Economics Questions

Re: Ricardo Effect, one step at a time.

nirgrahamUK — Sat, 05 Dec 2009 22:06:13 GMT

Evan Stephen:
e supply of capital does expand, but let's trace this back to it's source. As with anything else, if the supply of it increases, it does so because the demand increased. The mechanism is the price system, so prices on capital goods must have increased BEFORE the supply of it did, and was the reason it happened.

if i decide to forgoe some of my income that historically i would have consumedl then i plan to save and i offer a loan to an entrepeneur.I am not directly bidding for capital or labour, in fact, i am supplying 'capital' to entrepeneurs, for their consideration. hey entrepeneurs, could you make profits by using this capital i give you? from the perspective of an entrepeneur, my offering savings, constitutes an increase in supply, the demands i make, are projected into the future....

I am trying to turn my present purchasing power into future purchasing power. the entrepeneur considers what he can do with the the money if he takes the loan. surely, if he wants to start a new enterprise that in 5 years will start to produce many more widgets at lower costs than present widget producing business he will surely need to bid away some labour and some 'already produced' capital away from other entrepeneurs engaged in business. but his whole business plan, involves using that labour and capital to produce lots more capital, which will make his workers way more productive than his competitors. his plan doesnt involve breeding labourers and increasing their supply. so i still wonder whether that's the explanation...

I could be way off

Re: Ricardo Effect, one step at a time.

Evan Stephen — Sat, 05 Dec 2009 21:53:01 GMT

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 .

I see a bit of a problem with this also. The supply of capital does expand, but let's trace this back to it's source. As with anything else, if the supply of it increases, it does so because the demand increased. The mechanism is the price system, so prices on capital goods must have increased BEFORE the supply of it did, and was the reason it happened. I think all this is besides the so called Ricardo Effect. I think people like us who question ideas instead of swallowing them, being spoon fed, are ahead of the game. It seems like some of the contemporary Austrian authors would deal with the Ricardo Effect in a way that answers all these questions and objections that was neglected by guys like Hayed, De Soto, Mises, and Ricardo himself. Without a more thorough covering of the subject, I'm about to conclude that the Ricardo Effect is false.

Re: Ricardo Effect, one step at a time.

nirgrahamUK — Sat, 05 Dec 2009 19:09:33 GMT

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.

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.

Re: Ricardo Effect, one step at a time.

Evan Stephen — Sat, 05 Dec 2009 16:57:53 GMT

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?

Re: Ricardo Effect, one step at a time.

Evan Stephen — Sat, 05 Dec 2009 16:22:07 GMT

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.

Re: Ricardo Effect, one step at a time.

nirgrahamUK — Sat, 05 Dec 2009 13:50:11 GMT

DE Soto:

THIRD: THE RICARDO EFFECT

All increases in voluntary saving exert a particularly
important, immediate effect on the level of real wages. Chart
V-2 shows how the monetary demand for consumer goods
falls by one-fourth (from 100 m.u. to 75 m.u.), due to the rise
in saving. Hence it is easy to understand why increases in sav-
ing are generally followed by decreases in the prices of final
consumer goods.49 If, as generally occurs, the wages or rents
of the original factor labor are initially held constant in nomi-
nal terms, a decline in the prices of final consumer goods will
be followed by a rise in the real wages of workers employed in
all stages of the productive structure. With the same money
income in nominal terms, workers will be able to acquire a
greater quantity and quality of final consumer goods and
services at consumer goods’ new, more reduced prices.
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. To put it another
way, via an increase in real wages, the rise in voluntary saving
sets a trend throughout the economic system toward longer
and more capital-intensive productive stages. In other words,
entrepreneurs now find it more attractive to use, relatively
speaking, more capital goods than labor. This constitutes a
third powerful, additional effect tending toward the lengthen-
ing of the stages in the productive structure. It adds to and
overlaps the other two effects mentioned previously.
The first to explicitly refer to this third effect was David
Ricardo. He did so in his book, On the Principles of Political
Economy and Taxation, the first edition of which was published
in 1817. Here Ricardo concludes that
very rise of wages, therefore, or, which is the same thing,
every fall of profits, would lower the relative value of those
commodities which were produced with a capital of a
durable nature, and would proportionally elevate those
which were produced with capital more perishable. Afall of
wages would have precisely the contrary effect.
In the well-known appendix “On Machinery,” which was
added in the third edition, published in 1821, Ricardo con-
cludes that “[m]achinery and labour are in constant competi-
tion, and the former can frequently not be employed until
labour rises.”51
The same idea was later recovered by F.A. Hayek, who,
beginning in 1939, applied it extensively in his writings on
business cycles. Here we will for the first time use it, inte-
grated with the prior two effects, to explain the consequences
an upsurge in voluntary saving has on the productive struc-
ture and to detract from theories on the so-called “paradox of
thrift” and the supposedly negative influence of saving on
effective demand. Hayek offers a very concise explanation of
the “Ricardo Effect” when he states that
ith high real wages and a low rate of profit investment
will take highly capitalistic forms: entrepreneurs will try to
meet the high costs of labour by introducing very labour-sav-
ing machinery—the kind of machinery which it will be prof-
itable to use only at a very low rate of profit and interest.

Hence the “Ricardo Effect” is a third microeconomic
explanation for the behavior of entrepreneurs, who react to an
upsurge in voluntary saving by boosting their demand for
capital goods and by investing in new stages further from
final consumption.
It is important to remember that all increases in voluntary
saving and investment initially bring about a decline in the
production of new consumer goods and services with respect to
the short-term maximum which could be achieved if inputs were
not diverted from the stages closest to final consumption. This
decline performs the function of freeing productive factors
necessary to lengthen the stages of capital goods furthest from
consumption.53 Furthermore the consumer goods and serv-
ices left unsold as a result of the rise in voluntary saving play
a role remarkably similar to that of the accumulated berries in
our Robinson Crusoe example. The berries permitted Crusoe
to sustain himself for the number of days required to produce
his capital equipment (the wooden stick); during this time
period he was not able to devote himself to picking berries
“by hand.” In a modern economy, consumer goods and serv-
ices which remain unsold when saving increases fulfill the
important function of making it possible for the different eco-
nomic agents (workers, owners of natural resources and capi-
talists) to sustain themselves during the time periods that fol-
low. During these periods the recently-initiated lengthening of
the productive structure causes an inevitable slowdown in the
arrival of new consumer goods and services to the market.
This “slowdown” lasts until the completion of all of the new,
more capital-intensive processes that have been started. If it
were not for the consumer goods and services that remain
unsold due to saving, the temporary drop in the supply of
new consumer goods would trigger a substantial rise in the
relative price of these goods and considerable difficulties in
the provision of them.54

Re: Ricardo Effect, one step at a time.

Esuric — Sat, 05 Dec 2009 10:02:26 GMT

Evan Stephen:
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.

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

Evan Stephen:
Since real wages have raised, the company will allocate more of their investment to capital goods now, and less to labor.

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.

Evan Stephen:
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.

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

Evan Stephen:
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.

Capital investment will decrease because the interest rate rose.

Evan Stephen:
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.

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.

Evan Stephen:
t 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????????

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.

Evan Stephen:
shush????????

Huh?

Re: Ricardo Effect, one step at a time.

Evan Stephen — Sat, 05 Dec 2009 09:09:05 GMT

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????????

Re: Ricardo Effect, one step at a time.

Esuric — Sat, 05 Dec 2009 08:15:56 GMT

Evan Stephen:

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?

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).

Re: Ricardo Effect, one step at a time.

Evan Stephen — Sat, 05 Dec 2009 07:31:43 GMT

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?

Re: Ricardo Effect, one step at a time.

Esuric — Sat, 05 Dec 2009 06:19:56 GMT

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?

Re: Ricardo Effect, one step at a time.

Evan Stephen — Fri, 04 Dec 2009 21:34:56 GMT

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.

Re: Ricardo Effect, one step at a time.

JackCuyler — Fri, 04 Dec 2009 19:39:53 GMT

Evan Stephen:

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.

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

Re: Ricardo Effect, one step at a time.

Evan Stephen — Fri, 04 Dec 2009 19:03:26 GMT

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

Re: Ricardo Effect, one step at a time.

Evan Stephen — Fri, 04 Dec 2009 18:49:23 GMT

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.