1.2.1 David Ricardo

Who is looking for a biography of David Ricardo can find it, who would have thought it?, in Wikipedia: David Ricardo.

David Ricardo survived in the textbooks on economics with his theory of comparative costs. This theory is presented on half page of the 380 pages of "On the Principles of Political Economy and Taxation". In other words: In the original work this theory is nothing but an annotation.

For the comprehension of this chapter, it is useful having read the chapter on Adam Smith.

We see here a phenomenon we see very often in economics. From a complex theory survives only an isolated concepts, in the original theory nothing else than an annotation. We have already seen that in Adam Smith and the invisible hand, see natural price / market price and another example will be the law of Say.

There are even tragic examples of this kind. The famous multiplicator theory is in the General Theory of Employment, Interest and Money an annotation, but in textbooks about macroeconomics, it becomes the main message of Keynesian theory. This is tragic because therefore people assume that expansive fiscal policy is the main message of Keynes. That's not the case, see Keynes.

This happens because the authors of textbooks on economics copied from other textbooks, which had already copied from others.... It is very useful, not only in the field of economics, to check what the original author had said.

The fact that nobody reads the original texts leads to a situation where the differences between the different authors vanish. It is for instance presumed, that all the classics shares the idea that capital is materialised labour. That is not true for instance for Jean Baptiste Say. In relationship to David Ricardo and Adam Smith, it is only half true. David Ricardo indeed affirms that capital it materialised labour, but Adam Smith contradicts itself, and the concept of natural price / market price is incompatible with the concept of labour as materialised work. There are great differences between the authors of the nowadays denominated classical authors in temperament, philosophical background, methodology, style and economic concepts. It doesn't make any sense to summarise them under one term.

The theory of David Ricardo is based on four assumptions, and all of them are wrong.

The growth of the population is limited by the offer of food, and the land limits the offer of food. If the population grows, the prices of agricultural products rise because less fertile or more distant land must be cultivated what leads to higher production costs.
The second assumption is what was called later the iron law of wages. That's an idea he got from Thomas Malthus. The iron wage of the law states that the remuneration for labour will never be higher than the subsistence level because if this ever happens, the population will increase, what will lead to bigger supply of labour and more competition among the workers until the subsistence level is reached again. A second possibility, with the same effect, would be a raise in the prices of food, what would have the same effect.
He assumes that only labour creates values. (This very misleading, in this version, concept will have fatal consequences in Marxism.) This is perhaps the most fundamental error in economic thinking. Accumulation, that's the name given by Ricardo for saving is a condition for investments. The truth is that in a situation of unemployment there is no need for savings. Saving can only be interpreted as the production of capital goods instead of consumer goods. In a situation of full employment, there is a trade-off between the production of consumer goods and the production of capital goods. In a situation of unemployment, this trade of doesn't exist.
In the theory of David Ricardo, accumulation of capital is possible, but destruction of capital is impossible. The truth is that in the real world, every year as much capital is destroyed as created and if the adaptation of the economy to changes in the underlying structure would depend on capital, this adaptation would never be possible. Fortunately, adaptation to the economic structure are financed with money, not with capital, not consumed income of the past. Actually, David Ricardo means money, not capital. He assumes that the "capital" can flow in the most profitable use and that therefore the profit is the same in all branches of the economy. This is only possible with capital in its most liquid form: money.

The theory of David Ricardo is a very nice example of a theory that is based on implicit assumptions and is completely wrong if the implicit assumptions are wrong. David Ricardo took the assumptions mentioned above for granted. However, all of them have been turned out to be incorrect. Qualified labour can be very scarce and must be paid much more than the subsistence level. The agricultural industry is subsidised. Otherwise, they couldn't survive, and money is paid from the European Union if farmers didn't cultivate their land because there is too much of everything. In highly industrialised countries, the population decreases.

David Ricardo can be considered as the beginning of modeling in economics. Modeling always means that only the aspects that are considered relevant are taken into account. The problem is, see mathematical modeling, that the aspect taken into account very often are the effects of something, but not the causes.

With the above mentioned four assumptions, he gets to the following conclusions that don't fit at all with the historical data. At the beginning of human history, land existed in abundance and, therefore, nobody was obliged to pay for it, but capital was needed to cultivate it.

(David Ricardo never really explained where the first capital come from, but it is to assumed that he assumed something similar as Adam Smith. The first fisherman, hunter, farmer didn't spend all its time in fishing, hunting or cultivating his land. Part of his time he dedicated to producing tools in order to make his work more efficient. He produced, therefore, fisher-nets, bows, traps, plough, etc. That way the first "capital" was created.)

This early capitalist paid his workers with whatever was a means of payment in these times in order to make him work for him. (Another possibility is that he didn't paid him at all and held him like a slave giving him just what is absolutely needed to survive.) However, even this early capitalist already understood the mechanisms described by Karl Marx. He paid less than what corresponded to the value produced by this worker and, therefore, he got some added value.

This added value increased his capital and the more capital he had, the more workmen he could employ and the bigger the added value. This worked fine while the cultivable land existed in abundance and nothing was to pay for it. However, the more workmen the capitalist employed, the more land is needed to feed them and at a certain point land became scarce and something was to pay for it. That means that the capitalist has to pay more to his workmen in order to keep them alive, and that reduces his profits and the more workmen he employed, the more he have to pay them. At the end, the whole profits end up in the hand of the landowner.

With this theory, there are many problems, besides the problems already mentioned. First of all, it is not clear who gets the "the added value". In case that the labour needed is highly qualified, the "capitalist" has to pay much more than the subsistence level. It is very plausible that the workmen get the "added value".

Second it is hard to understand, how in a situation of competition the "capitalists" can set prices that allow them to get an "added value". In a situation of competition, prices will lower until the whole "added value" vanishes. David Ricardo assumes that the supply is always scarce, because of the lack of capital, and, therefore, the "capitalists", actually, the same as capital, because the capitalist is only qualified by the fact that he has capital, he is not an entrepreneur, can take whatever he wants. That doesn't fit with reality.

However, all these problems are not even the main problem if we consider classical thinking in general because these errors we find only in the work of David Ricardo.

The more fundamental error is his conception of capital, see interest rates. What the capital gets at the end is money. Only with money he can reinvest and only with money he can pay his workmen.

David Ricardo assumes that the profit on capital is the same in all sectors of the economy. The idea is that capital always moves to the most profitable use. Therefore, the profitability of the sector capital moves away will increase and the profitability of the sector capital move in will decrease until profitability is the same in all sectors. This is only possible if the capital is disposable in its most liquid form: money.

However, if capital is just money and can be printed as well and there is no need to squeeze it out from the workmen.

Money and capital are two different things for David Ricardo. An increase in the amount of money would lead to inflation, see money theory, but an increase in capital would lead to an increase in the national product although they are the same thing.

One could be induced to believe that this is ideology, but that's not the case. David Ricardo was one of the richest men in the 18th century, and he was interested in keeping money scarce and interest rates high. An increase in the amount of money would have lead to inflation or to lower interest rates. Both would have had an adverse impact on his fortune; that consisted most of all in money.

However, the misleading idea that money and capital are two completely different things is a common idea of the 18th and 19th century and even today there are a lot of people who uses the terms as synonyms.

Capital is defined by Adam Smith, David Ricardo and Karl Marx as non-consumed income of the past, in other words, it is the result of saving. (David Ricardo and Karl Marx call it accumulation, but that is actually the same thing.) This is a misleading definition and the faster we forget this definition, the better.

Savings must be defined in real terms. Saving is the production of capital goods instead of consumer goods. This definition makes sense. In case of full employment, capital goods can only be produced by charge of consumer goods. If there are no resources left, the production of one thing is only possibly in charge of something else. If someone works 24 hours a day, he can only do one thing or another. If someone in unemployed, this trade of doesn't exist. In case of full employment, saving is needed and in the case of unemployment, it is not.

The definition of savings or capital as non-consumed income of the past is misleading. In case of unemployment, idle resources can be activated with money. No need for prior savings. See as well interest rates.

If the workmen are unemployed, the "capitalist" can immediately employ them with money that can be generated by the banking system. There is no need to squeeze out before some added value of the workers. The same thing is valid for Karl Marx. Karl Marx assumed that more and more capital will be accumulated until it is concentrated in a few hands. The process can be accelerated by paying the workers with money. No need to squeeze out the added value from the workers in order to exploit still more workers.

The only thing that is true in all the Ricardian theory is his concept of rent, although he applies it only to land. Actually, this concept is true for any kind of productive resources. Rent, Alfred Marshall calls is producer surplus, see cardinal measurement of utility, is the difference between the market price and the actual cost of production of the different producers. .

David Ricardo assumes that the population will grow, and the amount of food needed will, therefore, increase, with the effect that less fertile or more distant land must be cultivated, the price for food therefore increases. However, there will be only one market price, but the costs of production will be very different.

If for instance the corn must be brought from a farm 100 miles away, the costs will be higher than when it comes from a farm nearby the town where it is needed. If the transportation costs are 50 dollars per tons in the first instance and 0 dollars in the second, the farmer near the town get a rent of 50 dollars because inside the town, there is only one price. It is, therefore, the most inefficient producer which can be still produced given a certain demand which determines the price. This is what is called nowadays in textbooks the marginal producer.

[We have already said, see as well natural price/market price, that the "marginal revolution" never happened with the neoclassical theory, because in the classic theory the concept is already there, sometimes even better explained, see the law of Say.]

David Ricardo applies this concept only to the land. Actually, it can be applied to any product, not only to agricultural products. For any product, there is always one market price, but great differences between the producers in the production costs. All the producers more efficient than the marginal producer will get a producer surplus.

David Ricardo applies the concept of rents only to the land because he assumes that "capital", actually money, always flows to the most profitable use. Under these assumptions, it is impossible that there are differences in the production costs and in the consumer surplus, because if they existed, capital would flow in until the differences have vanished. Under this assumption differences in the production costs can't exist. .

David Ricardo wanted to prove "scientifically" that there is no alternative to the actual distribution. The vast majority living in misery and a small group very rich. That is not even true if we abstract from any kind of governmental intervention.

David Ricardo assumes that labour is a homogeneous production factor and is never scarce. That is obviously not true today and is doubtful that it was true in the 18th and 19th century. Actually, labour is irrelevant. What is actually needed is know how. Know how must be produced, but once produced, it never belongs to the capitalist, but to the person who possess it. To simplify things a little bit: The "capitalist" has to invest in heads, otherwise, he can't produce anything, but once produced, he can only get his money back through a gentle agreement with the person who has the capital in his head.

[A possibility would be to train so much people, that the competition between these people is intense enough to make them work for a wage at subsistence level. However, this would be so expensive, that a gentle agreement is the more efficient solution.]

However, besides that, it is hard to see how a distribution of this kind can be maintained without suppression. The capitalist in the Ricardian theory has no function at all, is not an entrepreneur and not at all especially qualified. He is only qualified by the fact that he has "capital". Capitalist and capital is actually the same thing. Later on, Karl Marx will call his book The Capital and not The Capitalist. Capital allocates itself alone in the most profitable use, automatically and without the intervention of a human being. No knowledge is required to be a capitalist and no qualification. If the capitalist has no function, if he is just something like the French aristocrat, it is to suppose that he would have been abolished the same way the French aristocracy was abolished after the French Revolution.

David Ricardo was born in 1772 and died in 1832. He was therefore well aware of the French Revolution. Useless people who just live at the expense of others were hanged on the trees. The capitalist of David Ricardo is actually an aristocrat, and a lot of police is needed to keep this kind of people in power.

That's the big difference between David Ricardo and Jean-Baptiste Say. Capital is a productive factor in the theory of Jean-Baptiste Say. That is wrong, but at least, it doesn't move alone. Besides the capital, there is the entrepreneur and the entrepreneur is an extremely qualified person necessary in a market economy. Jean Baptiste Say distinguishes between capital, that yields a profit, and the income the entrepreneur gets for his activities. Capital and capitalist is not the same thing in the theory of Jean-Baptiste say.

The entrepreneur is not useless, he is very needed and survived the French revolution.

(Actually, it was the entrepreneur who made the French Revolution possible.)

David Ricardo is an illustrative example of a typical error not only in economic thinking. He took some things for granted which were actually nothing more than the result of a certain situation in a certain time. The infertile land is a question of the techniques used, and it can be less expensive to transport corn 3,000 miles than transporting it 100 miles. It depends on the means of transport disposable and these changes in throughout history.

Besides that, David Ricardo was obsessed with land as a productive factor. We deduce from that that the Ricardo family never ate fish. In Alaska, there is no cultivable land at all and the only plants growing there are frost flowers, but the Inuit lives there from what the get from the sea. They would say that perhaps fishes are scarce, but cultivable land is not needed at all.

Land, by the way, is never scarce. What is actually scarce is water. He assumed in his rainy England that it rains everywhere as much as in England. That's not the case and was not the case in the 18th century. Andalucia has a lot of land; that's no problem at all. However, sophisticated techniques are needed to irrigate it. Water is the problem.

If we say that water is scarce, we obviously describe the situation today, in 2015. The amount of water depends on the techniques to produce it. It is well possible that in fifteen years technological process will make it possible to produce any amount of fresh water from sea water. (See for instance solar desalination.)

What are "iron laws" for David Ricardo are actually nothing else than technological problems. If one had invested as much time in resolving these problems as was had been invested in the divulgation of the Ricardian ideas it is well possible that the problems would have been already resolved.

Throughout this website, we will see very often that most of the economic theories are based on some basic assumptions which are considered stable and never changing in the course of history. The problem is that the only thing stable throughout history is the belief that there are things that are stable and don't change.

However, all these little errors in the theory of David Ricardo are not the real problem because these are only 'specialities' of David Ricardo. The really fundamental error is his concept of capital. This misleading concept, in different versions, we can find until today on a daily basis in newspapers, in debate on television, in internet forums, in "scientific papers" etc.That capital, as the result of prior saving, is needed for investments, see interest rates.

It is very crucial for the understanding of Keynesian theory to understand to have a clear idea what the terms savings, capital, money, interest rates actually means or, to be more precise, what can be a useful definition of this terms.

The basic problem is that the IS-LM model, intended to be a graphical depiction of Keynesian theory, has a capital market, the IS curve, and a money market, the LM curve. Actually, a capital market doesn't exist in Keynesian theory, and the IS-LM model is, therefore, misleading.

The IS curve shows all combinations of the national income and interest rates where investments (I) equals saving (S). That suggests that I = S describes a classical relationship, where S is a condition for investments. That is the opposite of what Keynes actually said. Savings are the result of investments, not the condition, but in order to finance investments, money is needed, not savings defined as not consumed income of the past. The IS curve can be interpreted as well in a Keynesian way, but the IS curve is misleading.

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1.2.1 David Ricardo

David Ricardo and the Iron Law of Wages