Malthus & Ricardo

Thomas Robert Malthus (1766-1834)

 English cleric and Professor of History and Political

Economy (1805-34) at the East India Company College in
Hertfordshire – now Haileybury public school

 An Essay on the Principle of Population (1798), with

revised editions appearing until the 6th in 1826

 Provided key building blocks for David Ricardo’s

theoretical system:

Theory of subsistence real wages (due to population

change) – the “iron law of wages”

Initiated the differential theory of rent

 Friendly critic (through letters) of David Ricardo

1
David Ricardo (1772-1823)

 Highly successful dealer in government bonds. Later

purchased a country estate (Gatcombe Park in
Gloucestershire) and a seat in Parliament

 Strongly supported free trade: As MP (1818-23), was

highly critical of the Corn Laws (= tariffs on imported food
and corn, 1815-46)

 Self-taught in Economics. Discovered Wealth of Nations

by chance while on holiday in Bath

 The Principles of Political Economy and Taxation (1817)

 Formalised the Classical system. The first builder of

economic models:

assumptions  deductive reasoning  conclusions 

policy recommendations
2
 Ricardo had a huge influence…

Paul Samuelson (1915-2009) called Marx a “minor post-

Ricardian”

 … but not necessarily all positive?

Schumpeter (History of Economic Analysis, 1954) referred

to the “Ricardian vice” as the act of “piling a heavy load of
practical conclusions upon a tenuous groundwork”

(= drawing bold policy conclusions from oversimplified

models)

3
 Malthus’ Theory of Subsistence Real Wages

In LR, real wage kept at subsistence level by population

growth:

 “Iron Law of Wages” (named in mid-C19th by Lassalle*):

w → w SUBSIS as t → ∞

Malthus was not a theoretically-inclined economist. His work

mixed insights and opinions that were

 theoretical

e.g. S
L ↑→w↓

 empirical

e.g. population data

 ethical

e.g. strong and fixed sexual appetite of workers

 hard to interpret

Conventional interpretation of Malthus: L

S
perfectly elastic at
w SUBSIS

 Malthus was analysing how L

S
responds to exogenous w

But, arguably, Malthus’ theory explained (i.e. treated as

endogenous) both L and w

*
Ferdinand Lassalle (1825-64): German philosopher and founder of the
social-democratic movement in Germany. Also coined the term “night-
watchman state”
4
 An Essay on the Principle of Population (Malthus)

(6 editions, 1st in 1798, content revised)

 Population tends to  in a geometric progression

Doubles every 25 years

 Food production tends to  in an arithmetic progression

as “intensive” and “extensive” margins of cultivation

extended. [Former = farm existing agricultural land harder;
latter =  area of agricultural land]

 In LR, food production limits (= acts as a check upon)

population growth

 Two quotations from Chapter 2 of 1st (1798) edition of An

Essay on the Principle of Population:

1. “Yet in all societies, even those that are most vicious, the
tendency to a virtuous attachment is so strong, that there
is a constant effort towards an increase of population. This
constant effort as constantly tends to subject the lower
classes of the society to distress and to prevent any great
permanent amelioration of their condition”

5
2. “The way in which these effects are produced seems to be
this. We will 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 before the means of subsistence are
increased. The food therefore which before supported
seven millions must now be divided among seven millions
and a half or eight millions. The poor consequently must
live much worse, and many of them be reduced to severe
distress…

“During this season of distress, the discouragements to

marriage, and the difficulty of rearing a family are so great
that population is at a stand.

“In the mean time… the plenty of labourers…

encourage[s] cultivators to employ more labour upon their
land, to turn up fresh soil, and to manure and improve
more completely what is already in tillage, till ultimately the
means of subsistence become in the same proportion to
the population as at the period from which we set out.

“The situation of the labourer being then again tolerably

comfortable, the restraints to population are in some
degree loosened, and the same retrograde and
progressive movements with respect to happiness are
repeated.”

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 A Modern Interpretation (Model) of
Malthus’ Theory of Population and Living Standards

Assumptions:

 Diminishing returns to labour in agriculture

 PopN  (no. births > no. deaths) if w >w SUBSIS

PopN  (no. births < no. deaths) if w <w SUBSIS

 Real wage (in units of food), w, is closely related to

output/worker in agriculture, Y/L

Y
w=
L
(i.e. consumption of food per worker = output per
worker in agriculture) if the economy’s food output is
entirely consumed by its workers (effectively, shared out
between them) and all workers work in agriculture†

PTO for diagram

†
These “ifs” mean that the total monetary demand for food is WL, where
L = agricultural employment. Equating this to nominal food supply, P F Y ,
W Y W
and rearranging gives P = L (where P =w )
F F

7
 Y
 If L> LEQM , then L
< wSUBSIS

 L  back to LEQM (i.e. a stable eqm)

 Evaluation: Model is very static (e.g. eqm population

level, LEQM, is fixed), whereas Malthus’ writings have a
strongly dynamic flavour (e.g. “there is a constant effort
towards an increase of population” above)

To fit 2nd Malthus quote above better:

Perhaps add assumptions: that L tends to grow even

Y
when L =w SUBSIS; and that this causes more land to be
cultivated, i.e. Y function (agricultural production function)
shifts up (but still starts at the origin)

 LEQM grows over time

8
9
 The (Differential) Theory of Rent

 Initiated by Malthus; completed by Ricardo

Hence also “Ricardian theory of rent”

 Rent (payment by capitalist farmers  landlords) arises

when employment in agriculture  and land of inferior
quality is brought into cultivation

Ricardo referred to “law of diminishing returns”:

successive s in agricultural employment  smaller and
smaller s in agricultural output

Later (Neoclassical) economists would apply the notion of

diminishing (marginal) returns to all factors of production,
as the basis of a general theory of factor prices – e.g. eqm
real wage = MPL, where MPL  as L

Example:

 Two fields (A and B), which differ in quality (productivity)

and are owned by different landlords

Output (corn) = 10 in field A, 7 in field B

 One farmer, who wants to rent and cultivate one field

 Which field is rented and what is the eqm rent payment?

Eqm: Farmer rents field A and pays (just under) 3 in rent

3 (= 10 – 7) is the most that landlord A can charge. If

landlord A demands > 3 in rent  landlord B will make the
farmer a better offer

 eqm rent reflects superior productivity of rented field

10
Ricardo writes:

“When, in the progress of society, land of the second

degree of fertility is taken into cultivation, rent immediately
commences on that of the first quality, and the amount of
that rent will depend on the difference in the quality of
these two portions of land.

“When land of the third quality is taken into cultivation, rent

immediately commences on the second, and it is
regulated as before by the difference in their productive
powers. At the same time, the rent of the first quality will
rise, for that must always be above the rent of the second
by the difference between the produce which they yield…
With every step in the progress of population, which shall
oblige a country to have recourse to land of a worse
quality, to enable it to raise its supply of food, rent, on all
the more fertile land, will rise…

“[T]he capital last employed pays no rent.”

(From Chapter 2 of The Principles of Political Economy

and Taxation)

Observations:

1. “the capital last employed” = “the field last employed”

because capital (= advanced wages), labour and land are

used in fixed proportions – e.g. 1 worker per field

2. Message = “marginal land” (i.e. the worst quality

cultivated) is rent-free (if the next-best field has
approximately the same productivity)

11
 Ricardo’s “Corn Model”

CM is a mid-C20th formalisation of Ricardo’s views on

distribution, accumulation and growth:

“The produce of the earth—all that is derived from its

surface by the united application of labour, machinery, and
capital, is divided among three classes of the community;
namely, the proprietor of the land, the owner of the stock
or capital necessary for its cultivation, and the labourers
by whose industry it is cultivated.

“But in different stages of society, the proportions of the

whole produce of the earth which will be allotted to each of
these classes, under the names of rent, profit, and wages,
will be essentially different; depending mainly on the
actual fertility of the soil, on the accumulation of capital
and population, and on the skill, ingenuity, and
instruments employed in agriculture.

“To determine the laws which regulate this distribution, is

the principal problem in Political Economy.”

(Beginning of Preface to Ricardo’s Principles of Political

Economy and Taxation, 1817)

Structure of CM:

 Initially, a one-sector model of distribution, accumulation

and growth: the agricultural sector producing “corn”

Will add extra industries (e.g. “luxuries”) later

12
Agricultural wages and employment:

 L(of agricultural workers) perfectly elastic at w SUBSIS – due to

S

Malthusian population dynamics

 Capitalist farmers supply capital, which pays the

subsistence wages of agricultural workers in advance of
the harvest

 capital = a “wage fund”

 For simplicity, assume each worker works on a different

field

(There is an abundance of land, but fields differ in

productivity)

Note: No substitutability between factors (as in

Neoclassical theory). Each worker requires a fixed amount
of capital (= the advanced subsistence wage), and the
cultivated-land:labour ratio is also fixed

  level of employment (and land use), L, is determined by

the inherited wage fund:

( Wage fund )
L=
w SUBSIS

(For simplicity, we ignore farmers’ seed requirements,

which the “wage fund” would also have to provide)

13
Rents and profits:

 Landowners farm out their land (for rent) to capitalist

farmers

Rents consumed in “riotous living”

 Surplus (= output – wages advanced) is divided between

rents and profits

After the annual harvest, farmers replenish their capital

and pay rents to landlords

 farmers’ profits are the residual output

 Dynamics: Profits are accumulated (reinvested)  next

year’s wage fund and employment are larger:

( Wage fund )t +1=( Wage fund )t + Profits t

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Distribution of income:

 Determined by fact that fields differ in productivity

(“quality”)

Farmers start by cultivating the best land

Marginal productivity of labour (MPL)  as L  because

quality of “marginal”/newly-cultivated land 

Total corn output = area under MPL between 0 and level

of employment

 Assume that productivity of land varies continuously

= productivity difference between two neighbouring fields

(in the productivity ranking) is v small (infinitesimal)

 no rent paid on marginal cultivated field

because there’s always a vacant plot that’s

approximately as good

 owner of marginal field would be undercut by

owner of that vacant plot if he tried to charge a rent

Rent on all other cultivated fields given by difference

between “own” and marginal field’s productivity

15
“Stationary state”:

 SS (= end of growth) reached when MPL=w SUBSIS

 whole “surplus” (of output over the wage fund)

absorbed by rent

 Ricardo believed that rents prevent growth and “progress”:

“the interest of the landlord is always opposed to the
interest of every other class in the community” (An Essay
on Profits, 1815)

Gatcombe Park in Gloucestershire, DR’s home:

(DR criticised the landlord class despite being a substantial

landowner himself)

16
 Kaldor’s (1955) Diagram of the Corn Model

(From Nicholas Kaldor, “Alternative Theories of Distribution”,

Review of Economic Studies, 1955)

17
 Discussion of “Corn Model”

1. For Ricardo, CM served 3 (related) purposes:

a. CM provided a model (cause-and-effect explanation)

of economic growth and of distribution

b. CM provided a basis for policy recommendations

c. CM provided justification for Ricardo’s criticisms of

Smith’s “adding-up” theory of natural prices

2. Textual foundations (in Ricardo’s writings) of CM

3. Malthus’ objections to the CM (in letters)

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 1(a): Explanation of Rate of Profit ()

 Income distribution aside,  is important because it is the

growth rate of the economy’s capital stock (given that
investment = profits)

 In general – i.e. with many goods (as outputs and inputs)

– the rate of profit in an industry is

Value of Profit (£)

π=
Value of Capital(£)

 Competition (= free mobility of capital between industries)

tends to equalise  across industries

 can calculate the economy-wide value of  using data

(i.e. values of profit and capital) from any industry

 Problem: To determine  for a particular industry, we

usually need to know (relative) prices of goods

e.g. to calculate Value of Capital (£) above – given that

the input bundle used by an industry usually contains
multiple goods (i.e. “capital is heterogeneous”)

 need theory of relative prices – and Ricardo was unsure

about this (see below)

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1(a) cont’d:

 CM suggests a solution: the special nature of

agriculture revealed

In agriculture, both profit and capital (= advanced wages)

are quantities of the same good (corn)

 don’t need to know any product prices to determine

π AGRIC

Profits L AGRIC ( MPL AGRIC −w SUBSIS )

π AGRIC = =
Wage fund L AGRIC ∙ wSUBSIS

MPL AGRIC
¿ −1
w SUBSIS

 With π AGRIC given by the extent of agricultural cultivation,

competition will ensure that (relative prices are such that)
every other industry shares the agricultural rate of profit:
e.g.

P LUX ∙ q−W
= π
⏟ W π LUXURIES =Profit-per-worker /Capital-per-worker (the advanced wage)
AGRIC

where P LUX =¿ price of luxuries; q=¿ output per worker in

luxuries; and W =PCORN ∙ w SUBSIS =¿ money wage

Substitute in for W and rearrange:

P LUX w SUBSIS
P CORN
=
q
( 1+π AGRIC )

 Ricardo to Hutches Trower (8/3/1814): “it is the profits of

the farmer that regulate the profits of all other trades”

20
1(a) cont’d:

“The rational foundation of the principle of the determining

role of the profits of agriculture, which is never explicitly
stated by Ricardo, is that in agriculture the same
commodity, namely corn, forms both the capital
(conceived as composed of the subsistence necessary for
workers) and the product; so that the determination of
profit by the difference between total product and capital
advanced, and also the determination of the ratio of this
profit to the capital, is done directly between quantities of
corn without any question of valuation…

“It follows that if there is to be a uniform rate of profit in all

trades it is the exchangeable values of the products of
other trades… relatively to corn that must be adjusted so
as to yield the same rate of profit as has been established
in the growing of corn.”

(Piero Sraffa, Introduction to Ricardo’s Collected Works,

1951, p. 31. Italics added)

21
 1(b): Policy Recommendations

 Corn Laws (= tariffs on imported food and corn, 1815-46)

 large domestic agricultural sector

   (= economy-wide rate of profit) and economic growth

(which arises via reinvested profits) both low

Dynamic cost of protection

 Ricardo also explained the static cost of protection

“Principle of Comparative Advantage”

Usually illustrated via the “Ricardian Model” in

contemporary International Economics

 Arguably, modern Economics paints one-sided picture of

Ricardo’s views on gains from (international) trade

22
 Principle of Comparative Advantage

 GB and Europe (Eur) produce and trade corn and

manufactures

 Adam Smith explained the gains from trade when each

country has an “absolute advantage” in one of the goods

e.g.

Output per worker

Corn Manufactures
GB 10 10
Eu 15 4
r

Specialise and trade:

GB: Move 1 L from C  M

Eur: Move 1 L from M  C

Result: Specialising and trading can leave both countries

with more of both goods to consume

 But sometimes the pattern of absolute advantage isn’t as

neat as Smith assumed…

(e.g. GB might have AA in both goods)

23
24
 Ricardo showed that specialisation and trade created
gains more generally – i.e. outside the special pattern of
absolute advantage that Smith assumed

 Key concept = comparative advantage

e.g. GB has absolute advantage in both goods:

Output per worker

Corn Manufactures
GB 20 10
Eu 15 4
r

Specialise and trade:

GB: Move 1 L from C  M

Eur: Move 2 L from M  C

25
Result: Again, specialising and trading can leave both
countries with more of both goods to consume

26
 1(c): Criticisms of Adam Smith

 Smith explained the LR “equilibrium conditions” under

competition (= free mobility):

“Natural prices” for factors…

Labour: all workers of given type/skill earn same

wage

Capital: rate of profit () is equal across industries

… and commodities

Add up input costs, valued at their natural prices

Cost-of-production or “adding-up” (Sraffa) theory of

value

27
1(c) cont’d:

 But Smith lacked a unified theory/explanation of “natural”

factor prices. For example, WoN:

presented several (incompatible?) theories of real wages

( Wage fund )
e.g. “wage fund” theory (w= L
); subsistence
theory (based on Malthusian population dynamics);
monopsony theory

treated natural wage and natural profit rate as

independent

Ricardo doubted this, and his Corn Model showed

that w and  are (negatively) related‡

 potential for class conflict over the distribution of

income (a theme developed by Marx, in particular)

Sraffa (1960) showed that the negative w:

relationship is quite general

‡
Recall that the rate of profit in agriculture is given by
π=( MPL−w ) /w= ( MPL/w ) −1. Therefore, if LAGRIC is given, w    . The
situation is more complex if, instead, the agricultural wage fund is treated
as given (because then w   LAGRIC ), but  still depends on w (rather
than being independent of it).
28
 2: Textual Foundations of the Corn Model
(in Ricardo’s writings)

 Corn Model rationalises (provides reasons for) Ricardo’s

remark in a letter that “it is the profits of the farmer that
regulate the profits of all other trades”

Because, in agricultural sector of CM, the capital (“wage

fund”) and the product are the same commodity (corn)

 But Sraffa (1951) candidly admits that the CM “is never

explicitly stated by Ricardo”

 Mark Blaug distinguished between rational and historical

reconstructions in HET

“Rational reconstruction” = using today’s theoretical tools

to “reconstruct” (interpret/evaluate) historical ideas§

“Historical reconstruction” = getting “inside the head” of

the historical figure who had the idea; understanding the
idea in their terms

Late Blaug on RR vs HR:

“Although I have been guilty myself of the very sin I have

just deplored [i.e. rational reconstruction], I have come to
the conclusion that the only approach to the history of
economic thought that respects the unique nature of the
subject material, rather than just turning it into grist for the
use of modern analytical techniques, is to labour at
historical reconstructions, however difficult they are.”
(Blaug, 2001, p. 152)

§
e.g. the modern claim that by his “invisible hand” observations, Adam
Smith “really meant” that a perfectly competitive equilibrium is Pareto
efficient (a result known as the “first fundamental theorem of welfare
economics”)
29
 Blaug on origin of CM:

“This ingenious argument, which appears to explain the

determination of the rate of profit in purely physical terms
without entering into the question of valuation, is known in
the literature as the ‘corn model’. It was only in modern
times that Piero Sraffa, the editor of The Works of David
Ricardo, detected this line of reasoning as implicit in
Ricardo’s Essay. There is actually no direct evidence that
Ricardo had the corn model in the back of his mind but it
is true that the corn-model interpretation neatly
rationalises almost all of Ricardo’s arguments according to
which the economy is admitted to consist of two sectors
but the rate of profit is determined exactly as it would be in
a one-sector economy. Nevertheless, on balance one
must conclude that the corn-model interpretation of
Ricardo’s Essay is a ‘rational reconstruction’.”

(Blaug, Economic Theory in Retrospect, p. 89, italics

added)

 Regardless of what Ricardo “really thought”, CM played a

“living role” in C20th debates in economic theory

CM was used (by Piero Sraffa, Joan Robinson and

associates) in their criticism of later (Neoclassical)
explanations of the rate of profit that focussed on supply
and demand in the aggregate capital market

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 3: Malthus’ Objections to the Corn Model

(and to Ricardo’s economics more generally – partly in letters)

3(a): “In no case of production, is the produce exactly of

the same nature as the capital advanced.” (Letter from
Malthus to Ricardo, 5/8/1814)

 A criticism of Ricardo’s claim that the economy-wide rate

of profit () is determined in agriculture (where product &
capital = corn)

 Wages (the “capital advanced” from the “wage fund”) do

not consist solely of corn because workers consume a
heterogeneous bundle of commodities – e.g.
manufactures, as well as corn/food

In addition, various non-wage costs (e.g. for tools, raw

materials and component parts) must be paid “in
advance”, at the start of the production process**

Thus, capital is heterogeneous, rather than consisting of a single

**

commodity. Rather than assuming that all firms continue to resemble the
Classical economists’ “farmers” (who owned physical stocks of corn-
capital, which they “advanced” to workers in return for their labour), a
more modern interpretation – which leads to the same result – is that the
value of the money wage that firms must “advance” to their workers
equals the total cost of buying a heterogeneous consumption basket
(whose composition is determined by “fair wage” norms). From the point
of view of production costs (and thus invested/advanced capital), this
modern interpretation (where firms must pay their workers enough
money to buy a certain bundle of goods) is equivalent to the Classical
economists’ framework (where capitalists were assumed to pay their
workers in kind – e.g. in physical consumption goods)
31
 Value of Profit (£)
  to get a theoretical prediction for π=
Value of Capital(£) , we
need a theory of (relative) prices

Can’t use Smith’s “adding up” theory because that

uses  as an input into the determination of prices

 would lead to circular reasoning (= faulty

reasoning where the claimed conclusion is
essentially the same as an assumption – i.e. the
argument assumes what it is supposed to prove)

Effectively, the procedure would become: assume a

value for   derive product prices (by “adding up”
production costs)  solve for 

 it seemed to Ricardo et al. that we need an

explanation of (theory for) relative prices that is
independent of 

32
 Ricardo tried the Labour Theory of Value, but he was
aware that it was inadequate

In many cases, equilibrium relative prices do depend on ,

but LTV contains no role for 

Example 1: Different “periods of production” across goods

Good X (e.g. wine): l X labour in year 1; rest in year 2

(fermentation)

∴ P X = (1+ π )2 l X W

Good Y: lY labour  output in one year

∴ P Y =( 1+ π ) l Y W

PX lX
Eqm relative price: PY
=( 1+ π ) ∙
lY

P X lX
But LTV prediction: =
PY l Y

Example 2: Different ratios of materials:labour across

commodities

P X AC X l X m
Intuitively, eqm = >
PY AC Y l Y
if materials per worker ( l ) much
larger in X: see Adam Smith on the LTV

33
 Ricardo justified using LTV by arguing that, empirically,
the conditions for LTV to predict eqm relative prices
accurately were approximately satisfied:

“[E]xchangeable value varies… owing only to two causes:

one the more or less quantity of labour required, the other
the greater or less durability of capital… the former is
never superseded by the latter, but is only modified by it.”
(Ricardo, letter to James Mill, 28/12/1818)

George Stigler (American Economic Review, 1958)

famously referred to Ricardo’s “93% labor theory of value”

 In Production of Commodities by Means of Commodities

(1960), Piero Sraffa resolved Ricardo’s problem* by
showing that (given w)  and relative product prices are
simultaneously determined by a system of simultaneous
equations

Each equation (within Sraffa’s system) takes the form:

price = average cost of production for a particular good

[* “Ricardo’s problem” = the puzzle that it seems that 

must be known before it can be predicted/determined!
Reasoning in terms of sequential determination suggests
that:  depends on the value of capital, which depends on
product prices – which depend on !]

Sraffa (1960) confirmed, in much more general setting,

Corn Model finding that w and  are inversely related

34
Optional material: For information only††

Extended Discussion of:

When the Labour Theory of Value (LTV) Works and Fails

[“works” = accurately predicts equilibrium relative prices]

The LTV claims that, in long-run equilibrium, the relative price

of a good (say X) will equal its relative labour input. That is,

P X lX
=
PY l Y

where Pi = the absolute price of good i (e.g. £5), so PX/PY is the

price of good X relative to good Y (or in units of Y); and li = the
labour used to produce one unit of good i.

(Alternatively, the LTV sometimes refers to the doctrine that the

relative price of a good ought to reflect its relative labour
usage.)

Rather than providing an exhaustive coverage of all possible

cases, we will focus here on a few key (commonly-
encountered) cases where the LTV is (or is not) valid as a
predictor of equilibrium relative prices.

1: LTV works if labour is the only input

This is true:

††
This derivation treats the rate of profit () as the exogenous
“distributive variable”. Alternatively, one could assume that the real wage
in units of good Y, w ≡ W / PY , is exogenously given (i.e. determined
outside the “economic system”). The equation for PY implies that the
endogenous rate of profit would then satisfy 1+ π=1/ ( lY w ). Substituting this
into the eqm-relative-price equation, we get P X /P Y =lX / ( l2Y w ) – which,
again, differs from the LTV’s prediction
35
1(a): both in Adam Smith’s “early and rude state of society”…

In a fictional pre-capitalist society “which precedes both the

accumulation of stock and the appropriation of land”, workers
are able to support themselves during the year (in advance of
the “harvest”). Therefore, they receive their income after the
goods they produce are sold, and the equilibrium prices of
goods are

P X =l X W and PY =l Y W

where W, the money wage, must be equal across industries

(due to worker mobility).

Taking the ratio of equilibrium prices, we get P X /P Y =lX /lY in

equilibrium, in accordance with the LTV’s prediction.

1(b): …and under capitalism

Very similar to case 1(a). Key difference is that, under

capitalism, workers are propertyless, so the wage must be
advanced to them. Capital invested thus equals advanced
wages, and capital owners receive profit income (which is
proportional to the value of capital invested).

In equilibrium:

P X =( 1+ π ) l X W and PY =( 1+ π ) lY W

where  = the rate of profit (equalised across industries by

competition).‡‡

As in case 1(a), the ratio of eqm prices equals the LTV’s

prediction.

Cases 2 and 3 continue to focus on capitalist economies.

‡‡
i.e. the following isn’t essential material for exam preparation.
36
2: LTV fails if the “period of production” differs across
industries

See the “wine example” above, during discussion of Ricardo’s

use of the LTV.

(Note that the squared term in the equation for the equilibrium
PX arises because capital must be invested in the production of
X, “wine”, for two years before sales revenue is realised – and
capitalists expect compound interest on their investments.)

3: In general, LTV fails if materials must be “advanced” (=

invested at the start of the production process) in addition to
wages

By “materials”, I mean (for example) component parts, tools

and other “capital goods”. Of course, production does, in
general, require such materials as an input alongside labour –
so the failure, in general,§§ of the LTV (to predict eqm relative
prices accurately) seems very problematic! For simplicity, I
shall assume that all materials are entirely used up in a single
cycle of the production process. (This is called the “circulating
capital” assumption.)

With material inputs in addition to labour, the eqm prices of

goods X and Y are

P X =( 1+ π ) ( l X W +m X PM )

PY =( 1+ π ) ( l Y W +mY P M )

where mi = the input of materials needed to produce one unit of

good i; and PM = the eqm price of materials, treated as a single
good for simplicity. (We consider the production and pricing of
materials in more detail below.)
Note that P X =l X W + π l X W , where l X W is the value of capital invested (which must
§§

be repaid from sales revenue) and π l X W is profit per unit of X.

37
The Classical economists appreciated that the theory of
competitive prices would now have to give some role to
material inputs. (They didn’t just doggedly stick to the prediction
of the “naïve LTV” that P X /P Y =lX /lY .) Thus, they introduced the
concept of the “total labour embodied” in a good, which
combines both the direct labour input (our li terms) and the
labour indirectly contained in the input of materials. The
quantities of labour embodied in a unit of X and Y are defined
as follows:
e e
l X =l X +m X l M

e e
l Y =l Y + mY l M

and the LTV becomes the claim that, in equilibrium,

e
P X lX
=
PY l eY

Substituting into the above for the P and le terms,*** the LTV
works if

PM
l X +m X e
W l X + mX l M
=
PM l Y + mY l eM
l Y +mY
W

where P M /W is Adam Smith’s “labour commanded” measure of

the “real price” (of materials) – i.e. the amount of labour time
that is required to buy one unit of materials.

Result: Manipulating the above equation reveals that the LTV

works (i.e. accurately predicts the equilibrium relative price)
either if both industries use the same materials:labour ratio (i.e.
m X /l X =mY /lY ) or if the rate of profit is zero ( π=0 ).

***
We will see that there are some specific (“fluke”) cases where the LTV works.
38
[Proof: Rearranging the above equation and simplifying gives

PM e
∆=l M ∆
W

where ∆ ≡ lY m X −lX mY . There are two ways for this equation to hold.
First, ∆=0, which requires m X /l X =mY /lY -- i.e. a common ratio of
material:labour inputs.††† Second (if ∆ ≠ 0), P M /W =leM . We can
derive P M /W from the definition of PM:

P M =( 1+ π ) ( l M W +mM P M )

PM ( 1+ π ) l M
⇒ =
W 1−( 1+ π ) mM

(Remember that we are focussing on a long-run equilibrium

where prices are constant through time – so PM is the price
both of “M as output” on the LHS and of “M as input” on the
RHS.)

The definition of leM , which features itself because materials are

produced using materials, is
e e
l M =l M +m M l M

e lM
⇒ l M=
1−mM

Finally, we note that e

P M /W =l M only if π=0 .]

The upshot of this optional discussion of the LTV is that the

LTV is not generally valid as a predictor of equilibrium relative
prices (i.e. the circumstances where it is valid – e.g. labour the
only input; equal periods of production across goods; equal
materials:labour mixes across goods; a zero rate of profit – are

and, on the LHS, cancelling ( 1+ π )s and multiplying numerator and denominator by

†††

1/W
39
very specific). An immediate implication is that the so-called
“transformation problem” in Marxian economics is insoluble.‡‡‡

End of optional material

‡‡‡
The “naïve LTV” also works in this case – i.e. with a common materials:labour
ratio, we get P X /P Y =l X /l Y .
40
3(b): Possibility of a “general glut” of commodities

 Malthus: capital accumulation might  general

overproduction of goods (= a “glut”) compared to demand

Keynes-type argument:
AD < AS (i.e. “deficient demand”)  unemployment

Mercantilists  Malthus (“The first of the Cambridge

economists”, Keynes, Essays in Biography)  Keynes

 Whereas Ricardo saw landlords as a social bad

(consuming rents that could have been invested), Malthus
thought they performed socially desirable function of
spending their rental income on luxury consumption 
maintaining AD

41
Malthus’ argument [for landlords’ consumption]

 “[T]he consumption and demand occasioned by the

persons employed in productive labour can never alone
furnish a motive to the accumulation and employment of
capital.” (Ricardo’s Notes on Malthus)

 If non-wage income is saved, then the “circular flow” is:

 Problem:

For firms: Sales revenue (= cons of workers) < Prod’n costs

 “Deficient demand”  production and employment 

 Malthus’ solution: Landlords’ consumption provides

“injection” of extra demand

42
Ricardo’s response: Say’s Law

 Jean-Baptiste Say (1767-1832)

 A “general glut” of commodities is impossible because

“Supply creates its own demand” (Keynes’ formulation of
Say’s Law, The General Theory of Employment, Interest
and Money, 1936, chapter 2)

 Reasoning: Production (supply) creates income (= firms’

production costs) of equal value, which is spent.

 there is always sufficient spending (demand) to cover

firms’ costs

 Three quotes:

 “[T]here is no amount of capital which may not be

employed in a country, because demand is only limited by
production. No man produces, but with a view to consume
or sell, and he never sells, but with an intention to
purchase some other commodity… By producing, then, he
necessarily becomes either the consumer of his own
goods, or the purchaser and consumer of the goods of
some other person…

“Too much of a particular commodity may be produced, of

which there may be a glut in the market, as not to repay
the capital expended on it; but this cannot be the case
with respect to all commodities.”

(Ricardo, The Principles of Political Economy and

Taxation, 1817, italics added)

43
 “[T]here is no over-production; production is not excessive,
but merely ill-assorted.”

(John Stuart Mill, Principles of Political Economy, 1848)

 Common message of above quotes: “Gluts” of particular

commodities are possible, but a “general glut” is
impossible

 “All sellers are inevitably… buyers. Could we suddenly

double the productive powers of the country, we should
double the supply of commodities in every market; but we
should, by the same stroke, double the purchasing power.
Everybody would bring a double demand as well as
supply; everybody would be able to buy twice as much
because everyone would have twice as much to offer in
exchange.”

(John Stuart Mill, Principles of Political Economy, 1848)

44
 Idea that “saving is spending”:

 “[I]t is a familiar economic axiom that a man purchases…

commodities with that portion of his income which he
saves just as much as he does with that he is said to
spend… He is said to save when he causes the…
commodities which he purchases to be devoted to the
production of wealth from which he expects to derive the
means of enjoyment in the future.”

(Alfred Marshall, Pure Theory of Domestic Values, 1879)

“He is said to save when… the means of enjoyment in the

future.”: What we call “saving” is really buying goods to be
used as capital goods, which will produce consumption
goods (“wealth”) and thus utility (“the means of
enjoyment”) in the future

 Justification for “saving is spending” view: Investment (an

“injection”) is determined by saving (a “withdrawal”)

This might be because saving is investment ( I ≡ S ) – i.e.

households save by purchasing capital goods

Or because interest-rate variations equilibrate investment

and saving: e.g. S   r   I  too

 Keynes argued that changes in Y equilibrate I and S

because r is determined in the financial system (by MD and
MS)

45