Falling rate of profit was held by all leading classical economists except the English writer Thomas De Quincey (1785-1859).
Scottish economist Adam Smith (1723-1790) regarded the decline in profit as a result of ‘the competition of capitals’ whereas English economist David Ricardo (1772-1823) noted that diminishing returns in agriculture raised the real wage and reduced profits with which wages were inversely related.
Also see: theories of profits
A Smith, An Inquiry into the Nature and Causes of the Wealth of Nations (London, 1776);
D Ricardo, On the Principles of Political Economy and Taxation (London, 1817)
Historical cost vs. market value
The rate of profit depends on the definition of capital invested. Two measurements of the value of capital exist: capital at historical cost and capital at market value. Historical cost is the original cost of an asset at the time of purchase or payment. Market value is the re-sale value, replacement value, or value in present or alternative use.
To compute the rate of profit, replacement cost of capital assets must be used to define the capital cost. Assets such as machinery cannot be replaced at their historical cost but must be purchased at the current market value. When inflation occurs, historical cost would not take account of rising prices of equipment. The rate of profit would be overestimated using lower historical cost for computing the value of capital invested.
On the other side, due to technical progress, products tend to become cheaper. This in itself should, theoretically, raise rates of profit, because replacement cost declines.
A prisoner’s dilemma
If, however, firms achieve higher sales per worker the more they invest per worker, they will try to increase investments per worker as long as this raises their rate of profit. If some capitalists do this, all capitalists must do it, because those who do not will fall behind in competition.
This, however, means that replacement cost of capital per worker invested, now calculated at the replacement cost necessary to keep up with the competition, tends to be increased by firms more so than sales per worker before. This squeeze, that investments per worker tend to be driven up by competition more so than before sales per worker have been increased, causes the tendency of the rate of profit to fall. Thus, capitalists are caught in a prisoner’s dilemma or rationality trap.
This “new” rate of profit (r’), which tends to fall, would be measured as
- r’ = (surplus-value)/(capital to be invested for the next period of production in order to remain competitive).