Ricardo effect

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Updated: Aug 20, 2021

F . A. Hayek argued that, if the prices which firms received for their outputs increased more than the costs of their raw materials and wages, the average rate of profit on capital employed per year increased more for those firms with a short than for those with a long turnover period. This can best be illustrated by a simple arithmetical example. If the rate of profit per year is 5 per cent,£1OO of capital will yield £105 in one year and £110 in two years (approximately, ignoring compund interest). If output prices rise by, say, 1 per cent, the yield rises to £6 for one year and to £11 in two years. The rate of profit, therefore, rises to 6 per cent per annum for the capita! which can be turned over in one year, but only to 5½ per cent per annum for capital with a two-year turnover period. Consequently, in a boom, when commodity prices rise faster than wages, firms are discouraged from investing in capital goods industries because of the long production time required. This reaction is called the Ricardo cffect because of its affinity to Ricardo’s argument that, if real wages fall, firms tend to substitute labour for machinery. This conclusion contrasted sharply with J. M. Keynes’s views based on the principle of the accelerator.

Reference: The Penguin Dictionary of Economics, 3rd edt.



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James Knight
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