Today, we look at Ricardo on Rent
The Ricardian theory of rent can be
explained in a partial equilibrium context
and given a neoclassical interpretation.
I'm going to begin with
that interpretation but then later
I'm going to step back and
show how the theory is interpreted in the
classical context where it actually has
quite a different meaning. So on the
vertical axis we're going to put the
output of land, corn or food, and on the
horizontal axis we're going to put inputs
into land, which is going to be labor.
We're also going to array our land
from the highest quality down to the
lowest quality. Then we successively apply
units of labor to land, so the first unit
of labor is applied to the highest quality
of land and it produces a lot of output.
The second unit of labor is applied to
land of a little bit lower quality and
produces a little bit less output,
the third unit of labor is applied
and so forth.
Now suppose that we have "L" units
of labor in total, then by successively
applying units of labor to different
qualities of land, the total amount of
output will be equal to the area under the
output curve up until the quantity of
labor, "L."
Now let's focus on the quantity of
output which is produced by the marginal
labor, by the laborer who is working on
the lowest quality land.
That's given by the height
of the output curve at the
quantity of labor, "L."
Now here's the key to the model;
the wage of all the laborers
is going to be determined by the output of
the marginal labor. The wage is going to
be determined by the amount of output
produced by the laborer who is working on
the lowest quality land. Now why is this?
Well this is true because labor is a
uniform good, it's the same quality
everywhere, and because of competition.
So imagine that this were not true,
Suppose that the laborers on the highest
quality land were earning a lot more than
the laborers on the marginal quality land.
In that case, these laborers, the ones on
the marginal quality of land, who are just
as good as those laborers who are working
on different land.
They would go to the landlord
and say "Hey, hire us instead.
We're willing to work for a lower wage
than you're paying your current workers."
The landlord of course would agree
Through this process of competition
wages are going to be driven down to
the output level produced by the marginal
laborer.
That means that the
total wages are equal to the output of
the marginal labor times the total
quantity of the labor "L" for this area
which I've shown in the graph here.
That means that
the rent is what is leftover.
The rent is the total output after
total wages have been paid.
That's the Ricardian theory of rent
given a neo-classical spin.
To really understand the genius
of the theory, and also the craziness,
you have to understand how the theory fits
within the context of the classical theory
of value. In fact, the Ricardian theory
was meant to fill a gaping hole in the
classical theory of value.
In the classical theory, the value of
all reproduceable goods comes from labor.
So, they allowed for a few exceptions for
non-reproduceable works of art, antiques,
and so forth, but for everything else.
They wanted to argue, that the relative
price of any two goods was determined by
the amount of labor in those two goods.
Now, there is one obvious objection, what
what about capital? It's clear their
goods are created using both labor and
machines. How can we say that the price
depends upon labor alone, when obviously
you've got to pay for the machines as well
And Ricardo and the classicals
had an answer for this. They said that
capital is really congealed labor.
It's simply labor which was
earlier in time,
which was applied earlier in time.
Now, they did allow for
an interest payment.
So what they argued was that
in equilibrium, profit, the return
to capital, was really interest, and
really just a payment for time.
So, the payment for capital
really could be boiled down to two things:
the labor which was in the capital
and the fact that that labor was paid
earlier in time, gave rise to an interest
payment.
Ricardo calculated interest
could be at most, 7%. So, Stigler says
Ricardo has a 93% labor theory of value.
So we can basically ignore the capital part,
because most of that is just congealed labor anyway.
The part of that which isn't, is interest,
and that's small. Still, we have another
gaping hole in the labor theory of value.
And that's land.
What about land rent?
It's clear that rent cannot be a payment
to labor, the land was never created by
labor, maybe by God's labor, but we don't
count that.
So the rent, the labor, the land, was never
created by labor, not even
earlier in time. And it's not time.
There's no payment earlier in time.
So we can't say it's an interest payment.
So how are we going to
keep the labor theory of value
and also explain land rent?
Now, let's go back to the Ricardian theory
because that's exactly what Ricardo did.
We're now going to show how the Ricardian
theory of rent fits within the classical
context and how it fills a gaping gap
in the labor theory of value.
So we now interpret this in a general
equilibrium context. This is all of the
land which is available in the economy.
This is all of the labor which is
available in the economy.
And there is only one use of land,
which is to produce corn.
Which can be produced in only one way,
by applying units of labor to the land.
Now, let's focus on this marginal piece
of land, farmed by the marginal laborer.
As we showed earlier, the output from that
piece of land will be equal to the wage.
In other words, on the marginal land,
the rent is 0.
The wage exhausts all of the product.
There is zero rent on the
marginal piece of land.
Now, the price of corn is going
to be determined by marginal cost.
The price of corn is going
to be determined by the cost of
producing it on the marginal land,
which is just the wage.
Why is this?
Well, it's the same argument we had before.
Corn is a uniform good.
Therefore, it sells for the same price
everywhere.
It doesn't matter if the corn is produced
on the highest quality of land or
produced on the marginal land.
It sells for the same price everywhere
due to competition.
Therefore, everywhere,
the price of corn is going to be equal to
the wage on the marginal piece of land.
Now, notice, that means that the price of
corn is determined only by wages.
So, Ricardo has re-established the labor
theory of value. Even though landlords
get this big payment, even though they
get this big rent, this big payment,
the price of corn and of other products
is determined only by the marginal cost.
And that marginal cost is just wages.
So, the price of corn is not determined
by rent. Rent is not a part of the price.
Therefore, the relative prices of 2 goods
is determined by their labor input.
Ricardo has saved
the labor theory of value.
Now, to say the labor theory of value
may not be such a great thing, after all,
the theory is pretty untenable -
the assumptions aren't great.
Moreover, even within Ricardo's context,
if we adjust the assumptions so that
there is more than one good. Such as
corn and vegetables.
And If they use labor and land
in different proportions,
we are going to run into problems.
Even under Ricardo's theory, that is,
the price of corn will not be determined
only by wages once we allow for different
factor proportions, once we allow for
different uses of land, and so forth.
Nevertheless, given his assumptions,
Ricardo has shown that rent is
not part of the price and therefore,
he has been able to maintain the labor
theory of value. Even though landlords
are earning a big rent.
Pretty impressive.
Okay, here's an aside
before we get back to our main theme,
how are wages and rents determined
in the long run? Well,
there was a dynamic process.
And, at the base of that process,
Ricardo and the classicals thought,
following Malthis, that people
were going to breed. They were
going to breed like rabbits.
Therefore, the wage was going to pushed
down to the cost of reproduction,
the cost of reproducing labor.
So the wage would be pushed down,
in the long run to the subsistence wage.
This means that total wages would be this
amount and rent would be maximized.
So in the long run,
workers would get very little.
They would get only enough
to reproduce themselves and
the landlords would get an awful lot,
the landlords would get the rent.
So, that's the long run version
of the classical model.
I want to make one more comment
on the Ricardian theory.
Because modern economics generalizes
this point: so in the special case of
land, Ricardo derives the factor price,
the price of the land, from what the land
produced - the consumption.
He said, "Corn is not high", meaning,
the price of corn isn't high,
"because a rent is paid. Rather, a rent is
paid because the price of corn is high."
In other words, Ricardo derives
the factor prices, the so-called costs,
from what those factors produced.
Not the other way around.
The modern approach generalizes this.
Of course, in the modern approach,
we have not a labor theory of value,
but a utility theory of value.
Goods have value because, ultimately,
they could be used
to satisfy our preferences.
And only because they could be used
to satisfy our preferences.
So in the modern approach, in a
general equilibrium competitive economy,
the prices of all factors of production
are derived from the opportunity costs
of consumption.
So, for example, if we were to
move a factor of production from
one part of the economy to
another part of the economy,
what do we lose?
How much consumption do we lose?
What is the value of consumption
which we lose when we move
a factor of production from
one area of the economy to another
area of the economy.
That's where the prices of the
factors of production come from.
So, land, labor, capital - these goods
don't have costs in and of themselves.
They have costs only because moving them
from one part of the economy to
another part of the economy
has an opportunity cost in terms of
ultimate consumption.
So this generalizes Ricardo, in that
the prices of consumer goods -
consumer goods are expensive,
not because in general equilibrium,
the factors cost a lot, but rather
the factors cost a lot because
those factors have high value.
Because withdrawing
those factors from an area of the economy
would lose us, would cost us,
a lot of consumption,
a lot of high-value consumption.
So, ultimately,
the prices of factors of consumption,
the prices of factors of production,
are derived from the opportunity cost
of consumption.
Here are some further references:
Paul Samuelson, has a useful piece:
"The Canonical Classical Model"
which goes into the dynamics of
the classical model in more detail
than I have.
Again, I like Jurg Niehans' book
"A History of Economic Theory."
Mark Blaug has a good book
on Ricardian Economics.
This is Stigler's piece on the 93%
Labor Theory of Value.
And of course, take a look at some of our
other videos, in particular,
Tyler looks at Adam Smith's
theory of rent, which is the precursor
to the Ricardian theory.
And that's in a video on Adam Smith's
Book 1, Chapter 11.
Thanks.