Ricardo on rent

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, it 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 the 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 laborer, 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 of 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 they would 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 total wages are equal to the output of the marginal laborer times the total quantity of labor, L, or this area which I've shown in the graph here. That means that the rent is what is left over. The rent is the total output after total wages have been paid. That's the Ricardian theory of rent given a neoclassical spin. To really understand the genius of the theory, and also the craziness, you have to understand how the theory fit 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 reproducible goods comes from labor. They allowed for a few exceptions, for non-reproducible 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's one obvious objection. What about capital? It's clear that 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 an 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, let's say, 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 that'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 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 zero. The wage exhausts all of the product. There is zero rent on the marginal value, 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 whether 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 two goods is determined by their labor input. Ricardo has saved the labor theory of value. Now, to save 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're 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 a part of the price, and therefore he's 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 in the classicals thought, following Malthus, that people were going to breed. They were going to breed like rabbits. Therefore, the wage was going to be 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 derived 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 derived 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 can be used to satisfy our preferences, and only because they can 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 cost 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, 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 the factors of consumption, prices of the 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 Juergen E. Hans's book, A History of Economic Theory. Mark Blogg 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 was the precursor to the Ricardian theory. And that's in the video on Adam Smith, book one, chapter 11. Thanks.