Wealth Manager - the site for professional investment managers

Register free for our breaking news email alerts with analysis and cutting edge commentary from our award winning team. Registration only takes a minute.

50 Economics Classics: Principles of Political Economy and Taxation

50 Economics Classics: Principles of Political Economy and Taxation

Principles of Political Economy and Taxation

David Ricardo

David Ricardo was one of the great names in finance of his day. Principles of Political Economy and Taxation was his greatest work and helped forge his name as a political economist. His labour theory of value dominated his time, and his theory of comparative advantage provided the foundations of international trade economics.

Labour, Ricardo says, is like any commodity: it has its natural and market price. For a time, perhaps because of a labour shortage, workers can command higher wages. But this prosperity has an effect. As workers have more children, workforces and the supply of labour increases, which drives the price of labour down to its ‘natural’ price.

As with any commodity, Ricardo argues, the price of labour is continually reverting to its real ‘cost of production’, which, in the case of a human being, is the cost of feeding, clothing and sheltering him or her. Thus, wages will always be based on this ‘subsistence’ cost of living of workers.

Ricardo sought to analyse how wealth and resources were divided between landowners, capitalists and labourers.

Ricardo shared peer Thomas Malthus’s basic insight that while land and the capacity to grow food was limited, there was no limit to human population. His solution was the repeal of the Corn Laws, which would allow more grain imports, lowering the price of grain and therefore wages. This would mean higher profits to keep the economy humming and more investment in land and machinery.

However, Ricardo, like Malthus, turned out to be wrong about population outstripping food supply. Agriculture would become more and more productive, and countries would provide for a greater amount of their food needs through imports (thanks to liberal international trade).

International trade and comparative advantage

Absolute advantage, as 18th century Scottish economist Adam Smith pointed out, is simply one country’s ability to make something (and sell it on the international market) cheaper than another country, thanks to its cost of labour, climate, terrain or other factors.

Ricardo’s example is that it is easier for Portugal to make wine than Britain, while Britain may be well-suited to growing wool. If both countries trade their surplus of wool and wine with each other, each will be better off.

But what if Britain was better at both wine and wool production? It still makes more sense for Britain to specialise in either wool or wine.

Specialising in wool would make Britain more efficient in that production, while Portugal, by specialising in producing wine, could increase its efficiency and its comparative advantage. Specialisation based on a country’s comparative advantages increases efficiency globally. This is why international trade works.

Ricardo’s theory also explains why a country that has no absolute advantage in anything can still trade profitably in the world economy, because there is a cost to the other countries in not engaging in what they are really good at.

However, countries do still continue to produce things in which they no longer have any real advantage (agriculture is the obvious area) for political and social reasons, and their protection of these industries warps the international economy.

Ricardo’s theory also assumes that capital will flow to the industry or country that has a comparative advantage in something, but he admits that capital was only mobile in theory – people preferred to invest at home rather than abroad.

In addition, when a country specialises in only one or two commodities which experience major fluctuations in price, it can be disastrous.

The argument is that free trade allows countries to diversify and develop manufacturing or service industries which, by being more specialised, have a higher chance of price stability. But such a process of adjustment takes many years and there can be serious social costs.

Ricardo’s trade theory makes a break with the mercantilist view that countries grow rich and strong at the expense of others. Rather, countries trading with each other can all grow at the same time. The Ricardian theory of trade also remains a crucial counterpoint to arguments in favour of economic nationalism and protectionism.

The recognition that his model still works in its essence is what drives the array of international free trade agreements which seek to reduce tariffs and protectionism. Ricardo’s theory remains one of the greatest achievements of economics.

Final comments

The two policies Ricardo advocated – less protectionism and more international trade resting on the theory of comparative advantage – would form the foundation of 19th century Britain’s power and wealth, and create the template for international economics.

Today, the face of Ricardo is reflected in every new trade agreement that makes the world more economically linked but still preserves the power of the nation state.

Copyright © Tom Butler-Bowdon, 2017. The above is an abridged extract from 50 Economics Classics by Tom Butler-Bowdon, published by Nicholas Brealey Publishing.

Leave a comment!

Please sign in or register to comment. It is free to register and only takes a minute or two.
Citywire TV
1 Comment Play Quilter CEO on IFAs, robos & his own DB transfer

Quilter CEO on IFAs, robos & his own DB transfer

In the final part of our interview with Paul Feeney, the Quilter chief executive declares that the government has 'left the ring' on savings policy, rounds on robo-advice, and reveals his own experience of the DB transfer market.

Play CEO Tapes: ESG - we need to get better at the 'G'

CEO Tapes: ESG - we need to get better at the 'G'

In the second part of our CEO series, we explore the burgeoning ESG concept with fund bosses outlining how they try to make a difference.

Play 'They've done it before': Feeney on Quilter quitters

'They've done it before': Feeney on Quilter quitters

In the second part of our exclusive video interview with Paul Feeney, we hear the Quilter CEO's views on the investment managers leaving the firm, along with his promise to platform users.

Read More
Wealth Manager on Twitter