Classical Economics

Question 1

Globalisation

Answer 1

free movement of labour - work where you like

free movement of capital - invest where you like

free trade, buy and sell where you like

Question 2

Smith’s case for free trade

Answer 2

2 countries can gain from trade when they have absolute advantage in different countries

UK: steel is cheap to produce, corn is expensive - US is the other way around

so specialise and trade, both countries will benefit

Question 3

Ricardo on Free trade

Answer 3

suppose both goods expensive in the UK, cheap in the US

not in the US interest to trade which Ricardo says is because of comparative advantage

Question 4

Comparative advantage

Answer 4

assume UK and US have same amount of inputs (use graph of production frontier of steel and corn - different slopes)

specialisation and trade makes both countries better off so UK could specialise in steel and exchange some of it for US’ corn and vice versa

both countries end up better off in both goods

this is an argument for free trade

Question 5

Arguments against free trade

Answer 5

1. National security - selling weapons to a country you could fight
2. Infant industry - suppose UK will eventually have a comparative advantage in steel but has to build it up first (economies of scale) - would need to protect it from foreign competition

Question 6

Government intervention on free trade

Answer 6

governments aren’t good at forecasting comparative advantage so might protect the wrong industries

once you put tariffs on, lobbyists and politicians who want the industries votes will see they never come off

by the time the protected industries become competitive, technology or consumer demand may have moved on

Question 7

Further arguments for free trade

Answer 7

1. Increases size of firms’ markers with economies of scale and more incentive to create new technologies
2. Facilitates knowledge spillovers to other countries so they can learn deem imports of advanced consumer goods, import of advanced capital and learn by contact with foreign traders
3. Turns monopoly into competition, ‘dynamising’ firms who now have to hold onto their markets with technological innovations, efficiency gains and increased investment and therefore capital stock
4. Tariffs lead to retaliation (both countries worse off)

Question 8

Ricardo’s view on retaliating to tariffs

Answer 8

Ricardo says you shouldn’t retaliate as tariff’s damage consumers more than they benefit producers whatever the other country’s policy

Bastiat: retaliation is like throwing rocks into your harbour because someone has done the same to theirs

Question 9

Current bid for Unilateral free trade

Answer 9

Brexit pessimists estimate that leaving EU will cost UK up to 10% of GDP due to lost volume of trade

Economist for Brexit say to keep free trade with EU and abolish all tariffs against rest of the world and forecast a 4% gain in GDP

Question 10

Adam Smith institutes post-Brexit trade deal

Answer 10

will be no tariff or non-tariff barriers on imports to the UK

imports will be regulated in same manner as domestic production

Question 11

Why Ricardo isn’t good enough for libertarians with regards to trade

Answer 11

talks about countries trading but countries don’t trade individuals and firms do

if you talk about countries trading you lose sight of the fact that there’s no difference between trade across and within national boundaries

Question 12

Ricardo’s theory of rent - corn model

Answer 12

Landlords rent out land to farmers and capitalist farmers combine their capital equipment with hired labour to produce corn

workers work for a subsistence wage, if wages rise, population rises, less food per head so wages come back down again

assume 3 landowners A,B & C rent out land to three farmers

the limits of production depend of demand for corn

Question 13

Corn model continued

Answer 13

if Farmer A makes £160 from two workers at £20 subsistence wage his surplus is £120

But landlord can force farmer to pay rent

As land A yields £80 more surplus than B, farmer B will pay up to £80 to rent land A

Therefore landlord A can force farmer A to pay the same

Hence both farmers end up with B’s original profit

conclusion: profit depends on profitability of marginal land (worse land in use)

Rent depends on difference between marginal and better land

Question 14

Corn model - what happens next?

Answer 14

profits are positive so investment takes place and so capital accumulates

this raises demand for labour to work the capital

so wages rise, population rises, more births (follows Malthus) and demand for corn then rises

Question 15

Effects of increased demand for corn

Answer 15

more land comes into cultivation - all 3 farms fully worked

price of corn rises due to increased demand

workers’ real wages eventually return to subsistence

ie money wages match rise in prices and double too

Question 16

what has happened to incomes of the 3 classes?

Answer 16

workers - no real change, money wage has doubled but so has price of corn

Farmers(capitalists) - profits fall to zero

landowners - total rents rise and total share of product rises

Question 17

Lesson’s drawn from Ricardo

Answer 17

1. As population increases, landlords get an even larger share of national product
2. The price of corn determines rents
3. Profits will eventually fall to zero or to the point where farmer is no better off than his workers therefore investment and growth Peter out
4. You can tax rents without damaging the economy

Suppose you put 50% tax on rents: if landlord takes land out of cultivation, he gets no rent, so better to keep renting and pay the tax

so tax on on land, unlike taxes on capital and labour, doesn’t give a disincentive to supply it

Question 18

Why should all profits fall to zero if Ricardo only looks at agriculture?

Answer 18

1. Because like Smith he believed that profits tend to equality between all industries - thus falling agricultural profits drag others down
2. because industry, like agriculture, will have to pay higher wages (to keep workers at subsistence) even though their prices haven’t risen and so profits fall independently

Question 19

Long-term consequences of Ricardo’s Theory

Answer 19

1. Landlords depicted as unproductive and parasitical (as they steal the profits and extinguish growth)

This added momentum to campaign against protection of agriculture e.g British Corn Laws

Corn laws were a tariff on imported corn which kept the price of bread high, pushing up money wages and reducing profits (repealed in 1846 after Ricardo’s death)

2.Used by single tax movement:

Henry George, Progress & Poverty (1879) said to only tx rents but tax them as high as you like to raise revenue

so there’d be no interference with supply of factors of production

critics however say there would be interference as landlords improve their land so taxing land would be a disincentive

a solution to this would be to tax the unimproved component of the land i.e tax according to its value without improvement

Question 20

Land value tax

Answer 20

Currently in Denmark, Russia and Singapore

problem lies in working out what unimproved value would have been

usual method is to tax all land on basis of average price of land in the area

so improving land will push up the general rate of tax

but improved land won’t pay any more than unimproved