Friday, March 11, 2016

The Ricardian windfall: David Ricardo and the absence of the equity-efficiency trade-off

David Ricardo is rightly famous (among other things) for being the father of functional income distribution (distribution between the three factors of production: land, labor and capital). For it is in The Principles that the definition of each factor of production with its distinct source of income is most sharply made: to the landlords, the rent; to the capitalist, the profit; to the workers, the wage. But Ricardo, like other classical writers and later marginalists too, never cared to develop, or even look  at, personal income distribution. To Ricardo, like to Marx, what happens to personal income distribution was self-evident, even  redundant to explain because individuals were basically defined by their class incomes.  Workers' income was always at subsistence and landlords' income was determined by the cost of production of corn at the worst parcel of land such that it allowed “reasonable” profit of (say) 5% to the capitalist tenant.

As is well-known, the entire Ricardian apparatus was created to show the irrationality of the Corn Laws. With the Corn Laws and an increase in population, less and less fertile land will have to be cultivated to provide food for workers. The price of food will increase and since the real wage (in our usual terminology) is fixed, it would imply that capitalists will have to pay more of their net income to workers (so that the capital-to-labor income will move against capital; which in Ricardo’s terminology is called the increase in the real wage). Thus, capitalists’ profits will go down (say to 3%), workers’ wage will remain fixed, and landlords’ income will go up.

As Ricardo quite emphatically writes (Chapter XXI): “..however abundant capital may become, there is no other adequate reason for a fall in profits but a rise of wages, and further…the only adequate and permanent cause for a rise of wages [compared to profit] is the increasing difficulty of providing food and necessities for the increasing number of workers”.  (Note that Ricardo does not believe in diminishing returns to capital with capital deepening.)

If we now translate this “class-based” outcome in terms of personal income distribution where all workers are at the bottom of the pyramid, capitalists in the middle, and landlords at the top, we can derive a growth incidence curve (which charts the increase of real income against one’s initial position in income distribution). To make the figure more realistic  we can use the approximate incomes and population shares  of the three groups. From Colquhoun social tables for England and Wales (done for the period between 1798 and 1801) and recently systematized by Bob Allen in his forthcoming book The Industrial Revolution: A Very Short Introduction, we know that the average income of the landlords was about 54 times greater than subsistence, bourgeoisie (which we assimilate to capitalists) had an income 37 times greater than subsistence, and workers 4 times (that is, they were not at the physiological subsistence minimum as Ricardo tended, without data of course, to assume). Their respective population shares were 1.3%, 3.2% and 61% (I omit the other intermediary classes).

Take now that over the medium- to long-term, landlords move to have an income 64 times the subsistence, capitalists to 27 times and workers stay where they are. The growth incidence curve will look approximately as in Figure 1, and the share of the top 1% (that is, of the landlords) will increase from 16% to 20%, while the mean income declines. 

Thus, with the continuation of the Corn Laws, will not only functional income distribution move in favor of the rich landlords, but the personal income distribution would get worse too.

What was, as is also well known, Ricardo’s counter-proposal? Eliminate the Corn Law and let the foreign corn (from Russia, US) flow freely into England. Now, the reverse happens: landlords lose (as the production on their land becomes too expensive to compete with foreign corn), workers real wage stays the same, but to capitalists workers become “cheaper” since for the same quantity of food they have to pay them less out of their net income. The growth incidence curve now changes: the top loses, the middle gains, the bottom is unchanged. Income concentration becomes less. (I do not draw it here; it can be easily done.)

Moreover as Ricardo argued, if you do not follow his advice, the food produced in England will ultimately become so expensive that the entire capitalists’ income will be swallowed by wages, the net (after-wage) rate of profit will tend toward zero, capitalists will invest less and less, and the economy will go back to its historical stationarity. Thus higher inequality will be associated with slower growth, and ultimately with zero growth.

If the Corn Laws  are repealed however, capitalists’ profit will increase, they will save and invest more and the economy will grow. Therefore lower inter-personal inequality will be associated with faster growth.

Pace Okun, there is no trade-off between equity and efficiency for David Ricardo. In effect, just the very opposite: lower inter-personal inequality leads to faster economic growth. It took thirty years after The Principles… for the Corn Laws in England to be rescinded, but one can easily see how attractive was the sketch of development that Ricardo presented to his readers: he promised to deliver both faster growth and to reduce inequality. Shall we term it the “Ricardian windfall”?

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