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The Classical Theory of Distribution and Ricardian

Rent

"Political Economy, you think, is an enquiry into the

nature and causes of wealth -- I think it should rather be
called an enquiry into the laws which determine the
division of produce of industry amongst the classes that
concur in its formation. No law can be laid down
respecting quantity, but a tolerably correct one can be
laid down respecting proportions. Every day I am more
satisfied that the former enquiry is vain and delusive,
and the latter the only true object of the science."

(David Ricardo, "Letter to T.R. Malthus,

October 9, 1820", in Collected Works, Vol.
VIII: p.278-9).

Factor Payments and the Concept of Rent

The first thing to remember is this:
in all that follows, there are no produced factors of production, i.e.
there is no capital. More precisely, for the rest of this discussion, the
word "capital" is used in the same sense as "land", i.e. capital is
assumed to be an endowed factor of production.
Before proceeding, we ought to be clear about a few terms. By
"distribution" we mean the relative income received by the owners
of factors of production. If L units of labor are employed in the
economy, each unit being paid a wage w, then the income of
laborers (the owners of labor) is wL. If K units of (fixed, endowed)
capital are employed and paid a return r, then the income of
capitalists (the owners of capital) is rK. If we denote by Y the
economy-wide level of output, then the income share of labor can
be expressed as wL/Y and the income share of capital is rK/Y.
Consequently, the relative income shares of the capital and labor
can be expressed as a ratio wL/rK. The distribution of income is
about how total output in the economy Y, is divided up among
people. Edgeworth called it "the species of exchange by which
produce is divided between the parties who have contributed to its
production " (Edgeworth, 1904). The laborers get wL, the capitalists
get rK and, possibly, there might be some residual amount. This
residual amount, the amount of income/output produced which is
not paid back to the owners of capital and labor for factor services,
is R = Y - rK - wL. The residual is usually paid out to a class of
people known as entrepreneurs.
It is important not to confuse this "residual" with the "surplus". The
"surplus" is defined as the amount of output that is not paid out to
factors in reward for "factor services." So, if we define r and w as
the rate of return and wage in "reward" for factor services, the
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surplus is defined as S = Y - rK - wL. This seems mathematically

similar to the entrepreneurial residual, but it is, in fact, quite
different. Explicit in the definition of the surplus is the assumption
that r and w are what is called "economic earnings" alone. In
contrast, the r and w in the definition of the entrepreneurial residual
include both economic earnings and "rental earnings". So, if we
define re and we as the economic earnings of capital and labor and rr
and wr as their "rental" earnings, then the surplus is:
S = reK + weL
while the entrepreneurial residual is:
R = (re+rr)K + (we + wr)L
So, implicitly, while the residual accrues to the entrepreneur alone,
the "surplus" includes amounts that accrue to labor and capital in
the form of rental earnings.This may all seem a bit obscure and so
we need to define things a bit better. Just how do we distinguish
payments for factor services from payments derived from the
surplus, i.e. between economic earnings and rental earnings? . In
general, we can define them as follows:

Economic earnings are that portion of factor payments

by a producer which is necessary and sufficient to
employ the particular factor, i.e. to obtain "command" of
the factor services.

Rental earnings are any payments received by the

factor above their economic earnings and as a result of
their being in fixed supply.

Turning to economic earnings, what does "necessary and sufficient

to employ a factor" mean? For the Classical Ricardian school, the
economic earnings of a factor are merely the payments necessary
to maintain the factor "intact". Thus, for laborers, economic
earnings are wages required to keep the laborer alive and well, i.e.
"subsistence" wages. We can fix our ideas better by examining the
factor market equilibrium for a particular factor. An example for the
labor market is shown in Figure 1. The Ld curve is the economy-wide
demand for labor by firms, Ls is the economy-wide supply of labor by
households. The demand for labor is downward sloping ,specifically,
as the wage increases (holding all other factor prices constant),
firms will choose techniques of production that substitute away from
labor and towards other factors. We know, from profit-maximization,
that they will choose to employ labor until the marginal value
product is equal to the wage. The labor supply curve is upward
sloping because of labor-leisure choice issues: the greater the wage,
the greater the opportunity cost of leisure, and thus the more
households substitute away from leisure and towards labor.
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Fig. 1 - Factor Market Equilibrium

Factor market equilibrium is established where the economy-wide

demand for labor Ld is equal to the economy-wide supply of labor
(Ls). In Figure 1, this will be at w*, where Ld = Ls. Notice that at a
lower wage, e.g. w1, there is an excess demand for labor as Ld = L3
> L1 = Ls. At a higher wage, e.g. w3, we have excess supply of labor
as Ld = L1 < L3 = Ls.
The wage w* in Figure 1 is the equilibrium wage. Equilibrium
quantity is L*, thus economy-wide labor earnings are, in equilibrium,
w*L*, the area of the box formed by 0L*ew* in Figure 1. Economic
earnings and rental earnings are noted in Figure 1 by the areas E
(for economic earnings) and R (for rental earnings).
The reasoning for labelling the R and E areas in this manner can be
readily understood. When we are at the factor market equilibrium
(w*, L*), every worker is individually paid the equilibrium wage, w*.
However, it may be that some of these workers might have been
willing to work at a lower wage. They nonetheless receive w*. For
instance, notice in Figure 1 that at wage w1, the amount of labor
supplied is L1. Thus, the "economic earnings" of the first L1 workers,
the payment that would have been sufficient to command their
labor, is not more than w1. However, in equilibrium, these same set
of workers, L1, are paid the equilibrium wage w*, which is
considerably higher than w1. This principle applies to all the
"intramarginal" workers supplied between zero and L*. Thus, the
area below the labor supply curve reflects economic earnings, while
the area above the labor supply curve reflects, as we shall see,
rental earnings. Note the implications of the two extreme scenarios,
both depicted in Figure 2. Suppose leisure is so disliked that, in fact,
workers do not consider it a gainful alternative to employment. In
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this case, the labor supply curve is vertical as shown by Ls in Figure

2. In other words, any wage rate will call forth the entire labor force.
Now, equilibrium will still be where the labor demand and vertical
labor supply curve meet at e, thus we still have a strictly positive
equilibrium wage, w* > 0 and strictly positive labor earnings (the
area of the box, w*L*). However, notice that now that all earnings of
labor, w*L*, are rental earnings and economic earnings are nil.
Conversely, suppose labor supply is supplied with infinite elasticity,
′
i.e. we have a horizontal labor supply curve such as Ls in Figure 2. In
this case, an infinite amount of labor is supplied when the wage is
greater than w* and no labor is supplied when the wage is below w*.
Labor earnings are still defined at equilibrium e as the area of the
box w*L*. However, note that now equilibrium labor income w*L*
will be entirely composed of economic earnings and no rental
earnings are received.

Figure 2 - Pure Rental versus Pure

Economic Earnings

The reasoning for these two extreme cases is readily apparent.

When the labor supply is inelastic (vertical Ls), i.e. when there is no
alternative employment, then any earnings made by labor must
necessarily arise because firms are fighting over a limited supply of
them. In other words, firms are bidding up their wages "artificially"
above what is necessary to get them to work. The supply of
workers will be L* regardless of what the wage offered is. As such,
workers are experiencing a windfall gain in this case: they would be
willing to work for less, much less (indeed, near zero), but
competition among firms has bid their wages up regardless.
In contrast, when the labor supply is perfectly elastic (horizontal
Ls′ ), then there are no "intramarginal" workers. In other words, at
least w* is necessary to call forth any labor and, furthermore, w*
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calls forth an infinite amount of labor. Labor supply is not finite at

w*. This implies that, as long as firms pay at least w*, they do not
need to "fight" each other over a limited supply of workers. As there
is no "bidding war" ensuing from limited labor supply, firms will have
no incentive to pay workers above their minimal opportunity cost
wage, w*.
These examples permit us to better define the meaning of rental
earnings of a factor as that portion of earnings that arise purely out
of the fact that the factor is in fixed supply. This concept of rent, or
differential rent or Ricardian rent as it has been variously called,
was introduced simultaneously but independently by T.R. Malthus
(1815), Robert Torrens (1815), Edward West (1815) and David
Ricardo (1815), and became one of cornerstones of the Classical
Ricardian theory of distribution.
Classical theory generally did not assume that factors were fixed in
supply: in other words, they assumed that capital and labor could be
"produced". In terms of Figure 2, they believed the labor supply
curve was horizontal so that all payments to labor were economic
earnings. However, following David Ricardo (1815, 1817) they
recognized that land was fixed in supply and thus that land made
rental earnings. Figure 3 illustrates the Classical Ricardian theory of
rent. Here we are assuming only two factors of production: labor (L)
and land (T), where the labor is completely variable but land is in
fixed supply. The production function is thus Y = ƒ (L, T0), where T0
is the fixed total supply of land. In contrast labor is supplied with
infinite elasticity (a typical Classical assumption). This is captured in
Figure 3 by the infinitely-elastic labor supply curve, Ls, at the
subsistence wage rate, w.

Fig. 3 - Ricardian (Differential) Rent

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The horizontal axis in Figure 3 measures different amounts of labor

being applied to the fixed amount of land. The curves APL and MPL
are the "economically-relevant" portions of the average product and
marginal product of labor curves (i.e. the portions where marginal
product of labor is diminishing and below the average product
curve, what Ricardo called the portion above the extensive margin).
The Classical Ricardian story now proceeds as follows. For a given
amount of land, the more labor we apply to it, the smaller the
marginal and average products. This the Classicals conceived as a
natural truth with regard to agriculture alone. The basic idea was
that land was in fixed supply and of differing quality. The most
fertile lands were always used first and the less fertile ones only
used later. Thus, the more the scale of production increases (i.e. the
more dollops of labor are applied), the increasingly worse land
would be taken into cultivation and thus the lower the productivity
of labor on the marginal piece of land.
Now, the Ricardians argued that at least enough output must be
generated to pay for the factors of production. The wage paid to
labor is w and this reflects economic earnings entirely, i.e. must
cover "subsistence". In contrast, land, although a factor of
production, does not need to paid for. One can justify this in
Classical terms by saying it does not need to be maintained intact;
in Neoclassical terms, this implies there are no alternative uses for
land and thus no opportunity costs to be compensated.
However, and this is the gist of the Classical Ricardian story,
although land makes no economic earnings, we see that because
land is fixed in supply, it takes receives rental earnings. In fact, as
we shall see, in Figure 3, all surplus in production resolves itself into
rental payments for land. To see this, note that we can increase the
scale of production, and thus take in more land and apply more
labor, up until the marginal product of labor is equal to the
subsistence wage. This will be at L* in Figure 3. Thus, total wage
payments wL* are the area of the light-shaded box in Figure 3.
Now, at L*, average product is y = Y/L*. Thus, total output is Y =
yL*, i.e. the area of the box 0L*ay (alternatively, we could have
represented total output as the sum of the light-shaded box and the
triangle ewb formed under the MPL curve; the areas are equivalent).
Consequently, the surplus produced, defined as Y - wL, is the darkly
shaded box in Figure 3. This is the amount of output that is
produced over and above payments to factors. This remainder, the
early Classicals contended, accrues to landowners, thus it is referred
to as rent.

Modern Theory of Wages: The modern theory of wages is also known as the
demand and supply theory. According to the modern economists, wages are
determined by the interaction of the courses of demand for and supply of labor as
in the case of a market equilibrium of an ordinary commodity. The marginal
productivity theory is criticized by the modern economists on the following
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rounds.

1. It ignores the supply side of a factor of production.

2. It does not explain the real issue i.e. the determination of the price of a factor
of production.

Thus, the modern economist uses the forces of demand for and supplies of a
factor of production its price.

Modern theory of wage

Modern theory of wage is also known as modern theory of supply and demand.
Wages under perfect competition:
The rate of wages can be determined in the same way with the help of demand
and supply analysis.

Demand for labor:

There are various factors which influence the demand for labor. Four main factors
are as under:

Demand for labor is derived demand.

Elasticity of demand for product.
Proportion of labor cost to total cost.
Availability od substitution for labor.

Demand for labor is derived demand:

If the demand for a product is high in a market so the demand for labor producing
for particular type of product will also be high. If the demand for a product is low
in a market so the demand for labor producing for particular type of product will
also be low.

Elasticity of demand for product:

If the demand for a particular product is inelastic so the demand for a particular
labor will be inelastic. If the demand for a particular product is elastic so the
demand for a particular labor will be elastic.

Proportion of labor cost to total cost:

If the wages of worker for only a small proposition to the total cost of product then
the demand for labor will tend to be inelastic. So the rise in wages will not reduce
the demand for labor.

Availability od substitution for labor:

If the substitution of labor producing is easily available in the market then the
demand will be inelastic