The importance of David Ricardo‘s model is that it was one of the first models used in Economics, aimed at explaining how income is distributed in society.
Starting assumptions:
-there is only one industry, agriculture; only one good, grain;
-there are three kinds of people:
Capitalists: they start the economic growth process by saving and investing. In return, they receive profits (P), which is what is left once wages and rents have been subtracted from the gross revenue. Capital can be divided into fixed capital (machines, for example) and working capital (wage fund, WF).
Workers: they represent the labour force, in return for wages (w).
Landlords: they allow production(y) to take place in their lands in return for rent (R).
-law of diminishing returns: affects labour (variable factor of production) and land (fixed factor).
-principle of margin: marginal product of labour, which, along with the average product of land, is decreasing.
-principle of economic surplus: profits are determined as a surplus of production.
Analysis:
At a given initial situation, production is at a y0 level, which we can divide into wages, w0, and profits, P0. Rent paid to landlords corresponds to R0. From w0 and the level of labour, L0, we determine the wage fund at the initial situation, WF0.
In the long term, wages will arrive at a subsistence level, ws, which can be defined as the wage a worker needs in order to survive. From this, and the level of labour being employed, we determine the wage fund in the long run, WF*. As this level is the same as labour’s marginal product, the capitalist will not obtain any profits. On the other hand, landlords will get higher rents, R*.
Steady state:
Real wages will stagnate at subsistence level, the interest rate of capital will stay at 0 and rents will reach its maximum level.
Ricardo explains how this steady state is painful, especially for the working class. However, this steady state can be delayed with technological progress or international trade, as is shown in Ricardian trade theory.