Ricardian Theory of Development – Explained!

Economics as a science is, on the one hand, a body of knowledge and on the other hand, an engine of analysis.

As a result of knowledge, it contains generalizations about the working of economic system. Prof. Ricardo added little to the economic knowledge gathered by Smith.

As an analytical engine, economics provides an apparatus through which actual economic problems are analyzed.

Ricardo’s greatest contribution to economics is the provision of engine of analysis. By using the technique of deductive or abstract reasoning, he constructed a rigorous model in which some selected economic variables were systematically placed to form a logic. Such a theoretical model helps to understand how a system works and how the change in variables affects the working of the system.

Ricardo propounded no theory of development. He simply discussed the theory of distribution. This theory is based on the marginal and surplus principles. The marginal principle explains the share of rent in national output and surplus principle explains the division of the remaining share between wages and profits.

Assumptions:

The Ricardian theory is based on certain assumptions which are as under:

1. Supply of land is fixed.

2. Land is used for production of corn and the working force in agriculture helps in determining the distribution in industry.

3. Law of diminishing returns operates on land.

4. Demand for corn is perfectly inelastic.

5. Labour and capital are variable inputs.

6. Capital consists of circulating capital.

7. There is capital homogeneity.

8. All workers are paid subsistence wages.

9. The state of technological knowledge is given.

10. There is perfect competition.

11. Demand for labour depends upon accumulation of capital.

12. Demand and supply price are independent of the marginal productivity of labour.

13. The supply price of labour is given and constant.

14. Capital accumulation results from profits.

Ricardian system considers agriculture as the most important sector of the economy. The difficulty of providing food to expanding population is the main problem. According to Ricardo, there are three major groups in the economy. They are landlords, capitalists and labourers among whom the entire productive land is distributed. It is the capitalists who initiate the process of economic development in the society by reinvesting profits and, thus, increasing capital formation.

The total national output is distributed among the three groups as rents, profits and wages, respectively and the share of each group can be determined as under:

1. Rent per unit of labour is the difference between average and marginal product or total rent equals the difference between average product and marginal product multiplied by the quantity of labour and capital on land.

2. The wage rate is determined by wage fund divided by number of workers employed at subsistence wage. Thus, output of total corn produced and sold, rent has the first right and the residual is distributed among wages and profits, while interest is included in profits.

Production Function:

Ricardo’s production function assumes the existence of three factors-land, labour and capital and it is subjected to the restriction of diminishing marginal productivity due to perfectly inelastic of land and its variable quality He regarded economic development as the process of these factors of production. The marginal productivity of land, labour and capital declines with the increase in cultivation.

In agriculture, the rate of innovation introduced would be insufficient to affect the tendency for diminishing returns to set in at either intensive or extensive margin of cultivation. Thus, the introduction of improvements in the agriculture techniques might check the progress of diminishing returns it could have temporary effect on cost of agricultural production.

For the overall growth of the economy, it is necessary to examine as to which of these patterns prevail with respect to the output of industry and agriculture together. Ricardo is of the opinion that “Although, then it is probable that under the most favourable circumstances, the power of production is still greater than that of population, it will not long continue so, for the land being limited in quantity and differing in quality, with every increased portion of capital employed on it there will be a decreased rate of production while the power of population continues always to be the same”. As Smithian economy grows at an accelerated rate, Ricardian economy develops at a progressively slower pace.

Ricardian production function is given as:

Y = F (K ,N,L)

K = Capital

N = Labour

L = Land

This production function is subjected to following constraints imposed by diminishing marginal productivity:

Capital Accumulation:

Ricardo emphasized the rate of capital accumulation as capital acts as an engine of growth. “Capital” is the part of the wealth of a country which is employed in production and consists of food, clothing tools, raw materials, machinery etc., necessary to give effect to labour.

Capital accumulation depends upon two factors:

(a) Capacity to save.

(b) Will to save.

The capacity to save is more important in capital accumulation. This depends on the net income of society which is a surplus out of the total output after meeting the cost of workers subsistence. The larger the surplus, the larger will be the capacity to save. Landlords and capitalists invest through this surplus and the size of this surplus depends upon the rate of profit.

The Profit Rate:

The rate of profit is the ratio of profits to capital employed. But since capital consists of working capital, it is equal to the wage bill. So, as long as rate of profit is positive, the process capital accumulation will continue and the economy will progress. The labour force will grow proportionately and the total wage fund will increase. The profit depends upon wages, wages on price of the corn and price of the corn on the fertility of marginal land. Hence, profits and wages are inversely proportional to each other.

When there is improvement in agriculture, the productivity power of land increases and there is fall in the price of corn and as a result, subsistence wage also falls, but profits increase and there is more capital accumulation. This will increase the demand of labour and wage rate will rise, which will increase population and demand for corn and its price. Since the wages rise, the profit will decline and there will be less capital accumulation.

The process of growth will continue till the profits fall to zero or the whole of the total product less rent is used for the maintenance of labour at subsistence level. At this stage, capital accumulation stops and the progress of the economy reaches a stationary state.

Increase in Wages:

In Ricardian Scheme, wages play an active role in determining income between capital and labour. The wage rate depends upon the number of workers and wage fund. The wage rate falls with the increase in number of workers and vice-versa.

If the wage rate is sufficient to enjoy the comforts of life by labourers, the population is expected to increase and if the wage rate is the lowest the working class cannot meet the necessities of life, the population will decrease. Thus, there is positive co-relation between wage rate and size of population. The increase in wages with the increase in population absorbs the rise in price of corn. Since wages also increase, profits decline. These opposite tendencies ultimately retard the capital accumulation.

Declining Profits in Other Industries:

According to Ricardo, “The profits of the farmer regulate the profits of all other trades”. Ricardo uses agricultural profits as a basis and it is the agricultural profit which determines the industrial profit. The money rate of profit earned on capital must be equal in equilibrium in both agriculture and industry.

The rate of profit in the agricultural sector determines the rate of profit in the industrial sector of an economy. Thus, when the profit declines in the agricultural sector, it also declines in the industrial sector. The industry would have to raise the wages of labourers with the increase in price of corn and which in turn, reduces the profit. Thus, the price of corn determines the rate of profit in an industry. When profit declines in agricultural sector, it declines in all trades.

Other Sources of Capital Accumulation:

Ricardo is of the view that economic development depends upon the difference between production and consumption. He stresses on increasing production and reducing unproductive consumption. The productivity of labour can be increased through technological changes and better organisation and thereby stimulating capital accumulation. But the use of machines will employ less workers which will lead to unemployment and reduced wages since the economic condition of workers decreases with the employment of more machines. So Prof. Ricardo regards the technological conditions as given and constant.

Taxes are the source of capital accumulation in the hands of the government. According to Ricardo, taxes are levied only to reduce conspicuous consumption, otherwise the imposition of taxes on capitalists, landlords and labourers will transfer resources from these groups to government. Taxes adversely affect the investment. Therefore, Ricardo is not in favour of imposition of taxes, as taxes reduce income, profit and capital accumulation.

Prof. Ricardo is in favour of free trade as it is an important factor of development of the country. Free trade provides vast opportunities of investment to capitalists. The capitalists can make investment in export oriented industries and earn profits. The re-investment of profit by the capitalists will further enhance the developing activities.

The capital accumulation can be raised by importing corn. But the import of corn leads to fall in demand for labour which deteriorates the economic conditions of labourers. On the other hand, landlords and capitalists do not think it fit to import cheap corn from the foreign countries, as a result, their profits decline. Ricardian theory has been illustrated with the help of a diagram (Fig 2).

The quantity of corn is measured along the vertical axis and labour along the horizontal axis. The curve AP represents average product of labour and MP represents the marginal product of labour. With OE amount of labour, total corn produced is OPQE. Rent is shown by rectangle PQML, as the difference between AP and MP. At subsistence wage rate OW, the
supply curve of labour WN is infinitely elastic and total wage is OWNE.

Total profits WLMN, are the residue after deducting rent and wages from the total output:

WLMN = OPQE — (LPQM — OWNE)

Stationary State:

When the economic development proceeds real wage rate remains at the subsistence level and profit tends to fall. When the capital accumulation rises with increase in profit, total output increases which raises the wage fund. With the increase in the wage fund’ population increases which raises the demand for corn and its price. As population increases, inferior grade lands are cultivated to meet increasing demand of corn. Ricardo assumes that labourers and landlords spend all their income on consumption and hence, save nothing.

The saving is done by the capitalist for profit earners. But as the society progresses, the share of profit begins to decline. Fall in the rate of profit slackens the process of capital accumulation and the development receives a set back and at this stage, there is no further increase in capital and the economy enters in a stationary state.

In this state, capital accumulation stops, population does not grow, the wage rate is at subsistence level and technological progress ceases. “The basic casual force in this scheme is the fact of diminishing returns in agriculture, a grim tendency which can be postponed temporarily by technical progress. But technical progress cannot prevent the ultimate disappearance of profit and the onset of stationary state”. The phenomenon of stationary state is explained with the help of a diagram 3.

With the increase in capital accumulation, profits and wages tend to increase and the rise in wages bring about a decline in profits. The decline in profits will continue till a stage comes when the net product curve intersects the wage line OW at P. At this point, wages are equal to net product and the profit is nil. Any disturbance to the right of point P, will make the net product less than wage level which is impossible. So P is the point at which economy is in a stationary state.

Thus, “Ricardian system of development formulated certain inter­relations among capital, population and output on the basis of these relations, it traces the course of rent, wages and profits every time and finally it concedes with the celebrated forecast of the eventual advent of a stationary state”.

Conclusion:

The model tries to deal with the various problems relating to development. It determines the relative shares of different agents of production in national income. The economy in this model is considered to be ever changing with the passage of time, till it reaches stationary state.

This theory highlights the importance of major development variables such as capital accumulation, population, profits, wages and rent etc. Harrod observed, “May I remind you the bare bones of Ricardo’s dynamic theory? It was a large part of this whole theory. The prime motive for these was the tendency to accumulate. This may be identified with what we regard as savings and is rightly treated by Ricardo as dynamic concept……. “