One summer night, going to the pier, I run into two young girls. The blonde one was called Freedom, the dark one Enterprise. We talked and they told me this story.

Jim Morrison, Stoned Immaculate.

“The Ricardo Effect.”

The proposition here described as the Ricardo Effect asserts that a general change in wages relatively to the prices of the products will alter the relative profitability of different industries or methods of production which employ labour and capital (“indirect labour”) in different proportions. In its original form it asserts that a general rise in wages relatively to the prices of the products will reduce the profitability of the industries or methods employing relatively more capital to a lesser extent than those employing less capital.
An employer will chose to increase the proportion of capital to labor during a time of increased savings. A decrease in demand will cause a marginal decrease in prices. At this point, an entrepreneur is widening and lengthening the stages of production. Given an increase in the cost of labor in proportion to the prices of goods, it would make sense for an entrepreneur to exchange labor for capital-goods (machinery), since the latter is cheaper. The Ricardo Effect also holds that at the end of this period of investment, there will be an increase in demand for labor, as consumption increases and savings decrease (also, the production of these capital-goods will require labor).

F.A. Hayek


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