Economics Essay


Contents

First Essay: David Ricardo. 1

David Ricardo: Overview.. 1

Theory of Comparative Advantage. 1

The Iron Law of Wages. 2

Theory of Rents. 3

Conclusion. 5

Second Essay: Import Substitution Industrialization. 5

Problems Associated with Import Substitution Industrialization. 7

Conclusion. 8

References. 10

 

First Essay: David Ricardo

The aim of this paper is to discuss David Ricardo, the theories he suggested, and their applicability in the society today. David Ricardo was one of the economists of the 19th century who build a foundation for many practices followed in many economies today, for instance, comparative advantage which is used to guide countries in production of commodities.[1]

David Ricardo: Overview

David Ricardo was an English economist of the 19th century. His work was profoundly influenced by the ideas of Adam Smith, Stuart Mill, and Jeremy Bentham. For instance he founded the theory of comparative advantage to challenge Adam Smith’s theory of absolute advantage as it would lead to unidirectional flow of trade. The other two theories that Ricardo developed are the iron law of wages and the theory of rents.

Theory of Comparative Advantage

In this theory, Ricardo argued that a country which has the ability to produce a good at a lower opportunity cost as compared to another country has comparative advantage in production of that commodity. Efficient use of resources will guide a country to know whether to produce a good or not. Therefore, specialization should on those goods whose production involves the use of resources in the most efficient way. A country stands to gain the greatest economic benefits by specializing in the production of the good that they are most efficient in producing. The theory is based on the bilateral trade model in which countries trade by exchanging two commodities. It is beneficial for a country which lacks absolute advantage in the production of either of the two commodities to specialize in producing a good which involves the use resources efficiently and for which it has comparative advantage. It is applicable in today’s world in determining whether a country should produce a particular good. A less developed country should specialize in a good for which it has comparative advantage particularly when trading with a developed country which has absolute advantage in the production of both commodities. Applicability of the theory in trade shows that it is accurate and can be used in many economies to direct the production of various commodities.

The Iron Law of Wages

Ricardo challenged ‘The Corn Laws’ which encouraged government involvement in market decisions. Therefore, he encouraged free trade as it would have led to an increase in the level of wages. This theory suggested that laborers should acquire a minimum wage which would cater for their subsistence needs.[2] Capitalists supported this theory as it would maximize their profits even though the welfare of the laborers was not catered for adequately. Demand for labor depended on its supply.[3] According to the theory, supply would increase steadily because there was a high reproduction rate. However, the demand for labor did not increase as steadily. Thus, if wages was regulated by demand and supply, there would be a decrease below the subsistence level which would render the laborer unable to meet his or her subsistence needs. Therefore, free trade was not designed to attend to the welfare of the laborers as it widened the gap between the poor and the rich.[4]

Therefore, the theory is faulty due to the way in which it minimizes the level of wages of the laborers while subjecting their wages to market demand and supply. Nevertheless, it is vital today since it shows the need for governments to regulate markets, for instance in regulation of prices and minimum wage levels.[5] Government intervention encourages fair competition in markets, and ensures that the welfare of all stakeholders in the economy is safeguarded. In addition to this, government intervention is vital in managing foreign currency. The involvement of government leads to use of managed exchange rates and control over floating exchange rates. Managed exchange rates are widely used in economies where market forces of demand and supply regulate the exchange rate. Even in those countries, governments tend to intervene through monetary authorities particularly when the exchange rates do not favor the country’s economy.

Theory of Rents

The theory of rents as advanced by Ricardo states that the rent is equal to the economic advantage that is derived from a piece of land when it is being used productively. The theory assumes that land that is of the best quality will be used first. At the time the theory was being developed the demand for land was high, therefore the many people who did not acquire the best quality land resorted to lower quality land and this continued progressively due to high demand for land.  However, produce from the highest-quality land tended to be higher than one from less fertile areas. According to Ricardo, the economic rent is the differential surplus which arises from the fact that land has elements, such as fertility, that act as a factor productivity levels.            The theory is beneficial for today’s economies although it has been criticized for several reasons. The first criticism is that fertility of land can be altered. For instance, the use of manure and fertilizers can make a piece of land very fertile. The second criticism is that a piece of land can exhaust its fertility due to overuse. Nevertheless, this criticism can be countered because if land which was initially fertile is left fallow, its fertility can be restored. The third criticism is that rent would still exist regardless of the level of fertility. This criticism has valid grounds because land retains some value even when it is so infertile that no agricultural production can be undertaken on it.

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In today’s world, the theory is applicable based on the laws of demand and supply. To begin with, demand for land is essentially derived demand because it is based on the demand for the commodities produced on it. Therefore, a rise in demand for those products leads to a corresponding rise in the demand for the land on which they were produced leading to high rent payments and vice versa.[6]  The rent is determined by marginal productivity which is subject to the law of diminishing demand. Therefore, the curve for demand of land will be downward sloping. However, demand of land can also vary due to differences in quality, thus there are separate demand curves for land as a factor of production. On the other hand, supply for a commodity is fixed, though it can be extended by buying more land from others or through land reclamation projects. Nevertheless, land supply is perfectly inelastic because it remains the same regardless of rise or fall in rents charged.[7]

Conclusion

David Ricardo played a great role in showing the importance of specialization in production of goods in a country to ensure that maximum benefits are reaped from export trade for the mutual benefit of the countries involved. His theory of iron law of wages is also vital in showing the importance of government intervention in the markets especially in the foreign exchange market. Finally, his theory of rents is useful in the way it expounds on the law of diminishing demands and forces of demand and supply. All these theories are important and can be applied in the world today.

Second Essay: Import Substitution Industrialization

Import substitution industrialization refers to an industrialization strategy which is directed towards achieving self- sufficiency and decrease dependency on the developed countries. The strategy incorporates methods which are geared towards replacing the goods that are imported with domestic sources of goods which are produced and supplied within the country In addition to this, the theory of import substitution is aimed at protecting domestic industries from foreign competition. This paper sets out to explain the import substitution theory which is a theory advanced to develop self- sufficiency in various economies.

In many countries, local companies are protected from stiff external competition through introduction of foreign exchange restrictions. Foreign exchange restrictions include tariffs, barriers, and embargoes which a country uses to regulate the amount of goods imported. The government can introduce tariffs which limit citizens from importing goods that are being produced and sold within the country at a lower cost. This occurs due to the high price charged for the imported goods to cater for the tariff charge.[8]  Moreover, the country can encourage development of the small industries by encouraging investment into the sector it aims to develop. This is done through providing loans at a low interest rate into that area. This incentive encourages the development of industries thereby helping countries achieve the goal of import substitution. For instance, government provision of loans at low interest rates can help farmers to increase local production of agricultural products. This approach is beneficial not only in the production of final products but also in economic activities in general. Countries that use the strategy tend to develop and improve the processes involved in the production of the final product. However, implementation tends to become problematic in some cases due to the huge capital outlay involved.

Moreover, import substitution industrialization helps countries to protect their foreign exchange sectors by stabilizing balance of payments. The difference between the total value of payments given into a country and those outside a country over a period of time is referred to as balance of payments. The method is used to monitor international monetary transactions. There are three accounts which constitute balance of payments: the financial account, the current account, and the capital account. The current account records the goods imported and exported from a country over a given period of time, for example earnings from investments. On the other hand, the capital account records all international capital transfers, for instance non- financial assets. Finally, the financial account is used to record the inflow of foreign currency and the outflow of a country’s currency in business investments, stocks, and bonds. The balance of payment is composed of all these accounts and should be theoretically equal to zero.

Problems Associated with Import Substitution Industrialization

The main beneficiaries of import substitution industrialization are firms.[9] Contrary to the expectation that implementation of the import substitution strategy does not lead to the improvement of small industries, the imposition of tariffs encourages growth of firms that have been set up recently. Therefore, firms that are new in the market no longer face stiff competition from their established competitors in the production and sale of products. In addition to this, firms benefit a lot as they are more established within the country and the consumers are aware of the goods they produce and sell.

Trade deficits is also a major problem experienced with import substitution. The introduction of this method encourages a reduction in imports getting into the country. Therefore, the amount of foreign exchange reduces drastically as a result of this. For instance, in a country which introduces trade tariffs on importation of machines, the amount of foreign money earned from the past suppliers of the product reduces drastically. This leads to deficits of foreign income in the foreign exchange sector.

Moreover, the introduction of import substitution leads to unequal distribution of income. It widens the difference between the income the poor earn and one the rich earn. Those who work in firms benefit and earn a lot of profit from its introduction. On the other hand, consumers of imported goods have to pay more to acquire locally produced substitutes due to the relatively higher price charged. Therefore, the system leads to unequal distribution of income where those working in firms earn a lot while the local consumers spend a lot.

Besides, dependence on foreign inputs tends to arise following the initiation of new industries. The industries require machines that cannot be procured locally. However, the use of these machines encourages dependency on foreign inputs due to the lack of adequate resources and manpower to cater for development of the machines. In addition to this, the import-dependency syndrome ensues when the machines wear out and have to be repaired by foreigners. Local industries suffer huge losses during the repair period and the resulting unmet supply. Lastly, import substitution industrialization undermines other industries primarily agriculture. Many of the projects being initiated under import substitution are mainly targeted at capital goods industry. The agricultural industry is ignored, and this may affect the country adversely.

 

Conclusion

Import substitution industrialization is a capital-incentive production strategy that is geared towards local production to reduce reliance on imports. The aim is to encourage small industries to grow by protecting them from stiff competition from established foreign companies. In this context, foreign exchange restrictions are of utmost importance in all economies. Through the strategy, self- sufficiency is nurtured, and companies are able to compete with powerful multinational corporations. Ultimately, such efforts can help to reduce developing countries dependency on developed countries for economic survival. However, governments of developing countries should be ready to address the numerous problems that arise following the introduction of import substitution industrialization.

 

References

Garegnani, Pierangelo. “The Classical Theory of Wages and the Role of Demand Schedules in the Determination of Relative Prices.” The American Economic Review, 73, no. 2, (1983): 309-313.

Seth, Tushor. Ricardian Theory of Rent. London: Routledge, 2015.

Spengler, Joseph & Ricardo, David. Import Substitution Industrialization: An inward approach to economic development. New York: Blackwell Publishing, 2014.

Sraffa, Piero & Dobb, M. “On the Principles of Political Economy and Taxation.” In Piero Sraffa, M. H. Dobb. The Works and Correspondence of David Ricardo. Cambridge: Cambridge University Press, 1817.

[1] On the Principle of Political Economy and Taxation. In The Works and Correspondence of     David Ricardo. 11 vols. Edited by Piero Sraffa, with the collaboration of M. H. Dobb.             Cambridge: Cambridge University Press, 1951- 1973

 

[2] Joseph J. Spengler, David Ricardo (2014)

 

[3] On the Principle of Political Economy and Taxation. In The Works and Correspondence of     David Ricardo. 11 vols. Edited by Piero Sraffa, with the collaboration of M. H. Dobb.             Cambridge: Cambridge University Press, 1951- 1973

 

[4] Garegnani, Pierangelo. “The Classical Theory of Wages and the Role of Demand Schedules in the Determination of Relative Prices.” The American Economic Review, 73, no. 2, (1983): 309-313.

[5] Joseph J. Spengler, David Ricardo (2014)

 

[6] Tushar Seth, Ricardian theory of rent (2015)

[7] Ibid.

 

[8] Import Substitution Industrialization: An inward approach to economic development

 

[9] Import Substitution Industrialization: An inward approach to economic development


 

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