Topic 3: Ricardo

Question 1

IMPORTANT: What’s the difference between marginal productivity and returns to scale?

Answer 1

1. Marginal productivity: How much output increases when you increase ONE input by ONE unit
2. Returns to scale: How much output increases when you increase ALL inputs by SAME amount

Question 2

What’s constant returns to scale?

Answer 2

When you increase ALL inputs by same amount and output increases by SAME PROPORTION

Question 3

What’s increasing returns to scale?

Answer 3

When you increase ALL inputs by same amount and output increases by GREATER PROPORTION

Question 4

What’s Say’s Law?

Answer 4

Aggregate supply creates its own aggregate demand

Based on the assumption that when goods are created then sold, they create income to buy other goods

Therefore, all producer income eventually contributes to demand (whether it’s spent immediately or saved)

Question 5

What’s the stationary state?

Answer 5

The point where there’s no more incentive for businesses to invest and pop’n to grow

Question 6

IMPORTANT: What was Ricardo’s theory of value?

Answer 6

Ricardo’s theory of value was the LABOR THEORY OF VALUE

Question 6

What’s the effect of the stationary state?

Answer 6

Population stops growing and businesses stop investing -> profits and economic growth stops

Question 7

IMPORTANT: What was Ricardo’s theory of value about?

Answer 7

1. Ricardo’s LABOR THEORY OF VALUE says a commodity’s value is based on how much labor goes INTO it
   
   • Therefore more labor-intensive commodities worth more
2. Includes both DIRECT (labor applied directly to commodity) and INDIRECT labor (labor creating the capital applied to commodity)
3. Labor of different skill levels are treated as different quantities of labor
   
   • Eg. 1 hr skilled labor = 2 hrs unskilled labor

Question 8

IMPORTANT: What’s Ricardo’s thoughts on production and trade?

Answer 8

Like Adam Smith, he’s PRO-SPECIALIZATION and FREE TRADE to increase output

But unlike Adam Smith who likes specialization on a per-person level, Ricardo likes specialization on a COUNTRY level with his COMPARATIVE ADVANTAGE THEORY

Question 9

What 2 theories did Ricardo propose?

Answer 9

1. Labor Theory of Value (LTV)
2. Comparative Advantage Theory

Question 10

What’s Ricardo’s Comparative Advantage theory?

Answer 10

Supports his view of specialization and free trade being good

1. That if there are 2 nations and 2 goods they can make, both stand to gain more in output/consumption if they each SPECIALIZE in 1 good and TRADE
2. Even if 1 country has ABSOLUTE ADVANTAGE in both goods (produces them with less inputs), and as long as both countries specialize in the good they have a COMPARATIVE ADVANTAGE in (the good they can make with less input)

He used the England and Portugal example to illustrate this

Question 11

How did Ricardo support his Comparative Advantage theory?

Answer 11

With his England and Portugal example!

Question 12

In Ricardo’s Comparative Advantage theory, what’s a person-year of labor?

Answer 12

The number of ppl working 1 year to make a good

Question 13

In Ricardo’s Comparative Advantage theory Portugal and England example, what’re the assumptions?

Answer 13

1. There are 2 countries that can make 2 goods (cloth and wine) with only 1 input (labor)
2. 1 country Portugal has an absolute advantage in both goods (producing them with less labor)
3. Portugal: 90 PYL (person-years of labor) for 1 unit cloth, 80 PYL for 1 unit wine = 170 total workers
4. England: 100 PYL for 1 unit cloth, 120 PYL for 1 unit wine = 220 total workers
5. Fixed labor force
6. Constant returns to scale

Question 14

In Ricardo’s Comparative Advantage theory Portugal and England example, how does it work?

Answer 14

1. Before specialization and trading
   
   • Each country produces 1 unit of cloth and 1 unit of wine each = 4 total units of output
2. After specializing
   
   • Portugal produces all wine=2.125 units wine
   • England produces all cloth=2.2 units cloth
   • More total output!

Question 15

In Ricardo’s Comparative Advantage theory Portugal and England example, what’s the conclusion?

Answer 15

The conclusion is that
1. Specialization is good
- It increases productivity and output/consumption for everyone

2. Free trade is good
   
   • England doesn’t need to implement protectionist policies to protect its economy

Question 16

What’s the problem with Ricardo’s Comparative Advantage theory?

Answer 16

It’s TOO SIMPLE to capture real-world complexities: there are more than 2 countries and 2 goods and 1 input in real world, and a lot more geopolitical considerations