Ricardo Effect, one step at a time.

Economics Economics Questions
1

Let me take it one step at a time. I have one question. Suppose:

XYZ corp produces widgets, and sells them on the market.

XYZ’s cost is evenly split between labour, and capital.

Due to a change in the public’s time preference, the price of XYZ’s widgets increases.

Nominal wages remains unchanged, so XYZ enjoys higher productivity of labour expense.

Now, if the cost of capital goods also remains unchanged, then XYZ will enjoy the same increase in the productivity of capital goods as they did on labour, and there would be no incentive to adjust the proportion of investment to each. But according to the theory of the Ricardo Effect, there is an adjustment toward being more labour intensive, so here is the one question that I mentioned earlier.

May I assume that, in the situation that I layed out above, the price of capital goods WILL NECESSARILY INCREASE?

Even Stephen

2

My limited understanding of the Ricardo effect is that it mainly concerns the competition between labor and capital goods so if the cost of labor relative to the production of widgets decreases then the cost of capital good would also decrease to compete with labor.

3

I agree with bbnet.

as an aside, i think that oddly the vast majority of text out there in the world that mentions Ricardo effect, are fallacies of bad economics and unions that confuses causes with effects and elaborately think that scarcity can be done away with, and capital endlessly increased simply by artificially (through the law) fixing wage rates arbitrarily high. since if we force wages to be high, capitalists will bring in machines, and hence the wealth will be produced to justify the wage hikes. oops.

4

In the situation that I laid out in my question, nominal wages have remained unchanged. So if the price of capital goods is trying to compete with wages, it would have no need to change either. Both would remain competitive with each other; both would have dropped in real terms. Where is the incentive for the company to adjust and become more labour intensive?

5

If the productivity of labor increases, the productivity of capital goods will also want to increase, until then the company would be wise to become more labor intensive since it would result in the most bang for the buck for producing their widgets.

6

Where I got bucked off was the phrase “until then”. The increase in the productivity of labor was brought about because the selling price of their product increased, while the nominal wage remained unchanged. The same event had the same effect on capital goods AT THE SAME TIME. The productivity of capital goods, being unchanged also, is increased simultaneously by the same event. Why would the productivity of labor increase at an earlier time than the productivity of capital goods?

7

Sry for not paying closer attention to your example.

It seems that given your example then nothing would immediately change, the company would simply enjoy a better bottom line with no adjustment in labor/capital ratio.

From where did you get the information that this scenario would result in a more labor intensive firm?

8

The scenario that I’m using is from Jesus Heurta De Soto’s book: “Money, Bank Credit, and Economic Cycles”. Chapter 5, page 329 is where he discusses the Ricardo Effect. Let me just briefly set up the scenario.

The public increases their savings, and the expense of consumption. This causes consumer prices to decline, and according to De Soto, due to the Ricardo Effect, businesses respond by shifting investment away from capital goods, and begin to favor labor as a result. This “Ricardo Effect” is what I’m trying to understand.

9

Typo in the 2nd paragraph. It should read: The public increases their savings, AT the expense of consumption.

10

In your initial example, the price of widgets rose. In your quoting of De Soto, the price of widgets declined.

11

I don’t remember using an example in which I used a scenario where the price of widgets declined, instead of raised, but either thing can happen, and De Soto discussed it from both perspectives. Regardless of the scenario we choose to focus on, I don’t see why a change in the price of widgets, either up, or down, would have one effect on wages, and the opposite effect on capital goods, causing entrepreneurs favor labor over capital goods, or vis-versa.

12

The Ricardo effect is simply wrong, and I’ve explained it to you already. It confuses causality, labor demand and wages rise after capital is accumulated. Thus, raising wage rates in order to make labor more expensive relative to capital is nonsensical. The Ricardo effect is usually used as a justification for unions.

Widgets are capital goods, so I don’t know what De Soto is talking about. Maybe you misquoted, or just misunderstood. Could you please quote directly?

13

Where did you get the mention of raising wage rates? What is the causality you are talking about, and what is the capital accumulation you refer to?

14

The Ricardo effect is an argument made by interventionists who claim that raising wage rates above the equilibrium position will lead to increased capital accumulation, due to the high prices of labor. Since capital accumulation is desirable, this argument seems sound on the surface. But if you want high wage rates, and more capital, then you need not tamper with the market: as savings increases, the interest rates will fall, leading to an increased demand for producer goods, i.e., capital accumulation. As more and more capital is accumulated, more workers will be required, as the marginal productivity of labor increases. As labor demand increases, so will wage rates.

The true effects of increasing wages above the equilibrium level without first increasing the capital stock will (must) mean increased unemployment. Now, if De Soto is saying that if the quantity of producer goods increases, then the demand for labor, and therefore the wage of labor increases, he’s making sense (to me at least). It could be the case that the price of producer goods will fall in nominal terms, but if they’re relatively higher than the price of consumer goods, then their quantity will increase, and wages will rise (not instantaneously, the capital has to be accumulated first). Thus, it is also the case that even if the price of producer goods fall, labor demand will increase, and wages will rise as well (bust this can only happen after the boom phase, that is, it can never happen when there’s not inflation first pumping up the price of producer and consumer goods during the boom).

15

De Soto is saying that if the public decreases their time preference, saving more, and consuming less, the reduced demand for consumer goods will lead to a drop in the price of consumer goods. For a company in the first stage of the productive structure, or in other words a company who’s product is a finished consumer good, that companies employees’ nominal wages are unchanged, but their real wages have increased. This is because, since consumer goods prices have declined, they get more for their money now. Since real wages have raised, the company will allocate more of their investment to capital goods now, and less to labor.

If initially, the public had increased, rather than decreased their time preference, then they would be doing the opposite. They would be consuming more, and saving less. Assuming again, that nominal wages are unchanged, the real wages have declined, because employees get less with their pay checks now. According to De Soto, since real wages have declined in this case, the company will attempt to use more labor than capital goods, since in real terms, wages have declined.

Let’s look at it from the perspective of the company in the second scenario above, where real wages have declined. The company is getting less return on their investment on labor now, because the selling price of their product(s) has dropped, in other words, even though employees are doing the same quantity, and quality of work, for the same pay, the productivity of labor has dropped. Well, and good. But,…here is where I get bucked off. It seems to me that the same event (the rise in consumer prices) that caused the productivity of labor to drop, would have the same effect on capital goods as well, assuming that the nominal price of capital goods, like labor, remained unchanged. shush???

16

Real wages don’t increase until capital is accumulated; it’s not instantaneous.

Companies will engage in capital investments because the interest rate has fallen (right-ward shift in the supply of loans), and not because wage rates rose.

I don’t know why he assumes that nominal wages remain constant. That’s pretty odd.

Capital investment will decrease because the interest rate rose.

The productivity of labor falls because there’s less capital in the economy. Higher interest rates reallocate resources towards the lower phases of production–thus reducing the amount of producer (future) goods. If people are consuming more, then the price of consumer goods will rise, not fall. The highlighted text makes no sense.

You’re right, if the Ricardo Effect was valid, It would have the same effect, but the Ricardo Effect is not valid. Productivity has to do with capital per worker, and not with wage rates. I haven’t read De Soto, so I don’t know what he’s talking about, but he’s either confused, or you are. The former seems more likely.

Huh?

17
18

Real wages don’t increase until capital is accumulated; it’s not instantaneous.

In the instant that any consumer prices are reduced, workers earning the same nominal pay have received an increase in their real wage.

Companies will engage in capital investments because the interest rate has fallen (right-ward shift in the supply of loans), and not because wage rates rose.

There is no argument from me on this. De Soto is saying both things work together. the “wage increase” is not nominal; it is real, from the perspective of the worker.

I don’t know why he assumes that nominal wages remain constant. That’s pretty odd.

In our modern economy, they probably will in time. He is considering the forces at work without any intervention.

Capital investment will decrease because the interest rate rose.

Here again, even De Soto is acknowledging the effect of the change in interest rate, but is saying that in addition to that is his supposed Ricardo Effect that I have been wrestling with.

If people are consuming more, then the price of consumer goods will rise, not fall. The highlighted text makes no sense.

You are exactly right, I had that backward.

19

This increase in real wages, which arises from the growth
in voluntary saving, means that, relatively speaking, it is in the
interest of entrepreneurs of all stages in the production
process to replace labor with capital goods.

Why??? This is my whole confusion. The increase in real wages is a result of a decline in consumer prices. From the perspective of the company producing consumer goods, they see their profit margin reduced by way of a lower price for their product. It seems to me that they get less return on the amount they invest in everything proportionally, including capital goods. Therefore, I don’t see how any of this gives incentive for the company to invest more in capital goods and less on labor, or vis-versa, do you?

I think there IS reason to become more capital intensive, but it is because of lower interest rates, and not because of the so called Ricardo effect. wa-da-ya think?

20

spending on consumer goods declines, as money is redirected towards future production (savings/investment in capital goods production)

in the short term, the factories churning out consumer goods still churn out consumer goods, the market clears at lower nominal prices for these goods.

without wage rates changing nominally(at least at first), the income of a wage earner buys more consumer goods (as the price has fallen).

a worker now gets income of more goods at their contracted wages than previously.

an entrepeneur looking at the costs of keeping his labourers hired in terms of ‘real cost’ rather than ‘nominal cost’ sees, that he is paying his workers ‘equivalent to’ a larger amount of consumer goods than ever before, at the previous nominal rate. it seems to him that labour is relatively more expensive than it used to be.

I suppose your question concerns why the same analysis does not apply to capital goods and their rents, i.e.

without rents on capital goods changing nominally, the income of a capitalist who rents out capital goods, is capable of purchasing more consumer goods (as their price has fallen), a capitalist now gets income of more consumer goods at their previous rental rates

an entrepeneur looking at the costs of keeping his machines rented in terms of ‘real cost’ rather than ‘nominal cost’ sees that he is paying the capitalists a larger amount of consumer goods than ever before at the previous nominal rate. it seems to him that capital goods are relatively more expensive than they used to be.

but then again, this situation obtains because consumers where redirecting funds away from short term consumption to longer term consumption, i.e investment in capital . this has led to a relative increase in the availability of capital. whereas if the population is stable the availability of labour has remained unchanged.

so perhaps the answer is there, that since the supply of capital has been expanded whereas the supply of labour has not, even though both capital and labour is more ‘expensive’ due to greater purchasing power of money, labour is the relatively more expensive, since the supply has not grown as has the supply of capital .

now soon enough, capitalists try to substitute labour with capital, bidding up the price of capital as they purchase it to fit into their productive processes, but soon enough the capital bought in will have increased the productivity of labour, and so the virtous cycle can continue?

I would love to be more knowledgable and authoritative on this. I think I have proved to myself in trying to explain DeSoto’s writing, that I understand less economics than sometimes I think I do…

I would thank anyone who pointed out fallacies or innacurracies in my ideas, as I really want to figure out the source of any confusions I may have.