Labor Theory Of Value

The labor theory of value (LTV) was an early attempt by economists to explain why goods were exchanged for certain relative prices on the market. It suggested that the value of a commodity could be measured objectively by the average number of labor hours necessary to produce it. The best-known advocates of the labor theory were Adam Smith, David Ricardo and Karl Marx.

The labor theory of value suggested that two commodities will trade for the same price if they embody the same amount of labor-time, or else they will exchange at a ratio fixed by the relative differences in the two labor-times. For instance, if it takes 10 hours to hunt a deer, and 20 hours to trap a beaver, then the exchange ratio would be two beavers for one deer. Since it was developed in the 18th century, the labor theory of value has fallen out of favor among most mainstream economists.

In developing their labor theory of value, both Smith (in The Wealth of Nations) and Ricardo began by imagining a hypothetical “rude and early state” of humanity consisting of simple commodity production. This was not meant to be an accurate or historical reality, but as a thought experiment to derive the more developed version of the theory. In this early state, there are only self-producers in the economy who all own their own materials, equipment, and tools needed to produce. There are no class distinctions between capitalist, laborer and landlord, so the concept of capital as we know it has not come into play yet.

They took the simplified example of a two-commodity world consisting of beaver and deer. If it is more profitable to produce deer than beaver, there would be a migration of people into deer production and out of beaver production. The supply of deer will increase in kind, causing the incomes in deer production to drop – with a simultaneous rise in beaver incomes as fewer choose that employment. It is important to understand that the incomes of the self-producers is regulated by the quantity of labor embodied in the production, often expressed as labor-time. Smith wrote that labor was the original exchange money for all commodities, and therefore the more labor employed in production, the greater the value of that item in exchange with other items, on a relative basis.

While Smith described the concept and underlying principle of the LTV, Ricardo was interested in how those relative prices between commodities are governed. Take again the example of beaver and deer production. If it takes 20 labor-hours to produce one beaver and 10 labor-hours to produce one deer, then one beaver would exchange for two deer, both equal to 20 units of labor-time. The cost of production not only involves the direct costs of going out and hunting, but also the indirect costs in the production of the necessary implements – the trap to catch the beaver or the bow and arrow to hunt the deer. The total quantity of labor time is vertically integrated – including both direct and indirect labor-time. So, if it requires 12 hours to make a beaver trap and 8 hours to catch the beaver, that equals 20 total hours of labor-time.

Here is an example where beaver production, initially, is more profitable than that of deer:

Because it's more profitable to produce beaver, people will move out of deer production and choose instead to produce beaver, creating a process of equilibration. The labor-time embodied indicates that there should be an equilibrium ratio of 2:1. So now the income of beaver producers will tend to drop to $10 an hour while the income of deer producers will tend to rise to $10 an hour as the cost of production drops in beaver and rises in deer, bringing back the 2:1 ratio so that the new costs of production would be $200 and $100. This is the natural price of the commodities; it was brought back in line due to the arbitrage opportunity that presented itself in having the income of beaver producers at $11, causing the profit rate to exceed the natural exchange ratio of 2:1.

Although the market price may fluctuate often due to supply and demand at any given moment, the natural price acts a center of gravity, consistently attracting the prices to it – if the market price overshoots the natural price, people will be incentivized to sell more of it, while if the market price underestimates the natural price, the incentive is to buy more of it. Over time, this competition will tend to bring relative prices back into line with the natural price.

The labor theory of value interlaced nearly every aspect of Marxian analysis. Marx's pinnacle economic work, Das Kapital, was almost entirely predicated on the tension between capitalist owners of the means of production and the labor power of the proletariat working class.

Marx was drawn to the labor theory because he believed human labor was the only common characteristic shared by all goods and services exchanged on the market. For Marx, however, it was not enough for two goods to have an equivalent amount of labor; instead, the two goods must have the same amount of “socially necessary” labor.

Marx used the labor theory to launch a devastating critique against free-market classical economists in the tradition of Adam Smith. If, he asked, all goods and services in a capitalist system are sold at prices that reflect their true value, and all values are measured in labor hours, how can capitalists ever enjoy profits unless they pay their workers less than the real value of their labor?

It was on this basis that Marx developed the exploitation theory of capitalism. Classical economists had no answer until the Subjectivist Revolution.

The labor theory’s problems were finally resolved by the subjective theory of value. This theory stipulates exchange value is not absolute but relative and based on individual subject evaluations. Value emerges from human perceptions of usefulness. Voluntary economic exchanges take place only when each trading partner subjectively values the other’s good more than his own.

This discovery also reversed the relationship between input costs and market prices. While the labor theory argued input costs determined final prices, the subjectivist theory showed the value of inputs was based on the potential market price of final goods.

Three economists independently and almost simultaneously discovered and wrote about the subjective theory of value in the 1870s: William Stanley Jevons, Leon Walras and Carl Menger. This watershed discovery for economics is known as the Subjectivist Revolution.