countries but it does point out the factors that retard their rate of economic growth. The two basic assumptions of the Ricardian theory, diminishing returns to land and the Malthusian principle of population, are of particular significance for understanding the problems of over-populated underdeveloped economies. In an underdeveloped country, population increases faster than the increase in food supply. There is land hunger but there is the absence of technical improvements on land. As a result, the law of diminishing returns works with full force and productivity falls. The supply of cultivable land being scarce in relation to its demand, rents are high. But wages are low, because the labour supply is in excess of its demand and there is little tendency to substitute capital for labour. Under such circumstances, the level of income is low and there is little capacity to save and inducement to invest and the rate of capital accumulation is low.

2. J. Hicks, Capital and Growth, 1965.