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Ricardo’s Theory of Economic Development | Economics

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Although Ricardo drew heavily on Adam Smith’s writings, yet he was the first economist who presented the classical thought in a consistent body of economic analysis, presented in a vigorous form. His ideas are embodied in his book, The Principles of Political Economy and Taxation (1817) and the many letters that he addressed to contemporary economists. The Ricardian theory of rent is well known; but there are also ideas contained in his writings which throw light on the development process.

Role of Agriculture and Diminishing Returns to Labour:

Like that of Smith in Ricardo’s model growth and development depends on capital accumulation. And capital accumulation depends on reinvestment of profits. But the profits earned by the capitalists depend on the growth of agricultural output, especially food, or what is now generally called wage goods. However, the important fact which was emphasised by Ricardo was diminishing returns which occur as more doses of labour (equipped with some tools and equipment) are used in agriculture.

It is diminishing returns in agriculture that causes food prices to rise and result in rise of wages of workers which squeeze profits and ultimately lands the economy into stationary state. According to Ricardo, there are three agents of production that participate in the process of growth of output. The capitalist hires labour and land and plays a key role in the process of economic development. Ricardo uses the term capitalist in the sense the modern economists use the term entrepreneur. In the Ricardian model capitalist undertakes production, pays rent to the landlords and wages to the workers employed for the production work and what remains is his profits.

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Besides diminishing returns to labour in agriculture, the other fact emphasised by Ricardo, like other classical economists, is that wages were determined by minimum subsistence level of the workers. Whenever during the growth process wages rise above the subsistence level, population increases and brings them to the level of subsistence. On the other hand, wages cannot fall below the subsistence level because below it workers cannot survive.

Ricardian Growth Model:

Let us now explain Ricardian model of growth in detail. Ricardo makes two-sector analysis of the economy. He draws distinction between an agricultural sector and industrial sector. He assumes that agriculture is subject to law of diminishing returns while industry is subject to constant returns. Further, Ricardo regarded real wages to be fixed in terms of corn, i.e., the product of the agricultural sector.

Labour when supplied with corn (wage goods), i.e., circulating capital and also some fixed capital (tools and equipment) to produce more than its subsistence and the difference between the output and subsistence wages is the surplus produced by the labourers which is shared between the capitalists, the owners of capital, and the landlords, the owners of the lands.

Let us first take the agricultural sector which, according to Ricardo, is subject to diminishing returns. As more and more doses of labour and capital are employed, marginal product of labour and capital would diminish. The capitalist employer will employ labour to the extent that he just meets the expenses of production on the margin. The intra-marginal doses of labour employed would produce surplus over the expenses incurred on them, which is the source of capital, that is, the wage fund that will be used for employing labour in future for further production. The greater the volume of saving out of the surplus, the faster will be the rate of capital accumulation and more rapid the growth of output and employment.

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Graphically, the growth of agricultural output and employment of labour in Ricardian model is depicted in Fig. 18.1. In this figure marginal productivity of labour is depicted on the Y-axis and the amount of labour employment on the X-axis. The curve MP is the marginal productivity curve which will remain fixed as it is assumed that land is fixed and no technological progress occurs. If OB is the expenses on a dose of a labour and capital, then OL labour would be employed.

It will be seen from Fig. 18.1 that the employment of OL labour produces the total output equal to OQHL. The total expenses of production incurred on capital and labour are equal to OBEL. It is thus clear that labour produces surplus over costs of cultivation incurred on labour and capital. The surplus is equal to BQHE. This surplus represents the rent which will be obtained by the landlords, the owners of the land.

If OW represents the minimum level of subsistence wage which will be paid to the workers, then OWTL would be the share of labour (i.e., total wages bill) in the agricultural output produced. The remaining agricultural output equal to WTEB will be the profits made by the capitalist farmers.

According to Ricardo, surplus (i.e., profits) of capitalist farmers will be saved and reinvested. As a result of reinvestment both the output and employment will increase. Since the land for the society as a whole is fixed, marginal product curve of labour (equipped with certain tools) will remain unchanged. Due to diminishing returns, with the increase in more and more of employment of labour its marginal product, (MP) will go on falling till it becomes equal to minimum subsistence level of wages OW (that is, at point N on MP curve in Fig. 18.1).

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As a result of marginal product of labour being equal to minimum subsistence wages OW, profits will disappear and rent of landlords will increase. With this total agricultural output equal to the area OSNM (that is the area under MP curve up to point M) will be distributed between wages and rent, profits having been fallen to zero. Ricardo thought that the landlords who receive rent do not save and consume all their incomes.

It may be noted that in equilibrium, according to Ricardo, rate of profit in agriculture must equal the rate of profit in industry. During the development process as profit rate in agriculture falls capital will be shifted to industry. As we will see below, with the increase in capital accumulation in industry profits will decline in industry as a result of rise in wages due to rise in food prices caused by diminishing returns in agriculture.

Ricardo’s Model- Growth of the Industrial Sector:

It should be noted that the food-grain surpluses generated in agriculture are essential to employ labour in the industrial sector. It is in the industrial sector that stock of fixed capital plays an important role in the growth of output and employment, while in agriculture it is the amount of land which is of crucial significance. While the land as a whole is fixed and diminishing returns ultimately occur when more doses of labour and capital are used, increase in the stock of fixed industrial capital on the other hand is possible since it is made by man.

But workers engaged in building up of capital stock must be paid in real terms, i.e., in food-grains and other wage goods, or corn as Ricardo called it. As the stock of capital increases in the industrial sector marginal productivity curve of labour in the industry sector will shift upward implying that more labour will be employed at the minimum subsistence level of wages through the process of capital widening.

It is again worth emphasising that in the short run real wages may rise above the minimum subsistence level, but this will lead to the increase in population and labour force, so that as long as food-grains are available at the same price, the minimum subsistence level in money terms will remain constant and supply of labour will be perfectly elastic at the minimum subsistence level in money form. However, if the prices of food-grains rise due to the operation of diminishing returns in agriculture, the wages in the industrial sector will rise. But, the wage rate in terms of corn or wage goods will remain the same and the labour supply will be perfectly elastic at this rate due to the growth in population and labour force.

But availability of wage-goods surpluses proves a constraint on the growth of industrial sector. If sufficient food surpluses are not forthcoming and demand for them increases as a result of the growth in labour employment brought about by the expansion of stock of industrial capital, the prices of food-grains will rise. The increase in the prices of food-grains will raise the subsistence wage rate in terms of money which will reduce the surplus of the capitalists. Since Ricardo and others assumed that agriculture was subject to diminishing returns, the prices of food-grains will rise as cultivation on land is increased both extensively and intensively.

Therefore, as a result of the rise in the prices of the food-grains and thereby the rise of the wages of labourers will reduce the surplus or profits made by the capitalists in the industrial sector. The rate of profit expressed as ratio of net revenue earned on the capital will go on declining till it becomes zero. When the rate of profit becomes zero, further capital accumulation in the industrial sector will cease and in this way a stationary state will be reached. Before the stationary state is reached, the level of output and employment of labour force during any given period in the industrial sector will depend on the stock of given fixed capital (and therefore the marginal productivity curve of labour) on the one hand and the wage goods supply forthcoming from the agricultural sector on the other.

We depict the growth of output and employment in the industrial sector in Fig. 18.2. In this figure labour employment is measured along the X-axis and marginal product of labour is measured along the Y-axis, Along the Y-axis and below the origin the stock of capital is measured. To start with, suppose OK1 is the stock of industrial capital and corresponding to this the marginal productivity curve of labour is M1P1. Suppose OW is the minimum subsistence level of wages in real terms. With OW as the wage rate, OL1 labour force would be employed. At OL1 the marginal product of labour is equal to the given wage rate of OW, the total wage bill will be equal to OWEL1 and WEM1 will be the profits or net revenue earned by the capitalists.

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According to Ricardo, a good part of this net revenue or profits earned by the capitalists will be reinvested in the expansion of capital equipment. This reinvestment of the profits will result in the expansion of the capital stock. The expansion in the stock of capital will shift the marginal productivity curve of labour upward to the position M2P2. Now, if the subsistence wage rate remains at the level OW, OL2 labourers will be employed and the profits will now increase to WFM2. In this way, the profits will continue to be reinvested and stock of capital will go on expanding, resulting in the shift of the marginal productivity curve of workers and the increase in labour employment and output.

However, according to Ricardo, the industrial sector cannot go on expanding indefinitely. As according to him, agriculture is subject to diminishing returns, the increase in industrial output and employment and the resultant rise in the demand for food-grains will cause the prices of food-grains to rise. The rise in prices of food-grains will bring about the increase in the wage rate in the industrial sector.

If the wage rate rises to OW’ when the capital stock is OK3, labour force OL3 would be employed and the net revenue or profits of the capitalist would be reduced to M3W’G. Thus, the occurrence of diminishing returns in agriculture and the consequent rise in the prices of food-grains and the rise in wage rate, the rate of profits made by capitalists will go on declining till it becomes zero. When the rate of profit is reduced to zero, further expansion in the stock of industrial capital ceases to occur. As a result of this, the whole growth process of increase in output and labour employment will stop.

From the above, it is thus clear that in Ricardo’s model the growth of output and employment depends on capital accumulation on the one hand, and the available supplies of food-grains or wage goods on the other which are constrained by the operation of diminishing returns in agriculture.

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Stationary State:

Ricardo shows how the rate of profit goes on falling as more and more capital is accumulated and invested. As the rate of profit falls, the accumulation of capital also slows down. The economy reaches the stationary state when rate of profit is too low to provide any incentive for any business enterprise. After the initial rise in wages as economy grows forward, the wages are brought down to the subsistence level by the pressure of population. At this stage, the rents are high. The real wage rate is at its minimum and population growth slackens. The rate of profit falls to near zero and further expansion of capital ceases. These are all the symptoms of a stationary state.

Given the crucial importance of capital accumulation in Ricardo’s model of growth, anything that discourages investment will adversely affect capital accumulation and economic growth. Ricardo was therefore against imposing any levies, taxes and tariffs on inputs which raises the cost of production and lowers profits and thus serves as disincentive to make investment. That is why he emphasised imports of cheap food by abolishing Corn Laws in England at that time and thought that imports of cheap food would delay the reaching of stationary state indefinitely by holding down wages in terms of food.

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To quote him, “A country could go on for an indefinite time increasing its wealth and production for the only obstacle to this increase would be scarcity, and consequent high value of food and other raw produce. Let these be supplied from abroad in exchange for manufactured goods and it is difficult to say where the limit is at which you would cease to accumulate wealth and to derive profits from its employment.”

Such has been the appeal of Ricardo’s growth model that Arthur Lewis based his view of development in “Economic Development with Unlimited Supplies of Labour” for developing economy with dualistic structure on Ricardo’s model of growth. However, instead of assuming wages for the modern capitalist sector remaining equal to the minimum subsistence level based on Malthusian law of population Lewis considered perfectly elastic supply of labour to the modern capitalist sector due to the existence of disguised unemployment prevailing in the traditional sector (i.e., agriculture). He assumed that wages would stay at the given level until all disguisedly unemployed labour in agriculture is absorbed in the modern industrial sector.

Critical Evaluation of Ricardo’s Model:

We have seen above that Ricardo, like other classical economists, emphasised the wage goods as determinants of growth of output and employment in an economy. In the growth of output and employment, they ignored the role of aggregate effective demand despite the protest by Malthus. Their neglect of effective demand as a factor affecting growth of income and employment flowed from their belief in Say’s Law.

However, in the context of developing countries, his emphasis on wage goods as determinant of income and employment is quite right. In developing countries like India, the cause of mass unemployment and disguised unemployment is to be found in the lack of fixed capital and other cooperating factors and the supplies of the wage goods on the other and not in the lack of aggregate demand.

Therefore, a solution to the unemployment problem in labour-surplus developing countries lies in the accumulation of fixed capital as well as the expansion of wage goods supply in the economy. Keynesian remedy of curing unemployment through the increase in aggregate demand by expansionary fiscal policy financed by creating new money will not solve the problem of unemployment and disguised unemployment in developing countries.

It is worth emphasising that Ricardo rightly pointed out that the growth of output and employment in the industrial sector depends upon the availability of wage goods. That the availability of food-grain surpluses or wage-goods serves as a constraint on the growth of industrial output and employment has now been well recognised. In the Second and Third Five Year Plans of India and in the Soviet industrialisation, especially higher priority to basic and heavy industries brought about rise in prices of food-grains and the deceleration in the industrial sector.

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However, it may be pointed out that the contention of Ricardo that agriculture is subject to the law of diminishing returns that will ultimately raise the prices of food-grains and reduce the profits in the industrial sector which will ultimately result in the occurrence of the stationary state, is too pessimistic and unwarranted. In their analysis of the growth process, they underestimated the role of technological progress in raising production which can suspend the operation of the law of diminishing returns.

The increase in agricultural productivity due to technological progress can prevent the rise in prices of food-grains and therefore the reaching of the stationary state. In actual practice, in today’s developed countries, agricultural revolution took place along with the industrial revolution. In this regard, the gloomy prognosis of classical economists has not come true as far as capitalist developed countries are concerned.

A drawback in Ricardo’s theory of development is that it regarded all increase in the stock of fixed capital as increasing labour employment. In other words, it ignored the labour-displacing effect of capital equipment in which improved technology is embodied. Actually, much of technological progress made in advanced developed countries has been of capital-intensive nature.

It has tended to displace labour. Therefore, the technology evolved and developed in advanced countries does not suit the factor-endowment conditions of developing countries with surplus labour and scarce capital. Therefore, in developing countries, to accelerate economic growth and employment generation emphasis has to be put not only on the expansion of fixed capital but also on the right choice of technology which is labour-using rather than labour-saving.

Ricardo was also not right in ignoring the effective demand in determining growth of income and employment. Despite warning by Malthus, Ricardo thought that development process would not be constrained by lack of effective demand as he believed in Say’s Law that supply creates its own demand. The main hurdle in the development process, according to him, is the rise in wages due to diminishing returns in agriculture.

Ricardo thus writes, “There is no limit to demand—no limit to the employment of capital while it yields any profit, and that however abundant capital may become, there is no other adequate reason for a fall in profit but a rise in wages.” As has been emphasised by Keynes, there is nothing in the working of the capitalist economic system which would always ensure adequate effective demand so as to maintain full employment and ensure steady growth. According to Keynes, in a modern monetary economy, the saving and investment activities have been separated from each other. The investment may not be equal to the savings done at the level of full employment. Hence full employment and steady growth may not be maintained.

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Ricardo’s contribution to economic analysis and theory of economic development is regarded as outstanding and his view is widely shared by other classical economists. As in the case of other classical economists, his analysis of the economy relates to a long period of time as distinguished from a short period analysis. He regards the economy as dynamic and ever-changing.

It grows till it ultimately reaches a stationary state. In the development process, Ricardo focuses his attention on the major variables like capital accumulation, population growth and trends in profits. He studies interrelations among these variables and then draws conclusions about their behaviour. His analysis of the relative shares in the national income of the various agents of production such as rent, wages and profits is indeed thought-provoking.

It must, however, be said that although he refines and extends the classical theory of development, yet the main points in his analysis are haphazardly scattered in his book ‘The Principles of Political Economy’. His predictions regarding the advent of stationary state have not turned out to be true, nor are about the changes in relative shares of the various agents of production borne out by history. The two fundamental principles in his model of economic development, viz., the principles of population and the law of diminishing returns, are only partially correct. All the same, it has to be admitted that he made a significant contribution to the theory of economic growth.

Relevance of Ricardo’s Theory of Growth to Developing Countries:

The Ricardian theory of development as we have seen in his analysis is based upon two fundamental principles, viz., principle of diminishing returns and the principle of population growth. Ricardo like Smith realises that a high rate of capital accumulation is necessary for economic growth. He considers profits as the primary source of accumulation, although among the secondary sources he includes rent and wages (when they are high enough to generate a surplus over subsistence).

Further, in the Ricardian system, there is an organic relation between agricultural development and economic growth. In this context Ricardo attacks the landlords’ interests, as they are opposed to agricultural improvements. The fertility of soil, he says, falls as the margin is extended (as a result of increasing population). As such the rate of profit will fall in the absence of agricultural improvements and free trade.

Ricardo points out that the normal progress of the economy is towards stationary state. The gloomy forecast of the ultimate advent of a stationary state as envisaged by Ricardo has been falsified by history. The rapid economic strides by capitalist economies in many parts of the world in the past and the squeezing gulf between the capitalists and the labourers following a steady betterment in their economic status, all go to disprove Ricardo’s dismal picture about the future of capitalism.

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The two fundamental principles—the principle of diminishing returns and the principle of population on which Ricardo based his theory of economic development—have partially, if not completely, been negated in the developing countries of today. With improved techniques and technical know-how, it has been possible to effectively check the tendency towards diminishing returns to set in. In the same way, his views on population growth have been disproved for it cannot explain the changes in population in the developing countries. There is no tendency towards subsistence wages. Not only has that, Ricardo’s conjectures about the relative share of labour, capitalists and landlords not been proved to be correct.

Nevertheless, Ricardo’s emphasis on the role of agriculture in accumulation of the various methods of savings, including taxation of rent as an important element, entrepreneurial ability, specialisation of labour, attack on landlordism, the role of labour productivity which could be increased either through organisational or technological changes and the importance of the National Bank (Ricardo being the first to conceive of a Central Bank) still remain the policies of direct relevance to the developing economies.

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