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The Suntory and Toyota International Centres for Economics and Related Disciplines

Relative Prices, Growth and Trade in a Simple Ricardian System

Author(s): Ronald Findlay
Reviewed work(s):
Source: Economica, New Series, Vol. 41, No. 161 (Feb., 1974), pp. 1-13
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Relative Prices, Growth and Trade in a Simple

Ricardian System

The Ricardian system appears to have fascinated every generation of

economists since its original formulation. Ours is no exception. Knight
(1935), Stigler (1952), Kaldor (1956) and Samuelson (1959) to mention
only some of the most eminent theorists of our time, have all devoted
papers to examining and appraising the nature of Ricardo's unique
contribution to economic analysis. Piero Sraffa (1951), in addition to his
monument of scholarship in a complete edition of Ricardo's works and
correspondence, has also given in his Introduction a penetrating
interpretation of the evolution of Ricardo's thought. Pasinetti (1960)
has presented a mathematical formulation of the Ricardian system in
which it appears as a simple but elegant and determinate two-sector
general equilibrium growth model.
The first section of this paper gives an elementary diagrammatic
solution of the Ricardo-Pasinetti model, in terms of demand and supply,
which serves as the basis for the analysis of the rest of the paper. The
second section examines the role of demand in the model and the effects
of technological changes on relative prices and the distribution of
income. The final section extends the model to consider international

The economy produces two goods, corn and velvet. The first uses
labour and land as inputs and these are connected with output by the
usual production function in which there are constant returns to scale
and diminishing returns to either factor with the other fixed. Land is
assumed to be in fixed supply and of homogeneous quality. Velvet is
produced by labour alone with output being simply proportional to the
input of labour. "Capital" in this model consists of the wage-goods of
labour, which have to be "advanced" one period earlier than the time
at which the output emerges in either sector. All the difficulties of
different proportions of fixed to circulating capital, unequal "periods
of production" and so on are thereby assumed away. Corn is the sole
wage-good, and the "natural wage-rate", assumed always to prevail, is
a constant quantity of corn. This means that either population adjusts
very quickly to equalize the market wage-rate to the constant natural
wage-rate or that there is an "unlimited supply of labour" a' la Arthur
Lewis, say from Ireland. The initial wage fund of corn is taken as given
which yields the labour force on division by the fixed natural wage-rate.

Technology and factor supplies now being accounted for the transforma-
tion curve shown in Figure 1 between corn and velvet is determined.
It is concave to the origin, reflecting the fact that each unit of labour
withdrawn from velvet reduces output of that commodity by a constant
amount but increases corn output by diminishing increments since land
is fixed in supply.

0 Velvet

Perfect competition is assumed to prevail, which means that the rate

of profit and the wage-rate must be equal in the production of corn and
velvet. The quantity of each commodity supplied will be determined by
the condition that the marginal opportunity cost is equal to the price-
ratio of the two goods. Writing R for the rate of profit, C and V for the
two outputs, PCand P, for the money prices, LCand LVfor the labour
inputs, T for land, oafor the productivity of labour in velvet and w for
the wage-rate in terms of corn, the condition for equal profit rates can
be written as
(1) R =Pc[C- (aC/lT)T- wLc] PvccLv -PcwLv
where (aC/lT)T is total rent, equal to the marginal product of land
multiplied by the supply of land. From this, noting that C= (aC/lT)T+
(aC/1Lj)Lc,it follows that
(2) Pc-aLc Pa
which means that the marginal rate of transformation, or the slope of
the transformation curve, must be equal to the given price-ratio for the
profit rate to be equalized between the sectors. As the price-ratio is
varied, the equilibrium quantities supplied of the two goods can be
graphed on back-to-back supply curves as in Figure 2.


Corn 0 Velvet

What now of the other blade of the Marshallian scissors? Clearly

one cannot expect any sophisticated analysis in terms of consumer
preference and choice from Ricardo, for this only appeared fifty years
later with the emergence of the "marginal utility" approach. Casual
perusal of the Principles and the Essay on Profits does not turn up any
passage in which Ricardo explicitly confronted the demand problem in
his model. Frequently he asserts that the demand for corn is propor-
tional to the population and tries to close the system in that way. This,
however, is clearly illegitimate on his own assumptions since, except in a
stationary state, corn is demanded not only to replace the current wage
fund but also to expand it by accumulation out of profits. Since the rate
of profit is itself a variable of the system this route is not open.
Pasinetti however introduces a hypothesis which, although no textual
evidence is provided to support it, nevertheless accords well with the
spirit of the Ricardian approach. This is to link the demand pattern
solely to the distribution of income, with all wages and profit being
spent on corn and all rent on velvet, regardless of relative prices. Since
the distribution of income itself, however, depends on relative prices, in
the end one arrives at a demand curve which is a function of relative
prices. Moreover, it is a well-behaved demand function, since the higher
the price of velvet relative to corn the lower the output of corn and hence
the lower is rent in terms of corn, which means that the demand for

0 A 0' 0

velvet falls for two reasons, landlords having less corn to spend as well
as getting less velvet per unit of corn. The equilibrium price-ratio is
determined by the equality of demnandand supply for velvet which
implies that there must also be such equality in the market for corn.
The equilibrium price-ratio being determinate, all other variables in (1)
such as C, DC/DT,LCand Lv are determined and so also therefore is the
rate of profit R.
The equilibrium that has been determined is what is known as
"momentary equilibrium"in the language of modern two-sector growth
theory. The evolution of the system over time, and the terminal state to
which it tends, have still to be determined.Pasinetti devotes considerable
intricate analysis to this task which can, however, be rigorously es-
tablished by a very simYple line of reasoning.
Since the wage fund for the next period is (1l+br) times the given
initial wage fund the transformation curve of Figure 1 is shifted out, to
(1i+m) tites on the velvet axis but less than this on the corn axisn
because of constant and diminishing returns to the input of labour in the
velvet and corn sectors respectively. If relative prices are held constant,
what will happen to the output of each commodity on the new trans-
formation curve as compared with the original position of momentary
equilibrium? This question can be answered by means of Figure 3 in
which the marginal value productivity curves of labour in corn and
velvet are drawn with the same labour axis, read from left to right for
corn and in the opposite direction for velvet. The marginal physical
productivity of labour in corn is valued in terms of velvet at the original
equilibrium price-ratio. For the initial quantity of labour, measured
by the distance 00', tee competitive equilibrium allocation is QA to
corn and O'A to velvet, A being the point at which the marginal
productivity of labour in corn, valued in terms of velvet, is equal to cc,

the constant average and marginal product of labour in velvet. Let the
labour axis now be extended (1 + R) times its former length to 00". At
constant relative prices for the two commodities the marginal value
product curve for corn will not shift at all and so the new equilibrium
allocation of labour would continue to be OA to corn, with all the
increase 0'" going into velvet. In terms of Figure 1 it has been shown
that the tangent to the new transformation curve, parallel to the
equilibrium price-ratio for the first period, will touch it at a point
where corn output is constant and velvet output has increased. (This is a
special case of the theorem of Rybczynski (1955), in which the labour-
intensive good uses no land at all and hence does not require a contrac-
tion of the land-intensive good for its expansion at constant relative
factor prices.) In terms of Figure 2 the supply curve of velvet has
shifted to the right at the original equilibrium price-ratio, and by the
same argument, would have shifted to the right at all price-ratios.
The demand for velvet, at any price-ratio, depends upon the rent in
the corn sector corresponding to that price-ratio. In Figure 3, since corn
output will remain unchanged at the original price-ratio even though
labour has increased, rent in terms of corn, and hence the demand for
velvet, will also remain unchanged. By the same reasoning the expansion
of labour in the second period does not shift the demand curve at any
price-ratio. Consequently, momentary equilibrium in the second period
requires a decline in the price of velvet relative to that of corn. As
compared with the first period the output of velvet and of corn are both
higher. In terms of Figure 1 the equilibriumpoint on the second period's
transformation curve will be to the left of the point where the line
parallel to the first period's equilibrium price-ratio is tangential to it.
The increase in corn output can only come about with more labour
applied on the same land which means that the marginal product of
labour in the corn sector declines. Since (1) can be written as
R =(8C/8LC)-w

it follows that the rate of profit must decline. This in turn means that
the rate of growth of the wage fund must be deceleratinguntil in the limit
it approaches the zero value of the stationary state. Landlords benefit
increasingly, both from larger rent in terms of corn and from the
relative cheapening of their sole item of expenditure, velvet, in terms of
This completes the graphical solution of the Ricardo-Pasinetti model,
which forms the basis for the analysis of the next two sections. It is
worth remarking that the two-sector Ricardian model analysed here
has so far produced results completely in conformity with the simple
one-sector corn model exposited graphically in different but equivalent
ways by Baumol (1951) and Kaldor. The two-sector model, however,
can be used to analyse the influence of demand, technological change
and international trade on the rate of profit, rent and relative

commodity prices, all of which are beyond the scope of the simple
corn model. To these questions we now turn.

Although Ricardo started out as a strong adherent of an undiluted
labour theory of value, criticism by Torrens, Malthus and others led him
to recognize that the various manifestations of the role of time in
production would require modifications of the doctrine. After candidly
discussing the problem in the first chapter of the Principles he neverthe-
less held to the labour theory as an adequate first approximation, what
Stigler (1958) has called a "93 per cent labour theory of value". On the
influence of land on relative prices, however, Ricardo believed that rent
could be "eliminated" from consideration since relative prices are equal
to relative marginal costs and corn grown on marginal land pays no
rent. This has usually been regarded by later commentators as a stroke
of genius. In spite of the credit due to him for his grasp of the marginal
principle, however, Ricardo and most of his commentators did not
appear to have realized that this is not a viable defence of the labour
theory of value, considered as a doctrine that determines relative
prices purely from the cost or supply side. It was not until as late as
1959 that Samuelson put the cogent question of how the "rentless
margin" could be located without specification of demand. Since labour
per unit of corn varies continuously with the extent of cultivation the
level of corn output has first to be determined. In the simple Adam
Smith "deer and beaver" case relative prices are truly independent of
demand in the sense that relative costs are unchanged whatever the
proportions in which the two goods are demanded.
Graphically, the issue of whether relative prices are independent of
demand or not turns on whether the transformation curve is linear or
not. As shown in the previous section the transformation curve in the
Ricardo-Pasinetti model is concave to the origin and hence relative
prices depend on demand, however specified. The point would not be
worth labouring were it not for the fact that in his verbal interpretation
of the mathematically impeccable solution of the model, Pasinetti
(1960, pp. 84-85) insists that "it contains a theory of value which is
completely (and owing to our explicit assumptions) rigorously inde-
pendent of distribution" and that "the value of commodities depends
exclusively on technical factors (the quantity of labour required to
produce them) and on nothing else." This is argued on the basis of the
fact that relative prices are equal to the ratio of the marginal productivi-
ties of labour. One of these, however, is a variable, which takes on a
value in equilibrium that is determined by the working of the whole
system, including the distribution of income and the spending patterns
assumed for the various classes.
A simple generalization of the model shows this even more clearly.
Pasinetti assumes no rent to be spent on corn, and states in a footnote

that a minimum fixed expenditure for the subsistence of landlords

could be allowed for without affecting the qualitative properties of the
system. While it is true that if the average holding of land is large, a
condition prevalent in Europe in Ricardo's time, landlord subsistence
would be of trivial significance, it must not be forgotten that the landed
classes of that time employed hordes of servants, retainers, function-
aries and entertainers(think of Haydn in the serviceof Count Esterhazy).
The maintenance of this extensive group of people would come from
rent, and so one could legitimately argue that a not insignificantpropor-
tion of rent would be spent on corn for direct consumption, not by
landlords but by this category of workers. Such an assumption would
be entirely within the spirit of classical political economy, in which the
distinction between "productive" and "unproductive" labour was felt
to be of considerable significance in theory and an alteration of the
proportions in favour of the former an important policy objective for
the "growthmen" of the day.
Suppose therefore that only some fixed fraction of the corn rent is
spent on velvet. The effect in Figure 2 would be to shift the demand
curve for velvet to the left, resulting in equilibrium with a lower relative
price of velvet and hence larger corn rent and a lower rate of profit.
This should establish conclusively that relative prices in the Ricardian
system are not independent of distribution and demand patterns.
A key Ricardian theorem, which Pasinetti rightly emphasizes, is that
the rate of profit does not depend upon the technology for producing
luxury goods-velvet in the case of the present model. The instincts of a
neoclassical general equilibrium theorist would be to deny this, since
he is used to thinking in terms of mutual causation, with everything
depending on everything else. Since in the simple two-sector framework
luxury goods are identified with manufactures and wage-goods with
agricultural products, the theorem can also be expressed as the state-
ment that the rate of profit in manufactures depends upon the rate of
profit in agriculture. Stigler (1965, p. 186), for example, calls this an
"amazing proposition" and is sharply critical of Ricardo's reasoning
in defence of it. A good test of the usefulness of our graphical exposition
would be to see whether it can throw any light on this matter.
In Figure 4 let there be momentary equilibriumat the point m. Suppose
now that a, the average (equal to marginal) productivity of labour in
velvet were to double, while everything else remains the same. The
transformation curve would then have a horizontal co-ordinate twice as
long as before for each point on the vertical axis. Consider n, directly
to the right of m, so that corn output is the same at both points while
velvet is twice as large at n. Since corn output is unchanged rent is also
constant, in terms of corn. The slope of the outer transformation curve
at n, from equation (2) above, is half the slope of the original curve at m,
since a has doubled and aC/ILC is constant. This means that the price of
velvet relative to corn is half of what it was before. With the same
proportion of rent being spent on velvet at m and at n, demand for


m n_

0 Velvet

velvet has doubled. Therefore if demand and supply were equal at m

they must also be equal at n. To the right of n demand would exceed
supply and to the left supply would exceed demand. The rate of profit
continues to be at its original level in both sectors, the doubling of
velvet output being exactly offset by the halving of its price. Notice that
the allocation of labour, and hence of the wage fund, is unchanged.
The Ricardian theorem is therefore completely correct.
A symmetrical result, involving the effect of technical change in the
corn sector, was denounced as "rank fallacy" by Knight (1956, p. 86,
footnote 68). Since two inputs are used in corn, with a neoclassical
production function, the simplest assumption to make regarding the
technical change is that it is of the Hicks-neutral variety, with both
marginal physical products doubled at the same land-labour ratio.
Rent in terms of corn would be doubled at n in Figure 5 but the relative
price of velvet will also double so that demand for the commodity is
the same at n as at m. Since supply of velvet is also the same at both
points n would be the equilibrium point after the technical improve-
ment. The rate of profit in the corn sector would rise as a result of the
doubling of aC/lLC and the rate of profit in velvet would rise to the
same extent as a result of the doubling of PV/PC. These changes in the
rate of profit occur without any shift of resources taking place between
the sectors. It is interesting to note that in the Pasinetti case of zero
expenditure on corn out of rent the real income of landlords is not
raised as a result of agricultural improvements since the rise in the
price of velvet wipes out all the gain in terms of corn.
If the technical improvement in corn is "biased" instead of neutral
the allocation of labour between the two sectors will be altered. Thus
suppose that the innovation raises the marginal product of labour, with
the same amounts of land and labour as before used in corn, but
leaves the marginal product of land unchanged. Then rent in corn terms


0 Velvet

will be the same at n as at m but the relative price of velvet will be higher
since it depends on the relative marginal products of labour. Supply of
velvet, which is unchanged, will therefore exceed demand at n, which
means that the output of corn will expand and that of velvet contract
along the outer transformation curve until there is equilibrium in the
commodity markets. The rate of profit, which was higher at n than at mn
because of the rise in the marginal product of labour (circulating
capital) as a result of the innovation, will decline as corn output
expands because of diminishing returns on the fixed supply of land,
while the marginal product of land which was unchanged at n will now
rise. The rate of profit in the new final equilibrium position, however,
must be higher than before since corn output is larger and the rate of
profit can be expressed as current corn output divided by the fixed
initial wage fund minus unity. Rent is higher in terms of corn but real
income of landlords in the pure Pasinetti case would be reduced since
the output and hence consumption of velvet is now lower as a result of
its higher relative price.
The analysis for the opposite pattern of bias, with the marginal
product of land increased and of labour constant when the same
amounts of both inputs are used in corn, is also easily carried out. Now

the position at n will be such that rent in terms of corn is higher while
relative prices of corn and velvet are unchanged. Demand must there-
fore exceed the unchanged supply of velvet at n and so the new equili-
brium will involve an increase in the output of velvet and a decline in
corn output along the outer transformation curve. The rate of profit is
the same at n or at m, since the marginal product of labour is not
altered by the innovation when both inputs are held constant. In the
new equilibrium it is therefore higher since labour is switched to velvet,
raising its marginal product in corn on the fixed land. Real income of
landlords is higher.
It has thus been shown so far that innovations in corn always raise
the rate of profit but the real income of landlords can rise, fall or remain
the same, depending upon whether the innovation is "land-using",
"land-saving" or "neutral".
An extreme case of a "land-using" or "labour-saving" innovation is
of some interest to consider because it was used by Wicksell (1934, pp.
133-144) in his well-known criticism of Ricardo's views in the famous
chapter "On Machinery". Suppose that the marginal product of labour
falls, while that of land rises, when both inputs are held constant in the
production of corn. In this case the rate of profit is lower at n than at m,
as a result of the fall in the marginal product of labour, and the relative
price of velvet is lower. Rent in terms of corn being higher, demand
exceeds supply of velvet at n, which means that velvet expands and corn
contracts along the outer transformation curve in the new equilibrium
position, thus raising the rate of profit as compared with its value at n.
It is possible for this rise to be insufficient to offset the initial fall in the
rate of profit, so that in the new equilibrium corn output and the rate of
profit are lower than before the "labour-saving" innovation in corn.
The growth rate of the wage fund, and hence employment, is therefore
reduced by an innovation of this type. Thus, even though his analysis
was regarded as erroneous by Wicksell, Stigler and many other com-
mentators, it appears that there is a core of truth in Ricardo's conten-
tion that "labour-saving" innovations are inimical to employment. The
assumptions that have been made for this result here are, however,
quite different from those made by Ricardo himself in his chapter "On
Machinery", in which the innovation takes place in the manufacturing

While the theory of comparative advantage is perhaps Ricardo's most
famous single contribution to economic analysis and the repeal of the
Corn Laws the policy objective most closely associated with his name,
it is a curious fact that Ricardo always used different models in his
consideration of these problems. The exposition of comparative ad-
vantage in the seventh chapter of the Principles, the celebrated example
of cloth and wine traded between England and Portugal, assumes that

labour is the only scarce factor of production in both countries. Rent

and the rate of profit do not appear at all in the analysis. In his discus-
sions of the desirability of repealing the Corn Laws, however, for
instance in the Essay and in various parts of the Principles, the chief
emphasis is placed upon the reduction in rent and the rise in the rate of
profit that would ensue, and the beneficial effects that this would have
on economic growth. The gains from trade in the England-Portugal
example only appear in terms of the expanded consumption-possibilities
for both countries, increasing the "mass of commodities and the sum of
enjoyments" while "value" in the sense of man-hours of labour em-
ployed remains unchanged. In the Corn Law discussions trade is an
engine for increasing "value" over time by expanding the rate of growth
of the wage fund.
Our graphical exposition of the Ricardo-Pasinetti system, however,
enables an integrated analysis of comparative advantage, income
distribution and growth. If there are two countries, say England and
America, and tariffs and transport costs are ignored, the position of
momentary equilibrium will be shifted for each of them if international
trade is opened up. Ricardo himself never solved the problem of the
determination of the terms of trade, which had to wait for the "recipro-
cal demand" analysis of J. S. Mill and Marshall. In the present context
the problem is easily solved by the device of lateral summation of the
demand and supply curves for either commodity in both the national
markets. The intersection of the total demand and supply curves
determines the international price-ratio that clears both markets and
the volume of exports and imports from each country.
Which country exports which commodity can be inferred from the
comparison of their no-trade equilibrium price-ratios. Obviously a
country will export the commodity that is relatively cheaper in the no-
trade situation. In the usual simple Ricardian model the specialization
pattern can be determined from the ratios of the fixed labour input
coefficients, which is not possible in the present case because the
coefficients for corn are variables. In this wider framework the pattern
of specialization would depend upon differences in any or all of the
following: the technology for producing the two commodities, the
natural wage-rate, the composition of landlord demand and the
proportions of labour (and hence circulating capital) to land.
The Heckscher-Ohlin approach concentrates on factor proportions
as the principal determinant of comparative advantage. If all the other
differences except the last were excluded by assumption the Ricardo-
Pasinetti system would also lead to a factor proportions theory of
comparative advantage. To see this we observe that if the supply of land
and the initial wage fund are altered in the same proportion relative
prices and quantities of corn and velvet would remain unchanged if
technology, the wage-rate and landlord demand patterns are the same.
If the wage fund were to be relatively larger it has already been shown
that this would lead to an expansion of velvet output at constant

relative prices, with corn output remaining unchanged. This implies an

excess supply of velvet, since rent, being determined by corn output, is
the same. Velvet will therefore be relatively cheaper in the country that
is more abundantly endowed with labour (and circulating capital).
Since velvet requires no land at all it is the relatively labour-intensive
commodity and so trade conforms to the Heckscher-Ohlin hypothesis
in the Ricardo-Pasinetti model if the appropriate assumptions are
From equations (1) and (2) it follows that, if both countries are
incompletely specialized after trade, identical technology would imply
identical marginal products of labour in the corn sector, and hence
identical rents per acre and rates of profit, if the exogenous natural
wage-rates are the same in both countries. The rate of profit rises and
rent per acre falls in the country that exports velvet while the opposite
happens in the corn exporting country. These results conform of course
with those of the classic papers of Stolper and Samuelson (1941) and
Samuelson (1948) on the effects of protection on factor prices and the
equalization of factor prices through international trade. It is interesting
to see, however, how implicit they already were in the general Ricardian
system, although beyond the scope of the England-Portugal example,
where only one scarce factor is considered.
The long-run effects of the opening of international trade are also
easy to ascertain. First, we note that since trade equalizes the rate of
profit it also equalizes the rate of growth in this model. Both countries
will therefore have their supply curves for velvet shifting to the right,
absorbing all the increase of labour at the equilibrium international
price-ratio. The world supply curve of velvet therefore shifts to the right
at that price ratio. The demand for velvet in each country, and hence in
the world as a whole, remains constant at each price-ratio, as we have
seen, since rent in corn is unchanged at each price-ratio. With the world
demand curve unchanged and the supply curve shifting to the right the
international price-ratio must turn against velvet to restore equilibrium.
Hence world growth causes the terms of trade to move secularly in
favour of the corn exporting country. This means that rent per acre
rises and the rate of profit falls in both countries. In the end growth
ceases when the marginal product of labour in corn is driven down to
the natural wage-rate and the rate of profit is zero in both countries,
with all the surplus income accruing to rent.
The world as a whole therefore also tends to the stationary state. For
the exporter of manufactures, which is of course what England would
be in the mind of Ricardo, free international trade could only postpone
the stationary state. The "final, historical equilibrium", in Stigler's
words (1965, p. 193), is for England and the world to be in a stationary
state. As is readily apparent, any number of countries could be included,
with no difference in the result. It should be noted that while free trade
raises the profit and growth rates in England, albeit temporarily, it has
the opposite effect on the agricultural exporter, as Hamilton, List or

Prebisch would be quick to point out. On the other hand the analysis
predicts a secular trend of the terms of trade against the manufactured
exporters, a position that a long line of economists, including Keynes,
Robertson, Beveridge and E. A. G. Robinson have taken, one of the
many Ricardian legacies to British economic thought.
The analysis of the effects of international trade can also be carried
out on the basis of the "small country" assumption that the world
terms of trade are exogenously determined. In this connection, it is
interesting to note that an increase of productivity in velvet, which
was simply seen to cause a price decline of the same proportion in the
closed economy, would now lead to a diversion of labour from corn to
velvet for export, relative product prices being determined by the world
market, and hence to a rise in the rate of profit and a decline in rent.
The proposition on which Sraffa, Pasinetti and other critics of marginal-
ist economics place such emphasis, that productivity outside the wage-
good industries is irrelevant for the rate of profit, is thus not true in an
open Ricardian economy. It can, however, be argued that in this case
luxury-good exports are "indirect" wage-goods, thus preserving the
spirit of the theorem.

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