1. History of Economic Thought
Classical Economics

2. Classical Economists Adam Smith (1723 – 1790)
David Ricardo (1772 – 1823)
Thomas Malthus (1766 – 1834)
John Stuart Mill (1806 – 1873)
David Ricardo (1772 – 1823)
11/10/2018

3. Background – Influenced by – Contributions – Impact – Critique – Questions
David Ricardo (1772 – 1823)
David Ricardo (1772 – 1823)
11/10/2018

4. Background – Influenced by – Contributions – Impact – Critique – Questions
Personal
Third of 17 children born in London to Jewish immigrant parents
Joined his fathers stock brokerage at age 14 where his economic ability became apparent
Married a Quaker then converted to Christianity causing a rift with his father forcing him to establish his own brokerage where he made his fortune
David Ricardo (1772 – 1823)
11/10/2018

5. Background – Influenced by – Contributions – Impact – Critique – Questions
Personal
Become famous stock broker and extremely wealthy. At age 41, he is “sufficiently rich to satisfy all my desire”(Letter to Mill)
At age 42 he retired to his large country estate allowing him to further pursue his intellectual endeavors
In 1819 he took a seat in the House of Commons (Member of Parliament)
David Ricardo (1772 – 1823)
11/10/2018

6. Background – Influenced by – Contributions – Impact – Critique – Questions
Ricardo’s era
A time of rising industrialism and declining agriculture in the English economy
This change brought forth great debate on the issues of international trade and the role of government
David Ricardo (1772 – 1823)
11/10/2018

7. Background – Influenced by – Contributions – Impact – Critique – Questions
Influences
In 1799 he read Smith’s Wealth of Nations which spurred him on to the study of economics
He was friends with many of the eminent minds of his time (Mill, Bentham, Malthus)
He was encouraged by his friend James Mill to publish his first pamphlet
He had considerable correspondence with Malthus
David Ricardo (1772 – 1823)
11/10/2018

8. Background – Influenced by – Contributions – Impact – Critique – Questions
Adam Smith (1723 – 1790)
Inspired David Ricardo after he read “Wealth Of Nations”
David Ricardo (1772 – 1823)
11/10/2018

9. Background – Influenced by – Contributions – Impact – Critique – Questions
Jeremy Bentham ( )
Prominent Political Reformer and Utilitarian
Political radical who was a close friend of JS Mill’s father; spending a lot of time around the Mill household
Advised James Mill on the education and raising of his son JS Mill.
David Ricardo (1772 – 1823)
11/10/2018

10. Background – Influenced by – Contributions – Impact – Critique – Questions
Jeremy Bentham ( )
Prominent advocate of utilitarianism and animal rights
Viewed monetary expansion as useful only in helping to create full employment
Stated that pleasure and pain can be ranked by intensity, duration, certainty, etc. - ”Utility”
Set the precedent for the maximization principle for the firm and consumer
David Ricardo (1772 – 1823)
11/10/2018

11. Background – Influenced by – Contributions – Impact – Critique – Questions
Thomas Malthus ( )
Good friend of Ricardo and often had debates with Ricardo on many issues
David Ricardo (1772 – 1823)
11/10/2018

12. Background – Influenced by – Contributions – Impact – Critique – Questions
Jean-Baptiste Say ( )
French economist and businessmen, his work sparks numerous debates among economists at his time
David Ricardo (1772 – 1823)
11/10/2018

13. Ricardo’s publications include
Background – Influenced by – Contributions – Impact – Critique – Questions
Ricardo’s publications include
His first pamphlet, The High Price of Bullion, published in 1810
In 1815 he firmly established himself thru his essays against The Corn Laws (import tariffs designed to support domestic British corn).
Published his major work, Principles of Political Economy and Taxation, in 1817 at the age of 46, effectively surmounting Wealth of Nations
David Ricardo (1772 – 1823)
11/10/2018

14. Ricardo’s major contributions
Background – Influenced by – Contributions – Impact – Critique – Questions
Ricardo’s major contributions
Deductive Analysis
Comparative Advantage and Gains from Trade
Ricardian Equivalence
Refinement of (Labor) Theory of Value
Functional Income Distribution
David Ricardo (1772 – 1823)
11/10/2018

15. Background – Influenced by – Contributions – Impact – Critique – Questions
1. Deductive Analysis
Create usable economic models through the reduction of unnecessary elements (his particular strength)
Use these models to consider the impact of alternative economic policies
David Ricardo (1772 – 1823)
11/10/2018

16. Background – Influenced by – Contributions – Impact – Critique – Questions
1. Deductive Analysis
A model is like a map, which does not have many of the features of real world, but very useful.
David Ricardo (1772 – 1823)
11/10/2018

17. Background – Influenced by – Contributions – Impact – Critique – Questions
1. Deductive Analysis
This technique replaced the verbal arguments used by Malthus and Smith
This major contribution to modern economic thought places him as the first great theorist of economics (a theorist’s theorist)
David Ricardo (1772 – 1823)
11/10/2018

18. 2. Comparative Advantage and Gains from Trade
Background – Influenced by – Contributions – Impact – Critique – Questions
2. Comparative Advantage and Gains from Trade
Absolute advantage – a person (or a country) has absolute advantage in producing a good if he can produce that good with less resources (say less time, less inputs).
Malthus proposed this as the basis for international trade as it would result in more efficient resource allocation
Ricardo disagrees.
David Ricardo (1772 – 1823)
11/10/2018

19. 2. Comparative Advantage and Gains from Trade
Background – Influenced by – Contributions – Impact – Critique – Questions
2. Comparative Advantage and Gains from Trade
Comparative advantage – a person (or a country) has a comparative advantage in producing a good if his opportunity cost in the production of that good are lower.
Opportunity cost - is the cost incurred by choosing one option over the next best alternative.
David Ricardo (1772 – 1823)
11/10/2018

20. 2. Comparative Advantage and Gains from Trade
Background – Influenced by – Contributions – Impact – Critique – Questions
2. Comparative Advantage and Gains from Trade
The differences in the opportunity costs of production between trading partners is the basis for specialization and mutually beneficial trade
David Ricardo (1772 – 1823)
11/10/2018

21. 2. Comparative Advantage and Gains from Trade
Background – Influenced by – Contributions – Impact – Critique – Questions
2. Comparative Advantage and Gains from Trade
Main result: If people (or countries) have different relative productivity (different opportunity cost) in producing goods, then they can all gain from trading with each other (more goods can be produced). This is without working more.
David Ricardo (1772 – 1823)
11/10/2018

22. 2. Comparative Advantage and Gains from Trade
Background – Influenced by – Contributions – Impact – Critique – Questions
2. Comparative Advantage and Gains from Trade
Even if a country has absolute advantage in every good, it can never have comparative advantage in all the goods. There must be some goods in which the country has comparative disadvantage over other countries.
David Ricardo (1772 – 1823)
11/10/2018

23. Background – Influenced by – Contributions – Impact – Critique – Questions
2. GAINS FROM TRADE
Example. U.S.A. and Mexico can produce Medical Drugs (X) and Avocado (Y).
Time required (in minutes) to make one unit:
Opportunity Cost of one unit
Drugs (X)
Avocado (Y) X Y
U.S.A.
1.5 1
Mexico 10 2 5
1/5
U.S.A. has absolute advantage in both goods.
U.S.A. has comparative advantage in Drugs (X) and Mexico has comparative advantage in Avocado (Y).

24. 2. GAINS FROM TRADE Same information, different way.
Background – Influenced by – Contributions – Impact – Critique – Questions
2. GAINS FROM TRADE
Same information, different way.
Output per hour
Opportunity Cost of one unit
Drugs (X)
Avocado (Y) X Y
U.S.A. 40 1
Mexico 6 30 5
1/5
U.S.A. has absolute advantage in both goods.
U.S.A. has comparative advantage in Drugs (X) and Mexico has comparative advantage in Avocado (Y).

25. Time reallocation and gains from trade
Background – Influenced by – Contributions – Impact – Critique – Questions
2. GAINS FROM TRADE
Time reallocation and gains from trade
U.S.A.
Drugs (X)
Avocado (Y)
Mexico
Total change in output
1 hour
+40
-40
2 hours
-12
+60
+28
+20

26. 3. Ricardian Equivalence
Background – Influenced by – Contributions – Impact – Critique – Questions
3. Ricardian Equivalence
The use of debt vs. taxes as a funding mechanism is really only a matter of timing
If the government gives a tax break now, people understand that eventually the government will have to increase taxes to pay off its debt and interest. The public will therefore save the tax break in anticipation of future tax increases.
See notes on Ricardican Equivalence.
David Ricardo (1772 – 1823)
11/10/2018

27. 4. Refinement of Theory of Value
Background – Influenced by – Contributions – Impact – Critique – Questions
4. Refinement of Theory of Value
The theory of value attempts to answer the question “what determines the prices of goods?”.
The classical theory of value, articulated by Adam Smith, holds that the prices are equal to per unit costs.
In modern notation: 𝑃 = 𝑀𝐶, and in the long run = 𝐴𝐶
David Ricardo (1772 – 1823)
11/10/2018

28. 4. Refinement of Theory of Value
Background – Influenced by – Contributions – Impact – Critique – Questions
4. Refinement of Theory of Value
Labor theory of value relates prices of commodities to the amount of labor needed to produce them.
For simple economic activities such as hunting and fishing, the Labor Theory of Value was fine according to Ricardo:
“If among a nation of hunters, for example, it usually cost twice the labor to kill a beaver which it does to kill a deer, one beaver should naturally exchange for, or be worth two deer”.
11/10/2018

29. 4. Refinement of Theory of Value
Background – Influenced by – Contributions – Impact – Critique – Questions
4. Refinement of Theory of Value
In more complicated situations, the classical labor theory of value cannot be applied.
For example, suppose a ton of rice grown on less fertile Type B land requires 4 hours of labor whereas a ton of rice grown on more fertile Type A land requires 2 hours of labor. Would we then say that the price of the first ton of rice would be twice the price of the second ton of rice?
David Ricardo (1772 – 1823)
11/10/2018

30. 4. Refinement of Theory of Value
Background – Influenced by – Contributions – Impact – Critique – Questions
4. Refinement of Theory of Value
Ricardo explained how the labor theory of value should be applied in more general cases.
The rent on the least fertile piece of land is approximately zero. So the cost of rice grown on least fertile land is only the labor cost.
David Ricardo (1772 – 1823)
11/10/2018

31. 4. Refinement of Theory of Value
Background – Influenced by – Contributions – Impact – Critique – Questions
4. Refinement of Theory of Value
Similarly, the cost of wheat grown on the least fertile land reflects the wheat labor cost.
The relative price of rice and wheat are still determined by the wages of workers employed at the least fertile land.
David Ricardo (1772 – 1823)
11/10/2018

32. 5. Functional Income Distribution
Background – Influenced by – Contributions – Impact – Critique – Questions
5. Functional Income Distribution
Ricardo’s belief that total output will ultimately stop growing convinced him that the main issue in economics was not to figure out how economies grow richer but to figure out how the limited output in the economy’s stationary state is distributed or shared among the various sectors of the economy.
David Ricardo (1772 – 1823)
11/10/2018

33. 5. Functional Income Distribution
Background – Influenced by – Contributions – Impact – Critique – Questions
5. Functional Income Distribution
Question: How is the income received by various factors of production determined?
Assumptions of the agricultural model:
There are three classes of people, Landlords who earn rent, Workers who earn wages, and Capitalists who earn profits
Assume that wages are at subsistence level (25) and that capital is used in fixed proportions (1 shovel per worker)
David Ricardo (1772 – 1823)
11/10/2018

34. Background – Influenced by – Contributions – Impact – Critique – Questions
David Ricardo (1772 – 1823)

35. Background – Influenced by – Contributions – Impact – Critique – Questions
David Ricardo (1772 – 1823)
11/10/2018

36. Background – Influenced by – Contributions – Impact – Critique – Questions
David Ricardo (1772 – 1823)
11/10/2018

37. Background – Influenced by – Contributions – Impact – Critique – Questions
Case 1 (One Worker)
David Ricardo (1772 – 1823)
11/10/2018

38. Background – Influenced by – Contributions – Impact – Critique – Questions
Case 1 (One Worker)
The equilibrium payment to the worker with a shovel is 90 (or, more precisely, just slightly more than 90). Worker’s wage is 25, so the payment to capital is 65 (profit).
Total output would be 100. After paying wages = 25 and profit = 65, the residual rent would be 10.
David Ricardo (1772 – 1823)
11/10/2018

39. Background – Influenced by – Contributions – Impact – Critique – Questions
Case 2 (Three Workers)
David Ricardo (1772 – 1823)
11/10/2018

40. Case 2 (Three Workers) Plot Wages Profit Rent Total Output A 25*2=50
Background – Influenced by – Contributions – Impact – Critique – Questions
Case 2 (Three Workers)
Plot
Wages
Profit
Rent
Total Output A
25*2=50
55*2=110
190-80*2=30
190 B 25 55
90-80=10 90
Total 75
165 40
280

41. Background – Influenced by – Contributions – Impact – Critique – Questions
Case 2 (Three Workers)
The equilibrium payment to workers with a shovel is 80 (or, just slightly more than 80). Worker’s wage is 25, so the payment to capital is 55 (profit).
David Ricardo (1772 – 1823)

42. Background – Influenced by – Contributions – Impact – Critique – Questions
Case 3 (Six Workers)
David Ricardo (1772 – 1823)
11/10/2018

43. Case 3 (Six Workers) Plot Wages Profit Rent Total Output A 25*3=75
Background – Influenced by – Contributions – Impact – Critique – Questions
Case 3 (Six Workers)
Plot
Wages
Profit
Rent
Total Output A
25*3=75
45*3=135
270-70*3=60
270 B
25*2=50
45*2=90
170-70*2=30
170 C 25 45
80-70=10 80
Total
150
100
520

44. Background – Influenced by – Contributions – Impact – Critique – Questions
Case 3 (Six Workers)
The equilibrium payment to workers with a shovel is 70 (or, just slightly more than 70). Worker’s wage is 25, so the payment to capital is 45 (profit).
David Ricardo (1772 – 1823)
11/10/2018

45. Background – Influenced by – Contributions – Impact – Critique – Questions
Case 4 (Ten Workers)
David Ricardo (1772 – 1823)
11/10/2018

46. Case 4 (Ten Workers) Plot Wages Profit Rent Total Output A 25*4=100
Background – Influenced by – Contributions – Impact – Critique – Questions
Case 4 (Ten Workers)
Plot
Wages
Profit
Rent
Total Output A
25*4=100
35*4=140
340-60*4=100
340 B
25*3=75
35*3=105
240-60*3=60
240 C
25*2=50
35*2=70
150-60*2=30
150 D 25 35
70-60=10 70
Total
250
350
200
800

47. Background – Influenced by – Contributions – Impact – Critique – Questions
Case 4 (Ten Workers)
The equilibrium payment to workers with a shovel is 60 (or, just slightly more than 60). Worker’s wage is 25, so the payment to capital is 35 (profit).
David Ricardo (1772 – 1823)
11/10/2018

48. Payments to Factors of Production When Labor Increases
Background – Influenced by – Contributions – Impact – Critique – Questions
Payments to Factors of Production When Labor Increases
# of Workers
Wage per worker
Profit per unit of capital
Rent per slot 1 25 65 10 3 55 20 6 45
33.33 35 50

49. Message of the Ricardian Theory of Rent
Background – Influenced by – Contributions – Impact – Critique – Questions
Message of the Ricardian Theory of Rent
When the number of farm laborers goes up, the ones who benefit are not the workers themselves, but the land owners.
This finding has withstood the test of time. Economists use Ricardian reasoning today to explain why agricultural price supports do not help farm laborers per se but do make owners of farmland wealthier.
David Ricardo (1772 – 1823)
11/10/2018

50. Background – Influenced by – Contributions – Impact – Critique – Questions
Impact on Economics
Demonstrated the gains from free trade, which are part of todays text (Principles, Intl. Trade).
Abstract theoretical models as the foundation for proper policy formation
Provided a powerful impetus for a market based system
Theory of income among landlords, laborers, capitalists (land, labor, capital)
David Ricardo (1772 – 1823)
11/10/2018

51. Impact on Government Trade Policies
Background – Influenced by – Contributions – Impact – Critique – Questions
Impact on Government Trade Policies
The Corn Laws were eventually repealed
Malthus supported a “fair wage” for farmers
Ricardo’s model showed that overall productivity would be increased through examination of opportunity costs and specialization
Explained why government stimulus policies my not work.
David Ricardo (1772 – 1823)
11/10/2018

52. Controversy About Free Trade Agreements Today
Background – Influenced by – Contributions – Impact – Critique – Questions
Controversy About Free Trade Agreements Today
NAFTA
TPP
Hillary Clinton
Initially for, since 2008 against
Initially for, since 2016 against
Barack Obama
Against
For (created the agreement)
Bernie Sanders
Donald Trump

53. Policies against free trade are costly
Background – Influenced by – Contributions – Impact – Critique – Questions
Policies against free trade are costly
"over a thousand Americans are working today because we stopped a surge in Chinese tires.“ (Barack Obama 2012, State of the Union Address, Quote about tariff increase on Chinese tires imports).
Estimated jobs saved by the tariff: 1,200.
Cost to consumers (who spend more on tires): 1.1 billion in 2011 alone.
Cost per job saved in tire industry: $833,000 per job.
Without the tariff, the 1.1 billion could be spent on other goods and services, and create 11,000 jobs (at 100k).

54. Critique Overly simplified assumptions of models.
Background – Influenced by – Contributions – Impact – Critique – Questions
Critique
Overly simplified assumptions of models.
But that is exactly what makes models useful. Today we know that models are not supposed to be realistic.
Like Malthus, did not take into account the possibility of technological progress and economic growth. Therefore, he focused primarily on how fixed income is distributed among classes.
David Ricardo (1772 – 1823)
11/10/2018

55. Questions and Discussion
Background – Influenced by – Contributions – Impact – Critique – Questions
Questions and Discussion
Give example of comparative advantage and specialization in your life.
Would Ricardo support NAFTA if he was alive today?
Debate: argue in favor and against outsourcing. One student can be Ricardo (in favor of outsourcing) and another will be against it.
David Ricardo (1772 – 1823)
11/10/2018