Question

7. Explain David Ricardo’s theory of income distribution and economic growth. How and why did economic growth, in the absence of international trade, lead to changing shares of wages, rent and profit? How would these shares change? Why? What would happen to the economy, in the long run, according to this theory? Explain briefly.

Answer 1

According to Ricardian model of distribution of income, income is distributed among wages, profits and Rent. In a RIcardian model of income distribution the shares of rent, profits and wages change over time. The change in share is brought about in following mechanism:

Determination of share of rent, profits and wages.

Wages are set at subsistence level. Marginal principle explains the share of rent. Marginal principle says that rent is difference between marginal and average product at given emoployment level. Profit share is explained by surplus principle. Surplus principle says that Share of income left after distribution of wages and rent goes to profits. In Ricardian model profits are residual items.

As profits are reinvested, there is more capital formation and temporarily there is higher than subsistence wage to attract more labor force. This induces population growth and labor force growth. Under condition of diminishing marginal returns to land, there will be falling marginal and average product. This will lead to rise in share of rent in incomeand this will drive down the profits. while wages remain at subsistence level.

In absence of international trade in long run, Ricardo hypothised that profit share will reach to Zero and this will stop all capital formation and economy will attain steady state with no further growth.