There are many things Adam Smith got right about economics, including the discipline’s fundamental insight about the unplanned nature of market-driven economic and social order. He is rightly called the founder of economics for that reason. However, he did not get everything right. One of his most important errors, and one he shared with many 18th and 19th century economists, including Karl Marx, was his erroneous theory of value and explanation of price.
Smith was an adherent of what is known as the “labor theory of value” (LTV). At its most general, the LTV explains that the value (and price) of goods is determined by the amount of labor that went into their production. Sometimes the LTV is generalized a bit more to include other inputs, turning it into a “cost of production theory of value.” What is important here is that in all forms, the LTV and its broader interpretations see the value of outputs as being determined by the value of the inputs that went into producing them. On this fundamental point, Smith and the others got it exactly backward. Modern economics has rejected labor and other cost of production theories of value. Instead, value is understood as the subjective assessments by individuals of the usefulness of specific goods and services for satisfying their wants. This subjectivist and marginalist theory of value was developed in the 1870s and reversed the understanding of value in a way analogous to the way Copernicus reversed our understanding of the relationship between the Earth and Sun. By valuing outputs this way, we made valuable the inputs that created them . Goods don’t have value because labor has value; labor has value because the goods labor creates are valued by consumers. After exploring Smith’s views, I will outline the modern theory of value and show the ways it is superior to the labor theory of value.
Smith is very clear in The Wealth of Nations that he sees labor as the source of value. For example, in the opening paragraph of Chapter 5 on real and nominal price (I.v.1., p. 47), he writes:
The value of any commodity, therefore, to the person who possesses it, and who means not to use or consume it himself, but to exchange it for other commodities, is equal to the quantity of labor which it enables him to purchase or command. Labor, therefore, is the real measure of the exchangeable value of all commodities.
And later in that chapter (I.v.7., p. 51):
Labor alone, therefore, never varying in its own value, is alone the ultimate and real standard by which the value of all commodities can at all times and places be estimated and compared. It is their real price; money is their nominal price.
Smith is quick to note, as the second quote suggests, that matters are complicated when we are in a world where goods are traded for money. He points out that not all labor is the same, so simply measuring, for example, the hours of labor that went into producing an object might not tell us just how much effort went into that process. Some labor is just more skilled than others. But Smith says there is no easy way to solve this problem by finding an accurate measure of labor. Instead, these differences are evened out by the “higgling and bargaining of the market.” Even so, he is emphatic that labor alone is the “ultimate and real” standard for the comparison of value.
In the rest of the chapter, Smith discusses the ways in which a good’s “real” value determined by labor is distinct from the money price of the good, which he refers to as its “nominal” price or value. In a barter economy, Smith argues, we could perhaps more easily trade goods at ratios that directly reflect the labor required to produce them, as in his famous deer and beaver example at the start of Chapter 6. However, in a world where money mediates almost all exchanges, the money price of a good is an “estimate” of the ultimate and real value determined by labor. Smith goes on to claim that labor’s value has a permanence to it that cannot explain the variations in nominal prices that we observe in the market. Those variations can be due to changes in the value of the goods and services that come from changes in the value of the money commodities (such as gold and silver) that are used to purchase them. Underlying all of those market processes, however, is the labor that is the common element in determining the value of all goods and services.
Smith and the other classical economists did not ignore the concept of utility in thinking about value. The idea of labor as the source of value is discussed primarily in the context of the exchange value of goods. But what of goods’ use value to those who possess them? Here the classical economists were stymied in their understanding by their inability to solve what became known as the “water/diamond paradox.” The paradox was that water, which is necessary for human life, is normally very cheap, while diamonds, which are a luxury, are normally very expensive. If utility helped explain use value, something was wrong here. his struggle with utility, and the recognition that not all labor was the same meant that converting labor time into price was problematic (and was the problem that ultimately vexed Marx). As a result classical economists like Smith had multiple problems explaining value and price.
Those problems were addressed in the 1870s in the work of three different economists, all of whom stumbled onto variations of the same basic idea. William Stanley Jevons in England, Leon Walras in Switzerland, and Carl Menger in Austria all realized, in different ways, that the key insight was that value was determined “on the margin.” In what is now known as the Marginal Revolution in Economics, they argued that value depended not on the total supply of a good but on the particular unit that was being considered for purchase or sale at a given time and place. This resolved the water-diamond paradox: what matters for the value of a good is not its “total utility” (what its total supply contributes) but its “marginal utility” (what the specific unit in front of us contributes). So with water, the marginal unit is a very small piece of the total supply, so there are many substitutes for the particular unit. We don’t buy all of the potable water in the world, nor a substantial portion of it. One bottle of water is a tiny fraction of the total supply, so the value of that specific unit is low even though the total utility of water is very high. Diamonds, by contrast, are the reverse. One carat of diamonds is larger portion of the total supply than one bottle of water is to the total supply of water. The greater scarcity of diamonds means that the marginal unit will be more expensive than the marginal unit of water.
The idea that value was about the marginal unit fundamentally transformed the way economics operated. “Thinking on the margin” has become the core of the “economic way of thinking.” What it means to think that way is to compare the additional benefits and additional costs of any prospective decision and chose the one that provides the most net benefits. Notice the use of “additional” there. That is capturing the idea of the margin. Facing a choice, we don’t consider the total benefits or costs of the good or service in question, but the benefits and costs of this particular unit in this specific context. For example, when a student considers skipping a class, the right comparison is between the benefits and costs of that specific hour of class, not the benefits and costs of the course, or of her education, as a whole. It would be wrong to say “I shouldn’t skip this class because my college education is too valuable.” The right question is whether the value of this specific hour of class is greater, on net, than the value of any other alternative use of her time. It’s the marginal utility of education not the total utility that matters.
So this explains the water-diamond paradox, but what of the labor theory of value? A close reading of the explanation above suggests the answer: in comparing the marginal benefits and costs, nowhere did I suggest that those costs are related to the labor involved. If anything, the explanation implies that the evaluation of those costs and benefits is done by the actor herself, and not by some objective, external standard. In fact, in the history of economics, the idea of marginal thinking is connected up with what is generally known as the “subjective theory of value” or “subjectivism.” During the 19th century, a number of writers glimpsed the idea that value might not be determined by the costs of production such as labor, but by the particular ways in which individual choosers believed that specific goods and services would satisfy their wants. Their struggle was that you could not fully explain subjectivism without the idea of the margin. It took the contributions of Jevons, Walras, and Menger to provide the missing piece to those earlier, incomplete discussions of subjectivism.
Interestingly, it is equally true that one cannot fully understand the importance of marginal thinking for a theory of value without subjectivism. To best see this point, I need to focus on the work of Carl Menger. Even as all three marginal revolutionaries discovered a common insight, they articulated that insight in very different ways. The presentation in Walras was the most mathematical, with Jevons’ book being somewhere in the middle, and Menger’s absent of any equations. This is important because both Walras and Jevons understood the concept of the margin to be a mathematical one. They demonstrated the concept by presenting a mathematical function for total utility and then showing that marginal utility was the first derivative of that function. In non-mathematical terms, the mathematical margin means how much the dependent variable (i.e., total utility) changes with a small change in one of the independent variables (i.e., the factors that determine total utility). So if we have one more unit of the good (one of those factors) and put that in the total utility function, how much will total utility change? That change is marginal utility, mathematically understood.
Conceptualizing utility as both something measurable and as something that could be put in a continuous function so that the tools of calculus could be applied were foreign to Menger’s presentation because the mathematical representation did not take the subjectivism of value seriously enough. Menger begins his Principles of Economics by carefully defining what makes something a good, or gives it any utility at all. He argues that it is our perception that an object can satisfy one of our wants that makes it a good. What differentiates “economic” goods from “non-economic” goods is that economic goods are scarce. We do not have a sufficient supply to satisfy all of the wants we might have for them. Thus, all goods have utility, but only economic goods have value. In modern terms, if using a unit of a good for one purpose means sacrificing its use for an alternative purpose, the good has value. For both utility and value, the key for Menger is that people believe that the object can satisfy some want. It is that belief that makes the object a good and gives scarce goods value.
Like Walras and Jevons, Menger had the concept of the margin in his value theory. For Menger, the “margin” referred to the fact that all wants had to be satisfied by particular amounts of specific goods. The value of a good is “the significance that each concrete unit of the available quantities of these goods has for our lives” (1985 [1871]: 116). The footnote attached to the phrase “concrete unit” is Menger’s response to the water-diamond paradox. He differentiates the value of a whole “species” (such as a particular kind of tree that is useful for fuel) from the concrete units we need to satisfy the specific wants we have in the current context. “Not species as such, but only concrete things are available to economizing individuals. Only the latter, therefore, are goods, and only goods are objects of our economizing and of our valuation” (1985 [1871]: 116 fn. 3, emphasis in original). He (120-21) later writes:
Value is thus nothing inherent in goods, no property of them, nor an independent thing existing by itself. It is a judgment economizing men make about the importance of the goods at their disposal for the maintenance of their lives and well-being. Hence value does not exist outside the consciousness of men.
This summary of his argument contains both his subjectivism (value is about our “judgment” and “consciousness”) and his marginalism (value depends upon the “goods at [our] disposal” and not the total stock of the good). Once value is understood as thoroughly dependent on human perceptions about the usefulness of goods for satisfying wants of varying importance, subjectivism cannot be separated from marginalism because want-satisfaction will always depend upon specific “concrete quantities” of the good, and not the good’s “total utility.” What gives goods value is the belief in the ability of specific quantities of that good to satisfy specific human wants.
Suppose we have several uses for a one-gallon bucket of water. We can use it for drinking, we can water plants, we can wash clothes, or we can wash our car. Suppose we rank the importance of those uses in the order listed. And suppose we find ourselves with two such gallon buckets. Clearly, we will use one for drinking and the second for watering plants. The value of water to us can be looked at two ways. First, what’s the value of an additional gallon bucket? That is the importance we attach to the end of washing our clothes. The value of a bucket we already possess can be understood as the importance of the least pressing want we satisfied with a bucket – in this case, watering plants. Notice how the value of those gallon buckets is about the ability of “concrete quantities” to satisfy “specific ends,” and that the importance of those ends is determined by the subjective evaluation of the chooser.
Finally, we can see the idea of diminishing marginal utility here. The marginal utility of each additional bucket we obtain declines because the importance we place on the ends satisfied by each subsequent bucket declines. This also explains why we are willing to pay less per unit to purchase larger quantities of goods. We would not be willing to pay as much for the third bucket as the second given that the importance to us of washing our clothes is less than that of watering plants. This is the proper theory of value that lies behind the modern downward sloping demand curve.
By now, the way in which modern subjectivism and marginalism offer an alternative to the labor theory of value should be clear. Labor and other cost of production theories of value look backward to how a good was produced to find its value. Even a more sophisticated version that focuses on the value of the labor a good can procure still misses the key point that value is dependent on our beliefs about how goods can be used to satisfy our wants going forward. It is as consumers, not as producers, that we give goods value. The labor theory of value sees value being infused into goods through the process by which they are produced. But as Menger (146) points out, it does not matter to the value of a diamond whether we have stumbled across it on the ground or spent 1000 days digging it up. Value is forward looking, driven by our subjective perceptions of the way in which specific goods and satisfy specific wants.
This is where the marginalist revolution was the economics equivalent of Copernicus shifting our understanding of the solar system from a geo-centric to a helio-centric one. For Smith and others who accepted the labor theory of value, the value of the inputs determined the value of the output. After the 1870s, however, that understanding of causality was reversed. What we ultimately value are final goods that are able to satisfy wants. Because those final goods are believed to do have value, the inputs that went into making them also have value. Labor does not give goods value; the fact that goods are valued means that the labor that went into making them is valuable. The same is true with every other input. Value does not flow from input to output, or from production to consumption. Rather, it flows the opposite way. The value of inputs is derived from the value we attribute to the outputs. It is not the chef’s valuable labor that makes a gourmet meal valuable. It is the value we attach to the meal that makes the chef’s labor valuable.
This piece was first posted at AdamSmithWorks, part of the Liberty Fund network. For more from AdamSmithWorks about the Labor Theory of Value, check out Eric Schliesser’s piece, Smith’s Labor Theory Thought Experiment.
