lecture three ricardo, value and comparative advantage say’s law: classical “macroeconomics”...

Lecture Three

Ricardo, Value and Comparative Advantage

Say’s Law: Classical “Macroeconomics”

Marx: Capitalism and Revolution

Recap• Smith

– Labour as source of value– Labour-value as basis of price– Diamond-water paradox

• Labour-value solution: Effort to mine diamonds vs effort to draw water

• Utility no role in setting price– But problems with analysis, explanation of price– Key change: no interest in “macro” issues when

compared with Physiocrats, Mercantilists• Instead acceptance that market economy always

tends towards full employment: “Say’s Law”

Classical “Macroeconomics”: Say’s Law• Period characterised by

– dispossession of poor, mass unemployment, “poor laws”

– booms & busts from “South Sea Bubble” (1720) onwards• Effectively a major financial/economic crisis every

20 years• Some crises (1848, 1873) lead to near-revolutions in

Europe– Rapid industrialisation, growth of output, but large

fluctuations:

Relative Industrialisation

0

5

10

15

20

25

1700 1750 1800 1850 1900 1950

Years

% o

f Wor

ld M

anuf

actu

ring

United Kingdom

Habsburg Empire

France

GermanStates/Germany

Classical “Macroeconomics”: Say’s Law

Per Decade Output Change in UK

0

0.05

0.1

0.15

0.2

0.25

0.3

0.35

1820 1830 1840 1850 1860 1870 1880

Years

Per C

ent C

hang

eClassical “Macroeconomics”: Say’s Law

Economic crises, Rising unemploymenteven in UK; worse on Continent

“Say’s Law”• Paradoxically, economists accepted theory that economy

would always tend towards full employment, based on notion that utility the source of value:

• Say (writing 1821-34)– “Utility” theory of value (contra. Smith & Ricardo):

• “Give to a thing, to a material which has no value, utility, and you give it a value; that is,… you create wealth.” [OREF]

– Utility subjective:• “you call only useful that which is so to the eye of

reason, but you ought to understand by that word whatever is capable of satisfying the wants and desires of man such as he is... He is the sole judge of the importance that things are of to him,... We cannot judge of it but by the price he puts on them.” [OREF 105]

“Say’s Law”• Crises caused by “disproportionality” only

– Excess supply in one market, excess demand in others• “General gluts” or “general slumps” impossible• Argument

– Money only an intermediary in barter– People sell only to buy again (increase in utility the object)

• Each person’s supply is matched to his/her demand– Sum of all supply thus cannot exceed sum of all demand (no

“general gluts”); but– Slumps in one market can occur if supply of X exceeds

demand for X at price producers of X want; however• Price of X falls, demand for X rises: equilibrium...• Unless government regulations, monopolies intervene

“Say’s Law”– “Every producer asks for money in exchange for his

products, only for the purpose of employing that money again immediately in the purchase of another product; for we do not consume money, and it is not sought after in ordinary cases to conceal it: … . It is thus that the producers, though they have all of them the air of demanding money for their goods, do in reality demand merchandise for their merchandise.” [OREF]

• Say’s proposition accepted by most classical authors even though derived from a different theory of value (utility-based rather than cost of production-based)

Ricardo• Accepts much of Smith

– labour as source of value– effort, not utility, determines “value in exchange”

• Accepts Say’s Law (but rejects utility as source of value)• Accepts Malthus (“iron law of wages”) on population

– increased wages will lead to increased population, reducing wages to subsistence

• More rigorous than Smith & critical of logical weaknesses in Smith’s treatment of– Measurement of value, determination of prices– Income distribution & growth

• Also provided models which– Gave explanation of rent– Promoted free international trade

On Value• “Utility then is not the measure of exchangeable value,although it

is absolutely essential to it.” [OREF 131]• 2 sources of value: scarcity; labour

– Scarcity: “Some rare statues and pictures, scarce books and coins, ..., of which there is a very limited quantity, ... Their value is wholly independent of the quantity of labour originally necessary to produce them…” [131]•“Utility” may determine price here, but goods

involved the exception not the rule, and volume tiny compared to economy

– Labour: “By far the greatest part of those goods which are the objects of desire, are procured by labour, and they may be multiplied, ... almost without any assignable limit, if we are disposed to bestow the labour necessary to obtain them.” [131]

• Economic analysis applied to second class: things which can be reproduced

Measure of Value• Labour embodied the proper measure for an “invariable

standard”– “if the reward of the labourer were always in proportion to

what he produced, the quantity of labour bestowed on a commodity, and the quantity of labour which that commodity would purchase, would be equal, and either might accurately measure the variations of other things: but they are not equal; the first is under many circumstances an invariable standard, indicating correctly the variations of other things; the latter is subject to as many fluctuations as the commodities compared with it” [OREF 132]

• Wage “an invariable standard” because of– Subsistence view of wage

•means of subsistence relatively constant•thus labour-time embodied in a commodity almost

an “invariable standard”

Labour and Price• But how is wage kept at subsistence level?

– Output of normal commodities adjusts to demand– But Labour not produced for sale

• So what keeps labour’s “price” down to equilibrium if supply doesn’t adjust to demand?

– Malthus’s “iron law of wages”• Increased wage leads to… increased

population which causes… fall in wage• In Malthus’s words:

The “iron law” of wages“... suppose the means of subsistence in any country just equal

to the easy support of its inhabitants. The constant effort towards population ... increases the number of people ... The poor consequently must live much worse, ... the price of labour must tend toward a decrease, while the price of provisions would at the same time tend to rise ... the difficulty of rearing a family are so great that population is at a stand. ... the cheapness of labour ... encourage cultivators to employ more labour ... till ultimately the means of subsistence become in the same proportion to the population as at the period from which we set out. ... the restraints to population are in some degree loosened, and the same retrograde and progressive movements with respect to happiness are repeated.”

Wages thus tend towards subsistence even though workers not produced in proportion to demand…

Capital and Price• Smith’s “reward for stock” becomes payment for labour

embodied in capital– “Suppose the weapon necessary to kill the beaver, was

constructed with much more labour than that necessary to kill the deer ...; one beaver would naturally be of more value than two deer, and precisely for this reason, that more labour would, on the whole, be necessary to its destruction” [OREF 137]

• Income to capitalist thus reflects labour-time taken to build machinery owned by capitalist– Raises problem: where does profit come from, if cost of

machine equals its cost of production?•Not addressed by Ricardo; solved by Marx

(later)

Land, Rent, Surplus• Rent to landlord effectively a payment for “monopoly” over

good land– No rent payable on poorest land– Rent paid reflects differential soil quality, etc.

• Gave a long-run dynamic to Ricardo’s analysis:– Increasing population forces more marginal land into use– Diminishing yields means increased cost of food– Subsistence wage primarily for food– Increasing wage cuts capitalist profits– Landlords spend rent on rich living– Society will approach “stationary state”– Stagnation can be delayed if corn imported from

overseas: anti-Corn Laws

International Trade and Specialisation• Before Smith, mercantilist ideas dominated trade

– Try to be self-sufficient– Import as little as possible, export as much– Resulted in customs duties on goods– After Physiocrats, Smith: “laissez faire, laisser passer”

• but no systematic justification of this policy– Theoretical argument provided by Ricardo:

“Comparative Advantage”• Took case which Mercantilists would argue would

have meant rival (Portugal) “defeated” England in open trade

– Argued that England would benefit from free trade even if Portugal absolutely superior to England at producing everything

International Trade and Specialisation• Two countries (England & Portugal) producing 2

commodities (wine and cloth)• Assume

– Portugal more efficient at producing both– Relatively more efficient at producing wine than cloth

• More of both produced if– England specialises in cloth– Portugal specialises in wine

• Countries can then trade surpluses and increase consumption of both wine and cloth in both Portugal and England

Comparative Advantage• Portugal (per 1000 men)

– 90 men to produce x units of cloth– 80 men to produce y units of wine– can produce

• 11.1 units of cloth; or• 12.5 units of wine; or• any “straight line” combination of the two

• England (per 1000 men)– 100 men to produce x units of cloth– 120 men to produce y units of wine– can produce 10 units cloth, 8.5 units of wine, or

any linear combination:

Comparative Advantage• So with no trade:

– Portugal Max. 11.1 cloth, or 12.5 wine– England Max 10 cloth, or 8 1/3 wine

• Trade– Portugal 12.5 wine, England 10 cloth– Exchange surpluses, total output greater:

Comparative Advantage

Win

e

Cloth

PortugalEngland

Wine output without Wine output without tradetrade

Cloth output without Cloth output without tradetrade

Comparative Advantage

Trade: England produces Trade: England produces onlyonly Cloth, Portugal Cloth, Portugal only only

WineWine

PortugalEngland

Win

e

Cloth

Total output Total output higher, surpluses higher, surpluses

tradedtradedWine output without Wine output without tradetrade

Cloth output without Cloth output without tradetrade

Cloth output with Cloth output with tradetrade

Wine output with Wine output with tradetrade

Comparative Advantage• “Under a system of perfectly free commerce, each

country naturally devotes its capital and labour to such employments as are most beneficial to each. This pursuit of individual advantage is admirably connected with the universal good of the whole. By stimulating industry, by regarding ingenuity, and by using most efficaciously the peculiar powers bestowed by nature, it distributes labour most effectively and most economically.” (Ricardo 1817)

• Clever logical argument– aided repeal of Corn Laws

• Identical to modern economic belief• But behind Ricardo’s rhetoric, a Realpolitik…

Ricardo’s Realpolitik• “It has been my endeavour to shew throughout this

work, that the rate of profits can never be increased but by a fall in wages, and that there can be no permanent fall of wages but inconsequence of a fall of the necessaries on which wages are expended. If, therefore, by the extension of foreign trade, or by improvements in machinery, the food and necessaries of the labourer can be brought to market at a reduced price, profits will rise.” (Ricardo 1817)

• Ricardo’s real interest not efficiency, but– shifting income distribution: from landlords to

capitalists (workers irrelevant to Ricardo)– increasing rate of investment

Ricardo’s scorecard• Built on Smith

– accepted labour as source of value, Say’s Law• Far more rigorous than Smith

– Overcame problems in pricing– More complete model– But less social analysis than Smith– Sense of dynamics also lost

• Smith: increasing output through division of labour/economies of scale (with eventual stationary state as limits to division of labour reached)

• Ricardo– dynamics lead to stagnation (rising rents, declining

investment)– Static analysis (gains from trade with no reference to

time)

From Defenders to Critics• Smith, Say, Malthus, Ricardo

pro-capitalist, anti-feudal• Theories used to promote

capitalism against feudalism• Main class-conflict of the

time against feudal class, landlords

• By 1840, industrial capitalism dominant– severe economic

downturns• A new class conflict:

– Capitalist vs Worker• Classical economics turned

against capitalism by...

Marx• German Philosopher/poet, trained in Hegelian “dialectics”• Brilliant (but sometimes also turgid) writer and thinker

– Radicalised as completed PhD– Denied academic post in feudal Prussia, became

journalist– Supported peasants/workers against Prussian state– Exiled to France, later again exiled to England

• Began study of Political Economy in France with view understanding society, leading to revolution to better society

• Many contributions! Key ones arguably:– Sophisticated revival of systemic (“macro”) thinking of

Physiocrats– Economic analysis grounded in Dialectical philosophy

Dialectics• Philosophy of Dynamics, developed by Hegel

– Sought to explain processes of social change• Any Unity (person, thing, etc.) exists in society

– Society focuses on some aspects of unity; brings to foreground

– Forces other aspects into background– But unity cannot exist without background aspects– Dynamic tension created between

foreground/background aspects– Tensions can transform unity/society itself

Marx Pre-1857: the Labour Theory of Value

• Took classical economics of Smith & Ricardo, but made it critical of capitalism rather than supportive– many “Ricardian socialists” preceded Marx

• argued that since labour source of value, worker should receive all output: capitalists just “exploit” workers by paying them less than their value

– Marx far more sophisticated• argued profit derived even though workers paid their

value• critiqued capitalism on basis of its

– tendencies to crises, ultimate collapse– dehumanising, alienating impact of market society

• Solved many dilemmas of classical analysis– First: where does profit come from if all things

exchange at their value (“cost of production”)?


• Commodities exchange “at their value”• Value normally “labour-time taken to produce them’

– includes LT in machinery, as per Ricardo• Ability to work a commodity under capitalism:

“Labour-power”– Labour-time needed to produce labour-power =

subsistence wage– Capitalist buys Labour--actual work

• Say 5 hours work needed to produce subsistence bundle– Actual work lasts for 10 hours– Difference is “surplus value”: source of profit


• Labour only source of value:– Focus is on unique aspects of labour with respect to

all other commodities– Only commodity with difference between

“commodity” and “commodity-power”– A corollary: if labour only source of value, then capital

merely contributes stored labour-value to product• “However useful a given kind of raw material, or a

machine, or other means of production may be, though it may cost £150, or, say 500 days' labour, yet it cannot, under any circumstances, add to the value of the product more than £150.” [Capital I p. 199]

– contribution of machine to output equivalent to its depreciation


• Consequences:– Ideological: labour only source of profit, capitalism

based on exploitation– Predictions:

• increasing use of capital over time due to forces of competition between capitalists

– Collective rate of profit would fall, even though technical change might initially advantage capitalist who introduced it

• Fall in profit leads to class conflict– capitalists pay workers below value, to restore

profits• Class conflict leads to overthrow--socialism

– Socialism inevitable product of contradictions of capitalism


• Defined three key variables– v: Value of labour-power

• v for “variable” since labour alone, according to Marx, added new value

– If worker’s weekly means of subsistence take 20 hours to make, and a chair takes a working week to make, then the chair contains 20 hours of v

– c: value of machinery used up in production• c for “constant”, since according to Marx, machinery

merely transfers its value to output– adds to value of output what it loses in depreciation– If machinery which took 10 hours to make wears

out in making the chair, then the chair contains 10 hours of c


– s: Surplus-value• difference between what worker is paid (v) and the

number of hours worker actually works• If working week is 60 hours (common in Marx’s day),

then s=60-(v+c)=30– Three variables determine rate of surplus value

and rate of profit:

profit of Rate vcs

s Rate of surplus value (normally assumed constant)v

profit of Rate vcs

only sourceof surplus

• Problem I: the “Transformation problem”:– If labour only source of surplus, then profit should

be proportional to labour employed;– hence low capital/labor ratio industries should

have higher rate of profit than high K/L industries.:

constant assumed valuesurplus of Rate vs


high elower wher be should v+c

s Thusvc

c contributes nothing to

profit

Rate of profit “organic composition of capital”

s proportional to v


• But capitalists motivated by rate of profit• So for equilibrium, profit rate must be same

across all industries• So prices must equalise rates of profit

– High surplus-value in labour-intensive industries must somehow be moved to capital-intensive industries to equalise profit rates

– “Value” therefore diverges from price


• Problem of “transforming” values into prices. A 2 commodity economy example– Industry A:

•1000 hours labour + 1000 hours capital•Rate of surplus value 100%

– Profit in value terms = 500 hours– Industry B:

•100 hours labour + 1900 hours capital•Rate of surplus value the same (100%)

– Profit in value terms = 50 hours


• BUT– competition tends towards uniform rate of profit:

• 500/1500 + 50/1950 = 550/3450 = 13%– So price system must be consistent with

• (1000 + 1000) x 1.13 = price value of output of A• ( 100 + 1900) x 1.13 = price value of output of B• Profit in money terms thus 13% in both industries

– Prices thus differ from values and must cause transfer of value from labour-intensive to capital-intensive industries if Labour Theory of Value valid

– Prices of labour-intensive industries must be below value

– Prices of capital-intensive industries must be above value


• The “transformation problem”: transformation of values into prices– 1,000s of “solutions” to transformation

problem--none satisfactory

The Transformation Problem• Steedman Marx After Sraffa gives definitive treatment:

– Take hypothetical economy with 3 goods: Iron, Gold, Corn

– Take hypothetical wage (in terms of corn)– Convert physical data into labor-values according to

Marx’s rule that labor is the only source of surplus– Then impose equilibrium condition that price

competition equalises rates of profit across industries– Outcome will be a set of prices which are

• inconsistent– prices don’t enable industries to buy their inputs

• superfluous– prices can be derived directly from input-output data

without having to work out labor-values

The Transformation Problem• Steedman’s example economy:

Physical Input/Output DataInputs Outputs

Industry Iron Labour Iron Gold CornIron 28 56 56Gold 16 16 48Corn 12 8 8

56 80 56 48 8

Assume total wage equals 5 units (e.g., bushels) of corn

Net (surplus commodities) output is then3 units of corn48 units of gold

Call the value of one unit of labor input “1”. Then 3 simultaneous equations determine “labor values” of one unit of iron, gold, & corn:

The Transformation Problem• For Iron: 28 li 56 56 li 28 li 56 li 2

For Gold:

For Corn:

16 li 16 48 lg 16 2 16 48 lg lg 1

12 li 8 li 8 lc 12 2 8 8 lc lc 4

Value of labor (subsistencewage) = 5 units of corn:

V 5 l c 5 4 20

Surplus Value=Total labor minus V: S 80 V 80 20 60

Rate of Surplus Value same across all industries

SV

6020

31

So 3/4 of labor input is v, 1/4 is s:

The Transformation Problem• Converting physical data to value terms:

Physical Data in Value TermsInputs

Industry C v sIron 28*2 56/4 56*(3/4)Gold 16*2 16/4 16*(3/4)Corn 12*2 8/4 8*(3/4)

Physical Data in Value TermsInputs Output

Industry C v s tvIron 56 14 42 112Gold 32 4 12 48Corn 24 2 6 32

112 20 60 192

Now apply uniform rate of profit to work out prices:S

C V60

112 2045.455%

Per unit prices of iron, gold & corn are supposedly:

Iron Industry 56 14( ) 160

112 20

101.82

Gold Industry 32 4( ) 160

112 20

52.36

Corn Industry 24 2( ) 160

112 20

37.82

Find r w p i p c

0.521

0.268

1.704

4.296

The Transformation Problem

• But these “output prices” differ from “input prices” initially worked out (of iron=2, gold=1 & corn=4)– Even if both inputs and outputs

“transformed”, “prices” differ from those calculated straight from raw input/output data:

Given

1 r( ) 28 pi 56 w 56 pi

1 r( ) 16 pi 16 w 48

1 r( ) 12 pi 8 w 8 pc

80 w 5 pc

Per unit price of iron 101.8256

1.818

Per unit price of gold 52.3616

3.272

Per unit price of corn 37.828

4.728

The Transformation Problem• Marx’s “labor theory of value” prices are

– inconsistent• don’t enable each industry to buy its inputs• Marx’s rate of profit (45.5%) inconsistent with

rate worked out from basic input-output data (52.1%)

– superfluous• prices can be derived from direct input/output

data– and these prices are consistent

Problem: Tendency for rate of profit to fall• Argument that capital to labour ratio tends to rise over

time– Increased technology– Labour-saving inventions as response to struggle over

income distribibution• According to LTV, as c rises relative to v, rate of profit

will fall since surplus s proportional to v and independent of c.

• This will cause class conflict, leading to socialism• Marx lists many “countervailing tendencies”; nonetheless

– No conclusive evidence of tendency 140 years since first propounded

– “Tendency” depends on same (unsound) notions of profit which lead to Transformation Problem

Marxism Today: the Labour Theory of Value

• Current status of Marxian economics:– In crisis after fall of communism– Minority of adherents, still trying to solve technical

problems– Allegiance based on Marx’s grand vision, rather

than analytic strengths– Marxism no longer taken seriously by most

economists (though still popular with radical groups)

• So if this was all there was to Marx’s economics, it doesn’t look good for Marx…– BUT…

Marx Post-1857• There is an alternative Marx…

– Without the labour theory of value– Coherent alternative to neoclassical economics

• Pre-1857, accepted Smith/Ricardo on use-value & exchange-value– Exchange-value determines price– Use-value pre-requisite for exchange

• “Utility then is not the measure of exchangeable value, although it is absolutely essential to it” [Ricardo OREF I]

– No role for use-value beyond pre-requisite to exchange

• Post 1857, a whole new interpretation of use-value• Continued next lecture…

lecture three ricardo, value and comparative advantage say’s law: classical “macroeconomics”...

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