What is theory of cost and profit?

Answer 1

Two other aspects of the Ricardian theory of profits need to be examined before we turn to J. S. Mill's statement of the classical position: (1) a theoretical failure of Ricardo's theory of value, and (2) its use by some to criticize the prevailing distribution of income. After Wrestling for a long time with the role of profits in his value theory, Ricardo concluded that changes in the rate of profits played an insignificant role in explaining changes in relative prices over time. He decided that although relative prices depended theoretically upon the costs of both labor and capital, with the cost of capital being profits, the role played by profits in practice was so insignificant that they could be ignored. Thus, Ricardo's theory of value was in effect a cost of production theory with labor being the only cost. This aspect of Ricardo's theory of value attracted the attention of various economists who were compelled to improve the logical consistency of value theory by including capital costs as well as labor costs of production.

Such concern for the theory of profits was intensified by the attacks of the Ricardian socialists, who used Ricardo's value theory to show that labor was being exploited. They argued that labor produced the entire product but did not receive all its product as wages. Profits were a deduction from labor's rightful share; the capitalists, like the landlords, were parasites in the system who received an income while performing no essential economic function. Their argument was simple, and for that reason it could be used effectively in popular criticism of the existing economic order. It was, then, both to correct the logical defects of Ricardo's value theory and to buttress the prevailing ideology against the attacks of the Ricardian socialists that economists turned their attention to profits.

The most significant contribution to profit and value theory in the early post-Ricardian period was made by Nassau Senior, who first attempted to develop an abstinence theory of interest. In his value theory, Senior emphasized utility on the demand side more than did Ricardo, and when he came to the supply side, he emphasized disutility as a real cost of production. Using the basic psychological assumptions of classical economics, he maintained that people were rational and calculating. Wages, he said, are the reward paid to labor for incurring the pain of working. If we are to produce capital goods, someone must abstain from consumption, and the capitalist will not abstain unless he is rewarded for this pain. Because both capital and labor are necessary to produce final goods, their price must be sufficient to pay both of these real costs of production. Thus, Senior developed a cost of production theory of value with wages being the return to labor and profits being the return to the providers of capital. In classical economics, no distinction was made between profits and interest. Senior attempted to develop a theory of interest, which was a predecessor to the Bohm-Bawerkian theory developed near the end of the nineteenth century. Senior actually developed only part of a theory of interest, for his discussion deals solely with the supply side, in keeping with classical tradition. He examined only the forces that determine the supply curve of savings, whereas a theory of interest would also have to account for the demand for investment. As an argument against the socialists, Senior's abstinence theory of interest has several defects. He suggested that the supply curve of savings is perfectly elastic (horizontal) and that the pain cost, or disutility, incurred in saving is the same for the wealthy as for the poor. Because he dealt with interest exclusively as a payment for the pain costs, or disutility of forgoing consumption, no social or economic justification is given for the receipt of interest on capital that is acquired by inheritance or by gift. Thus, in the end, Senior's theory of interest probably raised more questions concerning the social justification for interest than it answered.