Chapter One of the Principles is entitled "On Value." Ricardo launches immediately into his argument, picking up the analysis where it had been left by Smith forty-one years earlier. To clear the field for the development of the argument, Ricardo begins by setting to one side a certain class of goods whose price cannot be explained by the theory he is going to advance, but which by the time he is writing played a negligible role in the capitalist marketplace. He writes:
"There are some commodities, the value of which is determined by their scarcity alone. No labour can increase the quantity of such goods, and therefore their value cannot be lowered by an increased supply. Some rare statues and pictures, scarce books and coins, wines of a peculiar quality, which can be made only from grapes grown on a particular soil, of which there is a very limited quantity, are all of this description. Their value is wholly independent of the quantity of labour originally necessary to produce them, and varies with the varying wealth and inclinations of those who are desirous to possess them.
"These commodities, however, form a very small part of the mass of commodities daily exchanged in the market. By far the greatest part of those goods which are the objects of desire, are procured by labour; and they may be multiplied, not in one country alone, but in many, almost without any assignable limit, if we are disposed to bestow the labour necessary to obtain them."
I love the reference to rare wines. Ricardo had made a fortune on the stock market, and we may infer that he lived a luxurious life in which such wines played a significant role. Notice, by the way, that he is here simply brushing aside the assumption on which neo-classical economics rests, which is that price is determined ultimately by the subjective utility of consumers. That may indeed be true for Rembrandts and 96 point Cabernets, but it is not true for cloth and corn and carriages and shoes, and in a capitalist economy, it is these reproducible commodities that dominate the economic landscape.
Ricardo now makes a number of simplifying assumptions about the workings of a capitalist system that enable him to carry out rigorous formal arguments. You must not be misled by the absence of equations and other familiar mathematic formalism in the Principles. That style of argument in Political Economy was still more than half a century in the future, and truth be told, Ricardo probably did not have the grasp of formal techniques required for casting his arguments in mathematical form. But his formal intuitions were brilliant, and a century and half later, a number of gifted mathematical economists recast his arguments, and those of Marx after him, in the appropriate mathematical form, thereby enabling them to ascertain exactly which of the claims of Ricardo and Marx were true, and which were not. It turned out that a startlingly high proportion of their claims were exactly correct. At the end of this mini-tutorial, I shall repeat some of the things I said in my tutorial on The Thought of Karl Marx about the modern literature, so that those of you who are interested can follow the contemporary discussion.
The first two assumptions Ricardo makes, as I have already noted, are that there is only one dominant technique of production for each commodity, and that there is a determinate real wage, or market basket of goods, that laborers purchase with their wages. The third assumption is that competition establishes a single economy-wide profit rate, or rate of return on invested capital.
This last assumption actually conceals, or presupposes, a number of subordinate behavioral and informational assumptions, each of which is a simplification of the reality on the ground. First of all, entrepreneurs are assumed to have essentially perfect information about the behavior of their competitors both in the marketplace and in their factories. That is, they are assumed to know when their competitors are offering equivalent commodities at a lower price. They are also assumed to know when a competitor has introduced a new and cheaper production technique. They are assumed to know what rate of return is being earned by capitalists in each sector of the economy. Second, entrepreneurs are assumed to have no irrational or traditional or emotional attachments either to the production technique they are using or even to the sector in which their capital is invested. If a new machine cuts production costs, they will very quickly substitute it for the machine they are now using. If junk dealers are earning 10% on their capital and luxury clothiers are earning 8%, they will leave the haute couture world and put their capital into junk, regardless of the complaints of their spoiled children. And third, consumers are assumed to choose from the many identical commodities in the market purely on the basis of price, about which they, like the entrepreneurs, are assumed to have perfect information.
Although Ricardo assumes one dominant technique of production for each commodity, he allows for innovation. A capitalist who pioneers a new, more efficient, technique will be able to cut his price and corner the market, increasing his profits. Since this will be known by his competitors, they will promptly shift to the more profitable technique, which will, after a bit, become the new dominant technique in that line of business.
The result of this ceaseless, utterly rational and ruthless quest for improved profits will be, he believes, a single economy-wide rate of return on invested capital. [Formally speaking he is quite correct about this, by the way.] That fact, together with the other assumptions, permits Ricardo to introduce his great theoretical innovation, and draw from it important -- although, as we shall see, ultimately unsuccessful -- conclusions.
Before proceeding to lay out that new idea, let me pause just for a moment for what might be considered a bit of specialist insider argumentation. These next few sentences are for the economics students among you [of whom, it is my impression, there are a few.] As we have seen, Ricardo assumes that entrepreneurs are motivated solely by their search for the highest rate of return on invested capital, and consumers are motivated solely by a search for the lowest price. But what happens if either of these assumptions is in fact false in any significant way?
Ricardo himself does not discuss this possibility, but his popularizer and follower John Stuart Mill. Mill, now best known for his long essays On Liberty and Utilitarianism, was the author of an enormously successful two-volume economics text called Principles of Political Economy. First published in 1848, the Principles went through many editions. It was the Samuelson of its day, and several generations of English students learned their economics from it. In Book II, Chapter iv, "Of Competition and Custom," which runs only eight pages in my 1897 copy of the fifth edition, Mill considers the fact that rents, wages, prices, and therefore profits do not always conform to the elegantly simple assumptions on which Ricardo had constructed his theory. Sometimes, consumers are moved by habit, or custom, to buy their goods at a shop whose prices are not the lowest available in the region [think Mom and Pop stores, or Whole Foods.] Sometimes, long custom, repeated over generations, maintains rents on a particular piece of land despite the fact that land of equal fertility is available more cheaply nearby. People, Mill suggests, do not always behave as the assumptions of classical Political Economy require for its deductions. What is the consequence of this well-known but theoretically unsettling fact? In a word, Macroeconomics. Permit me to explain.
There are two quite different ways of analyzing economic behavior. The first way is to lay down behavioral and knowledge assumptions and then deduce what economic actors will do when confronted with an array of facts on the ground. This is what Smith and Ricardo do [and Marx as well, by the way]. The result is a series of logical deductions and mathematical calculations that can be held to a quite satisfying degree of precision and rigor. This is what students learn in Microeconomics courses. The second way is to collect vast amounts of statistical information about the past behavior of economic actors, and then with the aid of various modeling techniques, make a series of extrapolations from past behavior to future behavior. This is what students learn in Macroeconomics courses. Although the formal representations of these extrapolations on the page can be quite formidable looking, the fact remains that they are simply guesses that things in the future will be as they have been in the past. To a serious theoretical economist, Micro is the Gold Standard and Macro a quite inferior brand, even though the Macro experts are the ones who get called to serve on the President's Council of Economic Advisors and are paid the big bucks as Wall Street consultants. I have always thought of Macroeconomists as modern versions of the people chained to the floor of Plato's cave, developing a knack for predicting the shadows on the wall but having no inkling of the nature of true reality.