ECONOMICS PAPER No. 5: Advanced Microeconomics

ECONOMICS PAPER No. 5: Advanced Microeconomics

MODULE No. 9:

Macro Theories of Distribution – Ricardian, Marxian

Subject ECONOMICS

Paper No and Title Paper-5 Advance Microeconomics

Module No and Title Module-9: Macro Theories of Distribution—Ricardian and Marxian

Module Tag ECO_P5_M9

ECONOMICS PAPER No. 5: Advanced Microeconomics

MODULE No. 9:

Macro Theories of Distribution – Ricardian, Marxian

Table of Contents

1. Learning Outcomes 2. Introduction

3. Ricardian Theory of Distribution 4. Marxian Theory of Income Distribution 5. Summary

ECONOMICS PAPER No. 5: Advanced Microeconomics

MODULE No. 9:

Macro Theories of Distribution – Ricardian, Marxian

1. Learning Outcome

After studying this module you will learn:

 The theoretical formulation of Ricardian concept of factor income distribution.

 How Marx extended the concept of factor income distribution which is based on Ricardian surplus theory.

2. Introduction

The principal problem in the political economy by Ricardo is the discovery of those regulations or principles which govern the shares of factor income distribution. Since Ricardo several theoretical models were developed to solve this principal problem of income distribution. In this module first the Classical theory or Ricardian theory of distribution is illustrated this is followed by how Marx developed his own theory of distribution based on Ricardo’s surplus theory. The analytical differences between these two theories are explained in the second part.

3. Ricardian Theory of Distribution

Ricardo’s theory emphasizes the fact that the principal problem in the political economy is the formulation of laws that govern the distributive shares of national income to the factors used in production. At the outset of his theory of distribution he mentioned the historical fact that “in different stages of society the proportions of the whole produce of the earth which will be allotted to each of these (three) classes under the names of rent, profit and wages will be essentially different”. Although his major concern in the problem of distribution is not only due to problems related to distributive shares, but to the belief that the whole mechanism of economic system can be understood by the theory of distribution.

Ricardian theory of distribution was based on the marginal principle and surplus principle. The marginal principle is used to explain the share of rent and the surplus principle focus on the distribution of residual part of the value of production between wages and profit. In order to explain Ricardian model, the following assumptions need to be highlighted:

ECONOMICS PAPER No. 5: Advanced Microeconomics

MODULE No. 9:

Macro Theories of Distribution – Ricardian, Marxian (1) The economy is broadly divided into two sector, agriculture and

industry.

(2) In agricultural sector a giant farm produces only one output, say corn. In order to produce corn three factors land, labour and capital are used. Total land used in production is fixed by the nature. The other two factors labour and capital are also used in fixed proportion to produce corn.

But the production technology between land and labour are assumed to be a variable coefficient.

(3) The production technology is subject to diminishing returns. This implies that as more and more of the composite of capital and labour are employed on a given amount of land, the marginal productivity of variable factor diminishes.

(4) The Malthusian law of population is assumed to operate. This implies that the population will increase (or decrease) when wages are above (or below) the subsistence level and in the long run the population will remain stationary at natural rate of wage (i.e., wage at subsistence level).

(5) Capital employed in production is classified in to fixed capital and circulating capital. As the turnover period is relatively long a small part of annual wage is used as capital, while the circulating capital is equal to the proper ‘wage fund’.

Based on the above assumptions we can explain how the forces operating in agricultural sector help determine the distribution of factors’ income in industry.

In the agricultural sector the distribution of income can be explained with the help of figure-2.1.

In the diagram the vertical axis measures quantities of corn and the horizontal axis measures the amount of labour employed in the production of corn. At given technology, the 𝐴𝑃 curve represents average product of labour and 𝑀𝑃 curve shows the marginal product of labour.

Because of the assumption of diminishing returns these two separate curves exist. For a given amount of labour the corn output is uniquely determined. That is, at 𝑂𝐿₁ unit of labour total output is measured by the rectangle 𝑂𝑅𝐺𝐿₁. The rent is equal to the difference between product of labour on marginal land and product on average land. That is the difference between average and marginal productivity depends on the elasticity of 𝐴𝑃 curve. However, the marginal productivity of labour (or produce minus rent) is the sum of both wage and profit rather than simply equal to wage. The wage rate in Ricardian model is determined by the constant supply price in terms of corn and is independent of marginal productivity of labour. According to modern economic theory the Ricardian hypothesis implies that at a given wage 𝑂𝑊 there is infinitely elastic supply of labour. This assumption of infinitely elastic supply of labour is based on the Malthusian theory of population. It states that population will increase indefinitely when wages are above the subsistence level and decline when wages are below the subsistence level.

The demand for labour in the Ricardian model is determined by the accumulation of capital which determines as to how many workers are employed at the wage rate 𝑂𝑊. The equilibrium is obtained not by the intersection of MP curve and the supply curve of labour, but by the aggregate demand for labour in terms of corn i.e., wages fund.

ECONOMICS PAPER No. 5: Advanced Microeconomics

MODULE No. 9:

Macro Theories of Distribution – Ricardian, Marxian When there is accumulation of capital, the labour force will grow. Hence the ‘agricultural wages fund’ is determined by the area 𝑂𝑊𝐸𝐿₁. For any given labour 𝐿₁ , the profits are determined by the residue generated from the difference between marginal product of labour and the rate of wages. Hence, the ratio of profits to wages (^{𝑃𝑟𝑜𝑓𝑖𝑡𝑠}_{𝑊𝑎𝑔𝑒𝑠}) determines the rate of profit per cent on how much capital is employed. This rate of profit per cent of capital employed is indeed equal to the ratio of profit to wages when capital is assumed to be turned over once a year in such a way that capital employed is equal to the annual wage bill. In equilibrium situation, both agricultural sector and industrial sector must generate the same money rate of percentage of profit earned on capital; otherwise the capital will shift from one form of employment to other.

However in agricultural sector the money rate of profit cannot deviate from the rate of profit measured in terms of its own product, that is, ‘corn rate of profit’. This happens as in agriculture both input (in terms of wages) and output is comprised of same product, i.e., corn, while in industrial sector, the input and output do not consist of same commodities. In agriculture the cost per worker is fixed in corn, but in industry for a given state of technology the product per worker is fixed in terms of manufacturing goods. Therefore, the equality in the money rate profit in both the sectors may occur only through the price adjustment between industrial and agricultural commodities. The rate of profit in terms of money in industry depends on the rate of profit in terms of corn produced in agriculture. The rate of profit in terms of corn is subject to margin of

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Macro Theories of Distribution – Ricardian, Marxian cultivation. For a given state of technology this margin of cultivation

reflects the extent of capital accumulation. Thus according to James Mill the profit can fall due to diminishing fertility of soil.

In order to make the whole structure of the Ricardian economy more logically consistent it is important to assume that wages are not only fixed in terms of corn, but the entire wage income should be spent on corn. If we relax this assumption, any change in relation between industrial and agricultural prices will change real wages so that it will no longer be possible to derive the size of surplus and the rate of profit on capital from the corn rate of profit. The corn rate of profit can be defined as the relationship between the product of labour and the cost of labour working on the marginal land. Let us assume that the agricultural products are considered as wage goods and industrial products are considered as nonwage goods. Now the annual wages fund can be determined by the total corn output (shown by the area 𝑂𝑅𝐺𝐿₁in figure-2.1). Of this total corn output 𝑂𝑊𝐸𝐿₁ is used in agriculture and 𝑊𝑅𝐺𝐸 is employed in rest of the economy. Now suppose due to protection to agriculture, any increase in 𝑂𝑊𝐸𝐿₁ will depress the rate of profit and reduce the rate of growth. In the same manner all the taxes other than those levied on land are imposed on profit and these will also reduce the rate of accumulation and growth.

4. Marxian Theory of Distribution

The Marxian theory is mainly based on the Ricardo’s ‘surplus theory’. But it differs analytically from Ricardo’s concept in many respects. Unlike Ricardo, Marx ignores the concept of diminishing returns and hence according to him there is no distinction between rent and profit.

Marx considers only two factors of production- labour and capital. The capitalist class owns the stock of capital and hires labour to produce commodities. The supply price of labour was considered fixed in terms of general commodities and not in terms of ‘corn’, while share of profits in total output is determined by the surplus value of output per unit of labour over the supply price of labour.

In the process of capitalism, capitalist first enters into market with money to purchase labour power and other means of production. After completion of production he returns to the market for selling his products and earn money. This entire process is expressed as 𝑀 – 𝐶 − 𝑀^/ where 𝑀^/ is larger than 𝑀. Marx refers to the difference between 𝑀^/ and 𝑀 as surplus value. According to him this surplus value arises due to higher productivity of labour relative to value of labour power. The value of any product according to Marx is determined by the amount of labour required to produce that product. Similarly, the value of labour power is the labour hour necessary for production and also the reproduction of this labour. This means that

ECONOMICS PAPER No. 5: Advanced Microeconomics

MODULE No. 9:

Macro Theories of Distribution – Ricardian, Marxian the labour power is the value of means of subsistence required for

maintaining the livelihood of the labourer. The wage rate received by the worker is equal to the value of labour power. In the capitalist system the amount of labour time engaged in production is divided into necessary labour and surplus labour. The portion of total product which is generated from the necessary labour is given to the labourer in the form of wage and the rest of the product in which surplus labour is used, is appropriated by the capitalist in the form of surplus value.

Marx gives the three concepts of capital generated in production under capitalism. These are value of constant capital, value of variable capital and the surplus value. The value of output is distributed among these three different components of capital. This relation can be written as

𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑜𝑢𝑡𝑝𝑢𝑡 = 𝐶 + 𝑉 + 𝑆 Where 𝐶 = Constant capital (Fixed capital and raw materials).

𝑉 = Variable Capital (wages & salaries).

𝑆 = Surplus value (interest, dividends and the amount for reinvestment).

According to Marx the value of net product has only two components 𝑉 (wage share) and 𝑆(profit share).

The distribution of surplus value among the various classes namely the capitalist, landlords and others has been less emphasized in the Marxian theory.

Marx provides the concepts of three important ratios to explain his theory of capitalism. First he defines the rate of surplus value or rate of exploitation by the ratio of surplus value to variable capital i.e., 𝑆/𝑉. The magnitude of this rate depends on three factors; the length of labour time, the amount of product necessary for real wage and finally the productivity of labour. The rate of surplus can be raised either by increasing labour time or improving labour productivity or lowering the real wage rate or by some combination of these three.

Secondly, the ratio of constant capital to the sum of constant and variable capital, i.e. ^𝐶

𝐶+𝑉 defines the concept of organic composition of capital in Marxian system. The organic composition of capital is determined by real wage rate, the productivity of labour, the production technique and the amount of capital accumulation.

Finally the ratio of surplus value to the sum of constant and variable capitals i.e. _𝐶+𝑉^𝑆 measures the rate of profit. According to Marx there is no share of surplus value obtained by landlord in the form of rent and surplus value is considered as profit. The rate of profit only depends on the amount of actual capital employed in production and not on the total investment. Thus the rate of

ECONOMICS PAPER No. 5: Advanced Microeconomics

MODULE No. 9:

Macro Theories of Distribution – Ricardian, Marxian profit varies with the changes in rate of surplus value and the organic

composition of capital. In notation this can be written as 𝑝 = 𝑆

𝐶 + 𝑉 = 𝑆 𝑉

𝑉

𝐶 + 𝑉= 𝑆

𝑉[1 − 𝑆 𝐶 + 𝑉] Or 𝑝 = 𝑠^/(1 − 𝑞)

Where 𝑝 = rate of profit

𝑠^/ = Rate of surplus value and 𝑞 = organic composition of capital.

Marx explains the nature of capital accumulation by using the above relation. The accumulation of capital happens when the surplus value of production is converted into capital. Thus in the capitalist system the activities of production, accumulation and reproduction are carried on continuously.

The demand for labour power increases with the progress of capital accumulation. For any commodity when demand for a commodity rises, there will be a resulting increase in price of that commodity and this will continue until the equilibrium is obtained. At equilibrium the price will be equal to its value. According to Marxian theory this principle of demand theory is not followed in case of labour power. The equilibrium obtained through demand supply mechanism is missing in case of labour power under the process of capitalism. Although capital accumulation increases the labour power, but the equality between wages and labour power is no longer assumed to happen.

Interestingly, this problem does not exist in the Ricardian model as he adopted the Malthusian theory of population in order to determinate the wage rate. When capital accumulation takes place the market wage rate will be higher than the natural wage rate and this will cause a rise in population. The supply of labour will increase and consequently the market wage rate will fall to its subsistence level. Marx did not follow the Malthusian theory of population. He solved this problem by suggesting that there exist a pool of unemployed labour called the reserve army of labour which causes a continuous downward pressure on the wage level through their active competition in the labour market. The reserve army constitutes of that part of labour force which has been displaced by machinery and additional working population. Now under capitalism with the installation of new machinery, the individual capitalist always attempts to minimize his wage cost. The overall effect of this wage cost minimizing behavior of all capitalists will result in a rise of unemployment. This in turn has a negative impact on wage level. This implies that when there is a tendency for a rise in demand for labour power, there is the counteracting pressure of the reserve army developed to retard the process of wage increase and vice versa.

ECONOMICS PAPER No. 5: Advanced Microeconomics

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Macro Theories of Distribution – Ricardian, Marxian In Marxian theory, there is progressive mechanization of production

process with the growth of capital accumulation. In this context the concept of mechanization means an increase in the organic composition of capital. From this concept Marx derived his famous law of the falling tendency of the rate of profit. It has been explained earlier that the rate of profit is related with the rate of surplus value and the organic composition of capital. That is in notation 𝑝 = 𝑠^/(1 − 𝑞).

Now if we assume that the rate of surplus value (𝑠^/) remains constant, the rate of profit (𝑝) declines with the increase in organic composition of capital. In the process of development 𝑞 shows an increasing trend and hence it can be said that there will be a tendency of 𝑝 to fall. At the same time the change in 𝑠^/ may exactly or more than offset the effects of change in 𝑞.

According to Marx, productivity of labour and relative share of profit increase with technical progress, while the share of wage declines. This happens due to the act that labourers fail to raise their real wages with the increase in labour productivity. Thus capitalists appropriate all additional outputs generated due to technical progress. Marx conformed with Ricardian view that there exists an inverse relation between share of profit and share of wage. However, there is a contradiction between them in regard to the direction of the movement of these shares. Marx suggested that there will be upward movement of profit share, while Ricardo’s prediction was that share of wage will rise.

Summary

 Ricardian theory of distribution was based on the marginal principle and surplus principle. The distribution of share of rent is explained by marginal principle concept, while the surplus principle is used to explain how the residual part of the value of production is distributed between wages and profits.

 In the Ricardian theory the economy is mainly divided into two sectors-- agriculture and industry.

 According to Ricardo the rent to the landlord is determined by the difference between product of labour on marginal land and product on average land.

 In the Ricardian model the marginal productivity of labour (or produce minus rent) is the sum of both wage and profit rather than simply equal to wage. Wage rate here is determined by the constant supply price in terms of corn and is independent of marginal productivity of labour.

 The demand for labour in the Ricardian model is determined by the accumulation of capital.

 The profits in this model are determined by the residue generated from the difference between marginal product of labour and the rate of wages.

ECONOMICS PAPER No. 5: Advanced Microeconomics

MODULE No. 9:

Macro Theories of Distribution – Ricardian, Marxian

 In equilibrium situation of Ricardian model, both agricultural sector

and industrial sector must generate the same money rate of percentage of profit earned on capital; otherwise the capital will shift from one form of employment to other.

 In Ricardian theory the equality in the money rate of profit in both the sectors may occur only through the price adjustment between industrial and agricultural commodities. The rate of profit in terms of money in industry depends on the rate of profit in terms of corn produced in agriculture.

 The Marxian theory of distribution followed the concept of Ricardo’s ‘surplus principle’.

 According to Marx there is no distinction between rent and profit as he ignores the concept of diminishing returns.

 Marx considered the supply price of labour determined in terms of general commodities and not in terms of ‘corn’, while share of profits in total output is determined by the surplus value of output per unit of labour over the supply price of labour.

 Marx gives the three concepts of capital generated in production under capitalism. These are value of constant capital(C), value of variable capital (V) and the surplus value(S).

 Marx provides the concepts of three important ratios to explain his theory of capitalism. First he defines the rate of surplus value or rate of exploitation by the ratio of surplus value to variable capital i.e. 𝑆/𝑉. Secondly, the ratio of constant capital to the sum of constant and variable capital, i.e. _𝐶+𝑉^𝐶 defines the concept of organic composition of capital in Marxian system. And finally the ratio of surplus value to the sum of constant and variable capitals i.e. _𝐶+𝑉^𝑆 measures the rate of profit.

 According to Marx the accumulation of capital takes place when the surplus value of production is converted into capital and thus in the capitalist system the production, accumulation and reproduction are carried on continuously.

 In Marxian theory, there is progressive mechanization of production process with the growth of capital accumulation (increase in organic composition of capital).

 According to Marx, the productivity of labour and relative share of profit increase with technical progress, while the share of wage declines.

 Marx argued that there will be upward movement of profit share, while Ricardo’s prediction was that share of wage will rise.