On Economic Value

Caution  

Please note that this essay constitutes some collected notes on the topic, and does not pretend to be original thinking.   It is not material suitable for publication or citation. Much of the contents has been cut-and-pasted from various Internet sources as listed at the bottom. And those sources should be the proper citation.   Because of the large amount of editing necessary to bring these collected thoughts together, detailed citations and references have been omitted.   Also note that this material is primarily a concatenation of the ideas of other writers, and while I have edited this material according to my own beliefs and biases, it does not necessarily imply that I have sufficient evidence to justify any claim that these opinions represent knowledge and truth.

Introduction

There are two fundamentally different answers to the question of where economic value originates. According to intrinsic theories of value, economic value is inherent in objects; remains constant despite changing demand, the passage of time, and other factors; and can be "objectively determined" by calculations based upon some fundamental scientific principle. The labour theory of value is clearly an intrinsic-value theory.

The other approach is the utility theory. According to this theory, economic value is not inherent in objects, but is a product of many different individual consumer and producer judgments about the utility (or use-value) of the product to them. According to utility theories, economic value depends upon people's desires: the more they esteem an object and are willing to trade for it (the greater its personal value), the more it is worth. This theory is the basis of free-market capitalism, which Marx bitterly opposed.

At first glance, both theories seem to make sense. It is generally true that the more labour invested in an object, the more it is worth; but it is also true that the more people want something regardless of how much or how little labour went into it -- the more it is worth.

Which theory is correct? Both of them cannot be, since they lead to diametrically opposite economic systems, and moral prescriptions. I will argue that the labour theory of economic value is fundamentally wrong and the market/utility theory of economic value is correct.

Preliminaries

The starting point for this discussion of economic value is a capitalist economy in long-run equilibrium. This is the "arch-typical" analysis basis for most economic analysis of the relevant portions of economic theory. By long-run equilibrium I mean that all firms, workers and consumers have been able to adjust their plans and their output and/or purchases to any and all changes in available knowledge, technology, or tastes. Of course this is unrealistic. In any real economy, incompatibilities in plans, shifts in demand, and changes in knowledge, technology or tastes occur far more rapidly than any of the players in the economic environment can fully adjust to. But by assuming this artificial scenario, it does allow us to investigate certain fundamental aspects of the economic system that are difficult to pick out from all the day-to-day movements of prices and output.

In keeping with both Marx and the Utility theorists, I will also assume sufficient competition so that the rate of profit is the same in all industries. Again, this is quite unrealistic. Certainly, when there are no barriers to entry or exit, capital will flow from low profit industries to high profit industries. Output will increase in industries attracting new capital, just as output will decrease in industries from which capital is fleeing. Prices in both industries will adjust until the profit rates are in the same range. But there are barriers to entry and exit in many industries. (Not the least of which is time.) The rationale for making this addition to the assumed set of stylized facts is twofold. First, we are trying to understand the nature and consequences of different theories of economic value in principle, and not as might be influenced by particular transitory circumstances. Second, if we cannot understand how prices and values behave under the simplest of conditions, we cannot hope to understand them under more realistic conditions.

Therefore the basis underlying this discussion is a highly simplified capitalism in equilibrium; an economy that is sufficiently competitive that all firms have fully adjusted their outputs and use of inputs to all demand and technological conditions, and all consumers have fully adjusted their plans and demands to all supply and conditions of taste.

Classical Theories of Value

The classical political economists shared three major points in their approach to developing a theory of value. First, all the classical economists thought it necessary to start their investigations of capitalism with the question of value. Second, all the classical economists searched for value in the conditions of production. It was in the workshop or the factory, not the marketplace, that goods acquired their particular values. Third, although they had somewhat different reasons, all the classical economists subscribed to one form or another of a subsistence theory of wages. That meant that the cost of labour was itself equal to the value of the goods and services that a working-class family needed in order to get by.

Smith: Adding-Up of Costs

Adam Smith found economic value - which he called "natural price"- by adding the costs of production. In a society without private ownership of land and which used only the simplest of tools, labour would make up the entire cost of production:

"If among a nation of hunters, for example, it usually costs twice the labour to kill a beaver which it does to kill a deer, one beaver should naturally exchange for, or be worth two deer. It is natural that what is usually the produce of two days' or two hours' labour, should be worth double of what is usually the produce of one day's or one hour's labour." [The Wealth of Nations, Book 1, Chapter 6.]

But this simple measure of value is not sufficient for the more complex production processes and property ownership patterns of capitalism. When the worker is hired by a capitalist, uses equipment owned by the capitalist, and works with raw materials purchased by the capitalist, there will normally be profit:

"In the price of commodities, therefore, the profits of stock [capital] constitute a component part altogether different from the wages of labour, and regulated by quite different principles." [The Wealth of Nations, Book 1, Chapter 6.]

By "quite different principles," Smith means that the worker is paid by the hour of labour while the capitalist is "paid" by the amount of capital and the length of time that the capital is engaged in that production process.

Whenever a product involves the use of land, there will be a third component included in its price:

"As soon as the land of any country has all become private property, the landlords, like all other men, love to reap where they never sowed, and demand a rent even for its natural produce. The wood of the forest, the grass of the field, and all the natural fruits of the earth, which, when land was common, cost the labourer only the trouble of gathering them, come, even to him, to have an additional price fixed upon them. He must then pay for the licence to gather them; and must give up to the landlord a portion of what his labour either collects or produces. This portion, or, what comes to the same thing, the price of this portion, constitutes the rent of land, and in the price of the greater part of commodities makes a third component part." [The Wealth of Nations, Book 1, Chapter 6.]

The real value, then, of any commodity, will be the sum of the labour cost and the profit plus any rent. Even though the capitalist purchases raw materials as well as labour, the raw materials - and anything else the capitalist purchases from other capitalists - can in turn be broken down into labour, profit and rent.

The next step is to investigate the value of labour itself. According to Smith, nature sets the "minimum" wage:

"A man must always live by his work, and his wages must at least be sufficient to maintain him. They must even upon most occasions be somewhat more; otherwise it would be impossible for him to bring up a family, and the race of such workmen could not last beyond the first generation." [The Wealth of Nations, Book 1, Chapter 8.]

It is difficult for wages to rise much above this minimum. Smith partially attributes this to inequality of bargaining power. The power of the worker to withhold his labour is far weaker than the power of the employer to withhold access to employment:

"A landlord, a farmer, a master manufacturer, or merchant, though they did not employ a single workman, could generally live a year or two upon the stocks [capital] which they have already acquired. Many workmen could not subsist a week, few could subsist a month, and scarce any a year without employment. In the long-run the workman may be as necessary to his master as his master is to him; but the necessity is not so immediate." [The Wealth of Nations, Book 1, Chapter 8.]

This "natural" inequality was supplemented by legal inequality. When Smith was writing The Wealth of Nations - and for another fifty years thereafter - British workers were prohibited from forming unions and bargaining collectively. There were no similar prohibitions on employers:

"We rarely hear, it has been said, of the combinations of masters, though frequently those of workmen. But whoever imagines, upon this account, that masters rarely combine, is as ignorant of the world as of the subject. Masters are always and everywhere in a sort of tacit, but constant and uniform, combination, not to raise the wages of labour above their actual rate. To violate this combination is everywhere a most unpopular action, and a sort of reproach to a master among his neighbours and equals. We seldom, indeed hear of this combination, because it is the usual, and one may say, the natural state of things which nobody ever hears of. Masters, too, sometimes enter into particular combinations to sink the wages of labour even below this rate." [The Wealth of Nations, Book 1, Chapter 8.]

Yet there were sometimes forces leading wages upward. Rapid economic growth can create a shortage of labour. The reinvestment of profits will lead to ever greater employment. However, higher wages, by improving living conditions and thus reducing infant and child mortality, quickly lead "To the great multiplication of the species." The race between the demand for labour and the supply of labour will eventually be won by the supply of labour and wages will once again fall to the "lowest rate which is consistent with common humanity."

Additionally, labour of greater skill or difficulty will itself take on a natural price in terms of common labour:

"If the one species of labour should be more severe than the other, some allowance will naturally be made for this superior hardship; and the produce of one hour's labour in the one way may frequently exchange for that of two hours' labour in the other. Or if the one species of labour requires an uncommon degree of dexterity and ingenuity, the esteem which men have for such talents, will naturally give a value to their produce, superior to what would be due to the time employed about it. Such talents can seldom be acquired but in consequence of long application, and the superior value of their produce may frequently be more than a reasonable compensation for the time and labour which must be spent in acquiring them." [The Wealth of Nations, Book 1, Chapter 8.]

Economic value, or in Smith's terms "natural price", is a central concept in Smith's work. Temporary deviations of market price from natural price provide his capitalists with their production directions. When the market price is above the natural price, profits will also be above their natural rates. New capital will be drawn to such an industry until increased production brings prices and profits down to their natural rates. When the market price is below the natural price, profits will also be below their natural rates. Capital will leave such an industry until decreased production brings prices and profits up to their natural rates.

The natural price, in turn, is determined by the costs of production. The costs of production can be broken down into labour costs, rent and profit. Labour, like any other commodity, also has its natural price. Which is the cost of the goods and services the workers need in order to work and raise families.

Ricardo's Labour Theory of Value

In the preface of The Principles of Political Economy and Taxation (1817), David Ricardo laid out the goal of his work. He was setting out to uncover the laws that regulate the distribution of the

"produce of the earth - all that is derived from its surface by the united application of labour, machinery, and capital . . .
 among [the] three classes of the community, namely, the proprietor of the land, the owner of the stock or capital necessary for its cultivation, and the labourers by whose industry it is cultivated." [The Principles of Political Economy and Taxation (Preface).]

The first step of this project was to understand the laws of value. As the heading of Chapter 1, he gives us the foundation of what came to be called the labour theory of value:

"The value of a commodity, or the quantity of any other commodity for which it will exchange, depends on the relative quantity of labour which is necessary for its production. . ." [The Principles of Political Economy and Taxation, Chapter 1, Section 1]

Rather than make his theory fuzzy enough to encompass the value of all goods, he excluded goods such as "rare statues and pictures, scarce books and coins, wines of a peculiar quality, which can be made only from grapes grown on a particular soil," since their

"value is wholly independent of the quantity of labour originally necessary to produce them, and varies with the varying wealth and inclinations of those who are desirous to possess them.

"These commodities, however, form a very small part of the mass of commodities daily exchanged in the market." [The Principles of Political Economy and Taxation, Chapter 1, Section 1]

This theory of value would be limited to the goods and services that were typical products of competitive capitalism:

"In speaking, then, of commodities, of their exchangeable value, and of the laws which regulate their relative prices, we mean always such commodities only as can be increased in quantity by the exertion of human industry, and on the production of which competition operates without restraint." [The Principles of Political Economy and Taxation, Chapter 1, Section 1]

But Ricardo was searching for an "invariable measure of value." This is truly an impossible goal. When the technology of production of a good or service changes, its value will change. All theories of value are in agreement on this. Even gold and wheat, two candidates for such a measure that were rejected by Ricardo, will alter in value as the technology of production changes. The same is true, in a more roundabout way, of labour itself. If new farming and/or baking technology reduce the value of bread, then the value of labour will also fall since the worker's capacity to work can be "produced" at a lower cost. [The Principles of Political Economy and Taxation, Chapter 1, Section 1]

It might be possible, Ricardo thought, to find a measure of value which would not vary as the distribution of income changed, even thought it would certainly vary with technological change. Ricardo's stated purpose was to discover which economic forces determined the distribution of income. The best candidate for such a measure was labour. If profits rose and wages fell, or if profits fell and rents increased, it would still require the same amount of labour to weave a bolt of cloth or to build a ship.

Ricardo's theory of wages was similar to Smith's, but much more severe. Thomas Malthus had published his famous Essay on the Principle of Population in 1798. While Adam Smith had noted a tendency for population to increase when wages were high, Ricardo (adhering more closely to Malthus) turned this tendency into a ruthless certainty:

"The natural price of labour. . .
depends on the price of the food, necessaries, and conveniences required for the support of the labourer and his family. With a rise in the price of food and necessaries, the natural price of labour will rise; with the fall in their price, the natural price of labour will fall. . . .
 It is when the market price of labour exceeds its natural price that the condition of the labourer is flourishing and happy, that he has it in his power to command a greater proportion of the necessaries and enjoyments of life, and therefore to rear a healthy and numerous family. When, however, by the encouragement which high wages give to the increase of population, the number of labourers is increased, wages again fall to their natural price, and indeed from a reaction sometimes fall below it.

"When the market price of labour is below its natural price, the condition of the labourers is most wretched: then poverty deprives them of those comforts which custom renders absolute necessaries. It is only after their privations have reduced their number, or the demand for labour has increased, that the market price of labour will rise to its natural price, and that the labourer will have the moderate comforts which the natural rate of wages will afford." [The Principles of Political Economy and Taxation, Chapter 5.]

Agricultural products presented a particular difficulty. Smith's solution had been to make land rent one of the components of natural price and simply add it onto labour costs and profits to get value. Ricardo started by examining how agriculture was different from manufacturing. When the demand for shovels increases, manufacturers can build more factories. There is no reason that these new factories cannot be as productive as the existing factories. That is, the amount of labour needed to produce a shovel will not change when we double or triple shovel production by building new shovel factories.

When the factory is a farm, however, we have a different problem. Land varies greatly in its productive qualities. It is usually the best land that is first drawn into agricultural production. Therefore, when the demand for wheat increases, it will take more than the average amount of labour to produce and transport the additional wheat. Ricardo's example supposes that there are three grades of land. On the best land it costs $3 to produce 10 bushels of wheat and deliver it to the town market. This cost includes the necessary amount of profit to get someone to farm the land. On the middle grade of land it costs $4 to produce the same amount of wheat and transport it to the town market. On the poorest land, it costs $5 to produce and transport 10 bushels of wheat. The increasing costs reflect the increasing amount of labour required to extract a given amount of wheat from successively less productive land. The same argument, of course, can be applied to the extraction of all renewable and nonrenewable resources from the land.

With a small population, the demand for wheat can be met by farming only the best land. The price of wheat will be $3 per 10 bushels. But as population grows, some of the middle grade land will be brought into cultivation. Now the price of wheat will rise to $4 per 10 bushels. If I own some of the best land and you farm that land, I can charge you a rent of $1 per 10 bushels of wheat. If I own some of the middle grade land, I cannot collect any rent since the cost of production on that land is the same as the price of the wheat. As population continues to grow, cultivation is extended even to the poorest land and the price of wheat rises to $5 per 10 bushels. Now the owners of the best land will enjoy a rent of $2 per 10 bushels and the owners of the middle grade land can collect a rent of $1 per 10 bushels.

This rising rent has important implications. Ricardo was able to show that the value of agricultural commodities, just like the value of manufactured commodities, is determined by the amount of labour it takes to produce them. The difference is that, with agricultural commodities, the value is governed by the amount of labour required under the most unfavorable circumstances - that is, by the amount of labour needed on the poorest quality land which the level of demand causes us to bring into production. Taking issue with Smith, Ricardo argued that "rent is not a component part of the price of commodities." Smith had claimed that high land rents drove up the price of wheat. Ricardo showed that high wheat prices - which themselves were caused by a growing population - drove up rent. Rent was the consequence, not the cause, of high food prices.

It all fits together into a fairly complete and consistent theory of value. Economic value is determined by the amount of labour needed for production, including, of course, the labour used to produce the raw materials and the 'worn out' part of the capital equipment. For wheat and similar products, value is determined by the amount of labour needed for production on the poorest land. Wages are determined by the values of the goods and services that a working class family needs to survive and reproduce. The capitalist pays his suppliers, repairs or replaces his worn out equipment, pays the workers and sells the product for a price determined by the amount of labour it took to produce it. Whatever is left over is profit. If the price of bread is high, wages will also be high and there will be little profit, but agricultural landowners will collect high rents. If the price of bread is low, wages will also be low and there will be high profits and little rent. Note that profit and rent are incorporated into this value theory, not added on as a cost as Smith had done.

There was still one major problem with the labour theory of value. It would only work well as a theory of natural price if the ratio of labour costs to capital costs was the same in all industries. Labour could not be an invariant standard of value when some industries used lots of labour and little capital while others used lots of capital and little labour, since a change in the distribution of income between wages and profits would alter costs in different industries by different amounts. Ricardo was still pondering this problem when he died. Nonetheless, Ricardo's labour theory of value was something of a sensation. Thirty years after Ricardo's Principles of Political Economy, John Stuart Mill, in his own Principles of Political Economy (1848) saw little reason to modify Ricardo's foundation of economics:

"Happily, there is nothing in the laws of Value which remains for the present or any future writer to clear up; the theory of the subject is complete: the only difficulty to be overcome is that of so stating it as to solve by anticipation the chief perplexities which occur in applying it." [Mill, John Stuart. Principles of Political Economy, Book 3, Chapter 1.]

Marx's Labour Theory of Value

According to Marx's Labour Theory of Value, all commodities have a common quantitative element. This element is the quantity of labour, or the average number of "Socially necessary" labour hours, involved in producing commodities, and it is the essence of commodity value. The use-values of a commodity are not comparable with each other, and therefore, the use-value cannot be the exchange value. Only the quantity of labour, which is the common quantitative element within all commodities, can become the exchange value. The monetary expression of the exchange value, or the quantity of labour, is the price of the commodity. The quantity of labour is measured by the socially necessary average labour hours. All commodities are regarded as products of labour, and "as values, all commodities are nothing but definite masses of congealed labour quantity."

For the most part, Karl Marx worked within the framework of David Ricardo's labour theory of value. The two most important differences were Marx's emphasis on fixed capital and his use of the particular accounting definitions within his labour theory of value to identify a source of profit. However, Marx used his labour theory of value to project capitalism's path in a way not anticipated by Ricardo.

Like Ricardo, Marx started by adding up all of the direct and indirect labour used. The "value" of something that requires 10 hours of direct labour plus raw materials that took 12 hours of labour to produce plus 1/1,000 of the life of a machine that took 5,000 hours of labour [including raw materials and tools] to make would be 'worth' 10 [labour] + 12 [materials] + 5 [depreciation of capital] hours of labour, a total value of 27 hours.

So how does the capitalist, who could normally sell this item at its value of the money equivalent of 27 hours of labour, make a profit? Only by being able to buy at least one of the inputs at a price below its value. He buys his machines from other capitalists - who are able to sell them at their value. He buys his raw materials from other capitalists as well, and has to pay full value. So profit doesn't come from machines or raw materials.

Labour is different. If the value of anything is the amount of labour it took to produce it, we need to ask: What is the value of labour? The value of labour is itself the amount of labour it takes to produce the food and other necessities consumed by the worker and the worker's family. And, at least since humans invented agriculture, labour has produced a social surplus - more than is necessary to simply sustain the worker at the level that was deemed by society to be 'right' for workers. If the worker in our current numerical example consumes goods and services that took 6 hours to produce, the value of his labour is the money equivalent of just that-6 hours of labour. And the value of his labour is just exactly what Marx's "perfect" capitalist pays. Which leaves the capitalist with a profit (surplus value in Marx's terminology) of the money equivalent of 4 hours of labour.

Why doesn't the worker simply work on her own and keep the entire value of the output rather than let the capitalist extract a large portion of it? Because the value of any commodity is based on what Marx called the socially necessary amount of labour used to produce it. If the worker, working without the advanced machinery owned by the capitalist, could produce the product from the example above in 50 hours of labour, she could still only sell it for the equivalent of 27 hours of labour because that is how much labour it takes to produce it using modern machinery and production methods. In other words, the capitalist is able to appropriate the social surplus because the capitalist owns the very machinery that allows the social surplus to be as large as it is.

Flaws in Marx's Labour Theory of Value

Misconceptions about "Use-Value"

Marx appears to be operating from a fundamental misunderstanding of the nature of "use-value". He does certainly recognize that the utility of a commodity is quite independent of the abstract-labour-content of that commodity. But he also clearly is thinking in terms of an absolute intrinsic utility inherent in the item. Although this is somewhat to be expected, given the historical context within which he was writing -- economists of his day, including Smith, Ricardo, and Mill, all approached the concept of value with the notion it was something intrinsic to the commodity. With the works of Adam Smith, the Marginalist theorists, and most especially the Vienna School of Von Mises and Hayek, however, the "intrinsic" concept of value has been rendered obsolete.

"The utility of a thing makes it a use-value. But this utility is not a thing of air. Being limited by the physical properties of the commodity, it has no existence apart from that commodity. A commodity, such as iron, corn, or a diamond, is, therefore, so far as it is a material thing, a use-value, something useful. This property of a commodity is independent of the amount of labour required to appropriate its useful qualities. When treating of use-value, we always assume to be dealing with definite quantities, such as dozens of watches, yards of linen, or tons of iron." [Part One - Commodities and Money; Chapter I - Commodities; 1. The Two Factors of a Commodity]

"Commodities come into the world in the shape of use-values, articles, or goods, such as iron, linen, corn, &c." [Part One - Commodities and Money; Chapter I - Commodities; 3. The Form of Value or Exchange] "Since no commodity can stand in the relation of equivalent to itself, and thus turn its own bodily shape into the expression of its own value, every commodity is compelled to choose some other commodity for its equivalent, and to accept the use-value, that is to say, the bodily shape of that other commodity as the form of its own value." [Part One - Commodities and Money; Chapter I - Commodities; 3. The Form of Value or Exchange]

The utility of a thing does not make it a use-value. The utility of a thing is its use-value. Utility, and thus use-value, is most definitely not a property of the commodity, nor is it limited to the physical properties of the commodity. The fact that a commodity is a material thing has nothing to do with the fact that it might also have some utility -- there being many non-material things that have utility, and many material things that have no utility. Utility is a relational concept -- a relationship between some one single individual and the item or commodity that that one single individual finds of use. A commodity has a use-value to someone for something (purpose). Nowhere does Marx seem to recognize this fact.

"A use-value, or useful article, therefore, has value only because human labour in the abstract has been embodied or materialised in it. How, then, is the magnitude of this value to be measured? Plainly by the quantity of the value-creating substance, the labour, contained in the article." [Part One - Commodities and Money; Chapter I - Commodities; 1. The Two Factors of a Commodity]

"Neither can it [the commodity] any longer be regarded as the product of the labour of the joiner, the mason, the spinner, or any other kind of productive labour. Along with the useful qualities of the products themselves, we put out of sight both the useful character of the various kinds of labour embodied in them, and the concrete forms of that labour; there is nothing left but what is common to them all; all are reduced to one and the same sort of labour, human labour in the abstract." [Part One - Commodities and Money; Chapter I - Commodities; 1. The Two Factors of a Commodity]

As in indication of Marx's basic misunderstanding of use-value, his attempt to abstract away the particular nature of the labour involved is quite significant. The products of the joiner, the mason, the spinner or any other kind of productive labour are of use (have use-value, utility) just exactly because of the special expertise and dexterity that these laborers bring to their products. If I need a cabinet, and it would take me a work-week to produce a cabinet that the joiner produces in a single day, then the use-value to me of that cabinet is the equivalent of four work-days. But if I am myself a joiner, who can also turn out that cabinet in one word-day, the use-value to me of that cabinet is but the equivalent of a single work-day. And if I do not need a cabinet, then the use-value of the joiner's product is exactly zero (ignoring momentarily the use-value it might have in exchange for something else).

"This common "Something' [to which each of the two commodities in an exchange must be reducible] cannot be either a geometrical, a chemical, or any other natural property of commodities. Such properties claim our attention only in so far as they affect the utility of those commodities, make them use-values. But the exchange of commodities is evidently an act characterised by a total abstraction from use-value." [Part One - Commodities and Money; Chapter I - Commodities; 1. The Two Factors of a Commodity]

The last sentence here is, of course, quite obviously wrong. The common "Something' to which each of the two commodities in an exchange must be reducible is just exactly the utility (use-value) of the involved commodities to the buyer and seller (each individually). Even if one conceives use-value as measured by personalized labour, his last sentence here clearly contradicts that meaning. Marx is correct in his recognition that it is not any common "natural property" of the commodities involved, and in his recognition that those natural properties claim our attention only in so far as they concern their use-value. And he may have been lead into this rather glaring error through his erroneous conception of use-value as an attribute of the commodity. In any event, he is totally incorrect to suggest that the exchange of commodities is in any way an abstraction from use-value. It is in fact the relative difference in the appreciation, on the part of the parties to the exchange, of the use-value of the commodities being exchanged, that entices and permits the exchange.

"In order to entice the money out of that pocket, our friend's commodity must, above all things, be a use-value to the owner of the money. For this it is necessary that the labour expended on it be of a kind that is socially useful, of a kind that constitutes a branch of the social division of labour." [Part One - Commodities and Money; Chapter 3 Money, 2A The Metamorphosis of Commodities]

The first sentence is correct. The second is most certainly not. It is only necessary that "our friend's commodity" be a use-value to the owner of the money. The amount and nature of the labour content of our friend's commodity (if any) is totally irrelevant to the amount of money he will be able to entice out of that pocket. He will be able to entice only that amount of money that is of less use-value to the owner of that pocket than is the use-value of the commodity being exchanged. Which means that the owner of the pocket must judge that the commodity being acquired would replace more of his own individual personalized labour in the pursuit of his own personal goals than would any other commodity that the owner could currently acquire with his money. And this is regardless of whether the labour content of that commodity (if any) is socially useful or not, regardless of the amount of that abstract-labour-content, and even regardless of the quantity of the pocket-owner's individual personalized labour involved.

"Lastly, nothing can have [labour-]value without being an object of utility. If the thing is useless, so is the labour contained in it; the labour does not count as labour, and therefore creates no [labour-]value." [Part One - Commodities and Money; Chapter I - Commodities; 1. The Two Factors of a Commodity]

It is odd that Marx can recognize that without utility, labour is valueless while at the same time not recognize that it is utility and not labour that creates the value in the first place.

The Vanishing Field of Applicability

The assertion that labour is the sole determinant of value is hard to accept just based upon common sense and experience. And Marx recognizes the limitations of his "labour-content" theory of value.

"A thing can be a use-value, without having value. This is the case whenever its utility to man is not due to labour. Such are air, virgin soil, natural meadows, &c. A thing can be useful, and the product of human labour, without being a commodity. Whoever directly satisfies his wants with the produce of his own labour, creates, indeed, use-values, but not commodities. In order to produce the latter, he must not only produce use-values, but use-values for others, social use-values. (And not only for others, without more. The mediaeval peasant produced quit-rent-corn for his feudal lord and tithe-corn for his parson. But neither the quit-rent-corn nor the tithe-corn became commodities by reason of the fact that they had been produced for others. To become a commodity a product must be transferred to another, whom it will serve as a use-value, by means of an exchange.) Lastly nothing can have value, without being an object of utility. If the thing is useless, so is the labour contained in it; the labour does not count as labour, and therefore creates no value." [Part One - Commodities and Money; Chapter I - Commodities; 1. The Two Factors of a Commodity]

Marx readily admits that many natural objects in which no labour has been invested -- such as scenic views, fresh air, pure water, gems and minerals, and wild fruits and vegetables -- do have use-value, but do not contain labour. And following Ricardo, Marx specifically excludes things like "rare statues and pictures, scarce books and coins, wines of a peculiar quality, which can be made only from grapes grown on a particular soil [The Principles of Political Economy and Taxation, Chapter 1, Section 1]" from his theory of value. Marx also admits that the labour theory does not account for the fact that people value some natural objects, such as paintings, diamonds, and other "intrinsically scarce" items tremendously more than would be justified by their labour content. And he again follows Ricardo -

"These commodities, however, form a very small part of the mass of commodities daily exchanged in the market." [The Principles of Political Economy and Taxation, Chapter 1, Section 1]

For these intrinsically rare things, Marx admits that it is customer demand, and the market interaction of supply and demand, that governs their value, rather than their labour content.

Without clearly defining his scope, Marx implies that his labour theory of value applies only to those commodities that are (a) reproducible by socially necessary labour time; and (b) produced with the intention of exchange. The first condition requires that the product produced must be non-unique, and producible in sufficient numbers that their market value is determined more by the socially necessary labour time required to produce them, than by the magnitude of consumer demand. The second condition requires that the product must not be an accidental consequence of nature, or an unintended by-product of some human action directed towards another purpose. In other words, to be treatable by Marx's theories, the commodity must be a "producible commodity" that results from capitalist mass production processes.

This implied definition for the scope of his labour theory of value suffers from one competitive disadvantage and one theoretical flaw. The competitive disadvantage is that Marx is readily admitting that his economic theory of Capitalism is incomplete. A more complete understanding of a capitalist economy requires an understanding of market/utility theory as well as Marx's labour theory of value. In as much as the Market/Utility theorists maintain that an understanding of the market/utility theory will adequately explain everything that Marx suggests that his Labour Theory of Value will explain, it is questionable why one would need Marx's theory at all.

As to the theoretical flaws, firstly Marx like Ricardo before him, assumes that there are commodities that are, by his definition, not intrinsically scarce. In other words, he is assuming that their are in fact "producible commodities" whose exchange-price is not more subject to the demand of customers than to the labour content. Marx fails to justify this assumption. And a reasonable argument can be made that his assumption is incorrect. All commodities, whether natural, artisan (non-capitalist) produced, or capitalist manufactured, can be treated as scarce according to Marx's own definition - consumers value them and will pay for them more than would be justified by their labour content. The aggregate demand (irrespective of price) for any useful commodity will always exceed the current supply. So one may more accurately conclude that it is the customer demand, and not the labour content that governs their value. (Although this argument does equivocate on the meaning of "value".)

The Transformation Problem

Marx was not able to resolve Ricardo's difficulty with using labour as a standard of value. Let us compare two industries. One, shirt making, uses a lot of direct labour and very little capital equipment. The other, petroleum refining, uses lots of capital and very little labour. If we tried to apply Marx's version of the labour theory of value in these instances, the "natural price" in each case would be equivalent to the total amount of "Socially necessary" labour used. The profit returned to the capitalist would be equal to the value of the direct labour minus the wages paid to those workers. The petroleum refinery would generate little profit, and since it required massive investment, the profit rate would be minuscule. The shirt making firm would generate a lot of profit, and since it required little investment, the profit rate would be high indeed.

Of course this would violate one of our initial assumptions: the profit rate in long run equilibrium will be the same in all industries. Note that this assumption was not adopted only to make our arithmetic easier - although it does do that; it is one of the stylized facts of capitalist economy in equilibrium. And even Marx accepts this. Moreover, the differences in surplus value between the industries in this example are not characteristic of real world differences in profit rates. We would generally expect the more capital-intensive industry to have a higher rate of profit than the labour-intensive industry.

Marx certainly recognized the problem. Unlike Ricardo, Marx also explored the effects of technological change on a capitalist economy. So differences across industries in labour or capital intensity (which Marx called the "organic composition of capital") could not be ignored. Labour values (the adding-up of the amount of labour in a product), Marx claimed, give us important insights into the nature of capitalism and provide a framework for the investigation of what we now call macroeconomic features of the economy - economic growth, the distribution of income and capitalism's crisis-prone nature. It was not so important that labour values were not the same as long-run equilibrium price. To avoid confusion, Marx used the term value only when it was directly calculated by adding the hours of labour necessary for production and used the term prices of production for the prices that would bring about a single rate of profit on invested capital. But it was important that labour values bore some predictable relationship to the prices of production.

Certainly there was a rough relationship. In a capital-intensive industry such as petroleum refining, any price that will offer a normal return on investment will be much higher than the price calculated by the labour value of that industry's output. In a labour-intensive industry such as shirt making, a normal return on investment will occur when the product price is below the labour value. We can envision an "average" industry - average in terms of the mixture of labour and capital - in which labour value and natural price are the same.

Lets try a numerical example. To keep the arithmetic simple, we will dispense with fixed capital. The capitalists buy materials from other capitalists, hire labour, produce goods and sell them. Industry 'A' purchases goods which took 80 hours to produce and hires 20 hours of labour to produce the finished good. It will have a value of 100 hours of labour. Industry 'B' purchases goods which took 20 hours to produce and hires 80 hours of labour to produce the finished good. It also will have a value of 100 hours. Using the labour theory of value, good 'A' is equal in value to good 'B.'

But how much does each capitalist get? If the cost of labour is 60% of its value, that is if the capitalist can hire 10 hours of labour by paying the worker enough to buy goods and services that took 6 hours to produce, then the direct labour costs of these two capitalists vary considerably. Remember, their suppliers sold the inputs at their full value. If the value of one hour of labour is $1.00 (but the purchase price of one hour of labour is $0.60) the capitalists of industry 'A' each earn a profit of $8.00 by paying $12.00 for labour which adds $20.00 to the value of the product. But the capitalists of industry 'B' each earn a profit $32.00 by paying $48.00 for labour which adds $80.00 of value to the product.

The profit rates even diverge by more than the profit amounts. Industry 'A' capitalists' investment comes to $92.00 ($80.00 for materials and $12.00 for labour). They earn a 9% return. The captains of industry 'B' only invest $68.00 ($20.00 for materials and $48.00 for labour). They earn a 47% return. Impossible, since our model calls for equal rates of profit. Nonsensical by real world standards as well, since the more labour intensive industry is earning a higher profit rate than the more capital intensive industry.

Marx thought that he could arithmetically "Transform" labour values into prices of production. In fact he had left a solution in the messy notes that his friend Engels molded into Volume III of Capital after Marx's death. Applying some tedious math to the numbers in the example above, we can calculate the prices that would provide equal profit rates and also keep the same amount of total profit. If good 'A' sells for $115 and good 'B' sells for $85, the profit rate in both industries will be 25% and the total profit (with one firm in each industry) will still be $40. We seem to have transformed the labour values into prices of production that equalize profit rates.

But the problem was more difficult than Marx had thought. It is not enough to find an average industry to use as a standard, because every industry purchases products from other industries. If the weaving industry seemed to have an average capital intensity, for example, that would not by itself get us off the hook. The weaving industry buys yarn from the spinning industry and power looms from the loom-making industry. And those industries in turn purchase inputs from other industries. All would have to be "average" industries. Or, in our numerical example above, we would have to go back and transform the prices charged by the industries that supply industries 'A' and 'B.' But those industries also have suppliers. We would have to carry out an infinite regress of such transformations, with each one changing the results of all the others.

The Non-Correlation between Labour-Value and Relative-Prices.

Labour values are not the same as long-run relative prices and the relationship between them is extremely complex. If the relative price is really the monetary expression of the different quantities of socially necessary average abstract labour time, the relative price differential must not fluctuate during circulation in the market. But in reality the relative prices not only fluctuate continually but prices in general are always prone to rise. Marx explained such a separation between value and price of a commodity as the agreement between total value and total price in the whole society (Capital, Vol. 3). But this explanation is an example of abuse of the concept of average, and is not an adequate explanation for the difference between relative prices and the labour-value content of commodities.

According to this explanation, complex labour is converted into simple "abstract" labour in the market. But this assertion is inconsistent with his statements that the price expresses the value that is determined by the quantity of labour congealed in the commodity during the process of production. (Assuming, as specified, an equilibrium environment where the price at which a commodity is exchanged is representative of the exchange-value as calculated from the labour-time). In other words, according to his Labour Theory of Value, the quantity of labour must be the basic expression of value, which must not be determined from any other activities than the process of production. Nevertheless, he said that the conversion of complex labour to "abstract" labour is determined by the functions of the market. Thus the theory of labour conversion is an example of circular reasoning.

The Value of Time and Position

The labour theory also ignores the importance of time and position. A 20-year-old wine and properly-aged beef are far more enjoyable, and thus in much greater demand and considered of much greater value (and can command a much higher price), than one-year-old wine and un-aged beef. A storehouse full of corn is of much greater value when sold in the depths of winter, than when sold at the peak of harvest season. And both of these, despite the fact that the labour content of both ends of the time scale are identical. Or, at the very least, the labour-time content of the storage facilities employed is not representative of the increase in exchange prices attained by the employment of those facilities.

It is perhaps the most grievous theoretical fault in Marx's labour theory of value that it ignores what economists call place-time preference. This is the common strong preference for goods and services here and now, rather than later over there. Present consumption is more valuable than future consumption.

Treating the commodities at each end of the place-time interval as different commodities, and thus applicable to different markets, does not address this concern. Firstly, it avoids explaining why the place-time interval imparts additional worth to the commodities involved, despite the absence of (meaningful) labour content. And secondly, it merely transfers the problem under the umbrella of the Transformation Problem described above.

The Anti-Entrepreneurial Bias

Marx's labour theory of value is anti-entrepreneurial by its nature because of the particular labels that Marx chose for the concepts he defines. Under his theory, sellers are advised to price all goods by the amount of labour that goes into them, rather than how much they are demanded by consumers. Otherwise, they are branded "capitalist exploiters of labour". Thus stores should charge no more for an aged wine than for a fresh wine (given equal labour input). A trucker should charge no more for a bale of cotton he has hauled from a distant field than is justified by his labour-time. A warehouseman should charge no more for the bushel of corn he has stored since last harvest, than is justified by the depreciated labour content of his warehouse.

Marx's bias shows up most particularly in his inclusion within the concept labelled "Socially necessary labour hours" all of the contribution of entrepreneurial organization and innovation. And his labelling as "Surplus value" the difference between what the commodity can be exchanged for, and what the capitalist pays the labour involved. Both labels lead the unwary into ignoring the fact that the entrepreneurial contribution is itself of great value. Marx himself falls into his own trap on this score.

"Our capitalist stares in astonishment, the [labour-]value of the product is exactly equal to the [labour-]value of the capital advanced." [Part III - The Production of Absolute Surplus Value; Chapter VII - The The Labour Process, 2 The Production of Surplus Value]

Clearly an indication of Marx's bias. Only someone ignorant of the basic elements of simple cost accounting would suspect that the capitalist would be astonished at the preceding accounting. Given Marx's labour content definition of "value", all that he has outlined here to "astonish" the capitalist, is elementary cost accounting. The costs of production (the labour-value of the product) is exactly equal to the (labour-value of the) capital advanced. If it were anything else, the capitalist would go looking for a new accountant.

Marx then proceeds to describe the "astonished" objections of the capitalist. But he is, of course, taking ad homenium liberties with his adjectives. As he properly describes, no capitalist would undertake the advancement of capital without an expectation of a return for his organization and risk.

 

Fallacious Argument

Marx's argument for his labor theory is unproven. In the entire first volume of Das Capital, where Marx proposed the labor theory, there is not one "positive proof". Rather Marx offers a fallacious proof in which he argues:

Premise 1 -- some factor in the production of a commodity gives it value.

[True only because he defines his concept of "value" as the consequence of labour-time. He makes no attempt to provide a non labour-time meaning for his concept of "value", and is particular in separating his concept of "value" from both utility and exchange-price.]

Premise 2 -- only those commodities to which man has applied labor have value.

[Again, true only because that is the way he has defined his term "value". Other things that are exchanged in the economy, and are considered worthy by the average person, are specifically denied to have "value".]

Procedure -- Examine all the factors producing a good by discarding those which did not create equal value in equal quantity, and end up with one factor -- Labor.

[False. By assuming a priori that value is intrinsic to the commodity, and must result from the process of production, he has failed to recognise that the worth and value of a commodity is its utility, and the factor that causes commodities to exchange at equal prices is the equality of the quantity of utility and not the equality of the quantity of labour.]

Conclusion: Labor must be the source of value.

[False. He has committed the logical fallacy of assuming his conclusion].

Marx defines his terms so that the equilibrium price at which commodities are exchanged is defined to be equal to the labour-hours that went into the production of that commodity. Once this definition is in place, he reasons backwards to find the "value" of the average socially necessary labour-hour. The rest of this discussion of Capitalism is based on this fundamental definition. It may be internally consistent, but it does not marry to the real world. The flaw in this reasoning process shows up when comparisons of that computed value is compared across commodities - as is described above under the Transformation Problem.

Marx promised to provide a positive proof in the Volume 3 of Das Capital. However, that book does not offer a positive proof, and implicitly refutes one. Marx proclaims that two types of capital exist in production, only one of which can produce "Surplus value". Thus exchange of items of equal value can have uneven mixtures of these two types of capital, implying that labor alone is not the sole determinant of value.

Some Minor Difficulties

"By making the coat the equivalent of the linen, we equate the labour embodied in the former to that in the latter." [Part One - Commodities and Money; Chapter 1 Commodities, 3-A-2 The Relative Form of Value]

This is quite incorrect. Marx is here discussing the meaning of the "20 yards of linen are worth 1 coat" equation (and the other related equations) with which he started this discussion of the "form of value". He is not discussing personalized labour evaluations, he is discussing his concept of abstracted labour time. And within that context, his statement is quite entirely wrong. By making the coat the equivalent of the linen, we express the historical fact that some one individual found that a coat had greater use-value to him than his 20 yards of linen. And vice versa. The historical fact of the exchange says nothing about the relative labour content of the two articles beyond the probability (and not certainty) that the seller of the coat included his costs of labour when evaluating the use-value to him of that coat. And vice versa for the seller of the linen. The fact of the exchange says nothing about the relative proportions of labour contained either the linen or the coat.

"The first chief function of money is to supply commodities with the material for the expression of their values, or to represent their values as magnitudes of the same denomination, qualitatively equal and quantitatively comparable. It thus serves as a universal measure of value." [Part One - Commodities and Money; Chapter 3 Money, 1 The Measure of Values]

The first chief function of money is to serve as a medium of exchange. And in so functioning to record the exchange-price of commodities that have already been exchanged in the same denomination, quantitatively comparable. Thus, on first appearance in this analysis of money, Marx is correct. However, since Marx's concept of "value" is "[labour-]value", within the context of his dissertation his statement is in fact wrong.

"The cotton that was bought for $100 is perhaps resold for $100 + $10 or $110. The exact form of this process is therefore M -- C -- M', where M' = M + (delta)M = the original sum advanced, plus an increment. This increment or excess over the original value I call surplus value. The value originally advance, therefore, not only remains intact while in circulation, but adds to itself a surplus value or expands itself. It is this movement that converts it into capital." [Part II - The Transformation of Money into Capital; Chapter IV - The General Formula for Capital]

This analysis assumes, of course, that the individual doing the trading in these two exchanges makes no change to the commodity involved in the exchanges. However, even assuming this restriction, Marx makes a fundamental error here. Assume that Mr. Abbott is involved with our friend in the first half of this pair of exchanges, while Mr. Baker is involved in the second half. So the M -- C half of the exchange-pair takes place because (and only because) Mr. Abbott use-values the $100 more than he does the commodity he offers in trade - say a bale of cotton. And the C -- M half of the exchange-pair takes place because (and only because) Mr. Baker use-values the bale of cotton more than he does his $110. Now baring exceptional circumstances, why would Mr. Baker not trade directly with Mr. Abbott. It would certainly benefit Mr. Baker to the tune of $10 to deal directly. And since there is a difference of at least that $10 in the use-values that each would bring to the exchange, they might settle on a compromise price of $105, thus benefiting each.

The only reason why, in the normal course of affairs, Messrs. Abbott and Baker would deal with our friend rather than each other directly, is that our friend is bringing to the pair of exchanges something extra. And that something extra is worth (use-value / utility) a combined sum of $10 to Messrs. Abbott and Baker. It does not matter what that something extra is. It must be worth at least $10 to Messrs. Abbot and Baker, or the two would deal directly with each other. In addition, whatever that something extra is that our friend brings to the exchange-pair, it must be worth (use-value / utility) less than the $10 to our friend, or he would not be involved in the exchanges in the first place.

Therefore, what Marx is calling "Surplus value" is not in fact surplus at all. It is the market-determined labour-value of the socially necessary average labour-time that our friend labours to produce the something extra that he brings to the exchange-pair.

"Use-values must therefore never be looked upon as the real aim of the capitalist; neither must the profit on any single transaction. The restless never ending process of profit making alone is what he aims at." [Part II - The Transformation of Money into Capital; Chapter IV - The General Formula for Capital]

There are, of course, people for whom the hustle and bustle of "business" is their principle source of happiness, and for whom "profit" is merely score-keeping in a marvelous game. But I do not believe that Marx is intending his comments to describe only this miniscule proportion of "capitalists". And his comments certainly do not apply to the great population of those who are labelled "capitalist" by Marxists today. It is possible that in his day, his knowledge of "capitalists" was limited to those for whom "business" was an enjoyable game. But for the larger population of people Marx and current Marxists label "capitalist", people who buy commodities in order to sell them, his description is quite totally wrong.

For most capitalists, as for most non-capitalists, the aim is to amass as much "wealth" as possible given the circumstances. Where, in this context, "The accumulation of wealth" is understood even by Marx as the accumulation of use-values (utility).

 

The Utility (Marginal) Theory of Value

After Marx, starting in the 1870's, political economists worked out a more sophisticated version of the supply and demand theory, which seemed to them capable of explaining whatever the labour theory of value could explain, and of explaining other economic phenomena as well, by means of a few simple assumptions which seemed to correspond realistically with actual human behavior.

The "utilitarian" (or "marginalist") paradigm has many roots. One is the difficulty, as described briefly above, of actually using the labour theory of value (and particularly Marx's theory) as a theory of long-run relative prices. Additionally, as a foundation for the understanding of a functioning economy, Marx's labour theory of value looks like a hodgepodge of not quite comparable elements. There is the main theory which covers only easily reproducible goods and services. This must be accompanied by a theory of rent - to be used for the products of farms and mines where the relevant quantity of labour is not the average socially necessary labour time, but the marginally necessary labour time on the land of poorest productivity. Some items are of fixed supply - first editions of Ricardo's The Principles of Political Economy and Taxation for example - and their pricing is completely outside the orbit of the labour theory of value (as acknowledged by both Ricardo and Marx). These "intrinsically scarce" items require a theory of supply and demand driven market-exchange value. And then is labour itself. As was described under the Transformation Problem above, and as well investigated by Von Mises and Hayek, Marx's theories must be supplemented by a supply and demand driven market-exchange theory of the value of labour wages. By the 1870's, a century after the start of the industrial revolution, average wages in Britain were clearly on the way up and a subsistence theory of wages (Ricardo) was no longer sensible.

Nor could the ideological implications that some drew from the labour theory of value be ignored. Whether intended by their authors or not, many turned the term itself into an assertion that labour created all value and was therefore entitled to all value, or at least entitled to a much larger share than labour was getting. There were Ricardian Socialists well before Marx. And while the capitalists as a class could not have asked for a more fervent supporter than David Ricardo, the capitalism of Ricardo's model was anything but harmonious. In both Ricardo and Marx, class is posed against class in a struggle over income. The economic gains of one class are the losses of another. The times were ripe for a new theory of value.

Finding Value at the Margin

In one sense, Ricardo had overthrown his own theory of value. The neoclassical economists essentially developed the Marginal Theory of Value out of Ricardo's theory of rent. The marginal theory of value finds value at the margin of production, just as Ricardo had found land rent to be determined at the margin of cultivation. To Ricardo, agriculture and mining had been special cases because the costs per ton of corn or coal increased as we pushed into poorer lands or deeper mines to meet increasing demand.

The marginal theory of value combined two stylized facts. One was to assert that increasing cost industries were the norm, rather than special cases. For a given (fixed) capital base, costs per unit rise the more units of any one product we produce in a given period of time. The other was to assert that the desire for any particular good weakens the more units of that good we have consumed in a given period of time. The fourth pint of ice cream in a week brings us less pleasure than the third. The fifth pint will bring us even less pleasure than the fourth. This was generalized into the law of diminishing marginal utility: the utility (pleasure) of consuming an extra (thus marginal) unit of any good or service declines as the number of units we have consumed in a period of time goes up.

With costs increasing while benefits are decreasing, we can ascribe a simple rule of behavior to all economic actions. If the benefit exceeds the cost, do it. If the cost exceeds the benefit, don't do it. If the costs and benefits are exactly equal all is for the best. When the price exceeds the cost, producers will increase output. As they do, costs per unit of output will increase.

This is much simpler than the labour theory of value. Instead of an apparent hodgepodge of not quite comparable theories, the marginal utility theory addresses all aspects of the economy with a single framework. Economic value will be the actual price once all the producers and consumers have had time to adjust their consumption and production to any changes in taste and/or technology. In other words - aside from the time frame - there is no difference between value and price according to this theory. So there is no need to "Transform" value into normal price as with the labour theory of value. What you see is what you get. The value to the consumer of the last unit consumed (the marginal unit to the marginal consumer) - which, because of declining marginal utility, is the least valuable unit of that product consumed - is equal to the cost of the last unit produced (again, the marginal unit). Since marginal cost is presumed to rise with output, the last unit produced is the most costly. They reach equilibrium where marginal utility equals marginal cost and both are equal to normal price.

Note that this shifted the foundation of economics from production to exchange. The classical economists found the determinants of value in the conditions of production; the neoclassical economists found the determinants of value in the meeting of buyer and seller in the marketplace. Instead of originating in production, value now emerged from exchange - from demand intersecting with supply.

It also shifted the attention of economists away from social classes to individuals, in line with the more Individualist philosophies of Mill, Locke, Jefferson and the rest of the English Individualists. If one assumed that the act of exchange was governed by the same laws whether the item being exchanged was a yard of cloth, a pint of ale, an hour of a carpenter's labour, the use of 160 acres of Iowa farm land for a year, or the use of a million dollars for a year, or the Mona Lisa, then there was no essential difference among capitalists, workers and landlords. Each was both a buyer and a seller; each was similarly bound by the inexorable laws of supply and demand.

The same marginal concept can be applied to the distribution of income. A business hires labour, leases land and utilizes capital. We can treat the business as sort of a consumer. The difference is that instead of "utility," the business gets a sellable product out of the exchange. The firm is concerned with the contribution that the hour of labour, acre of land, or unit of capital makes to production. The operative concept is marginal productivity: the addition to output that is due to hiring another "unit" of any factor of production - and the factors of production are labour, land and capital.

If we can assume that the 200th hour of labour per week by the workers in a small firm adds less to output than the 199th hour of labour; that the 100th acre of land brought into the farm adds less to output than the 99th acre; and that the 60th unit of capital adds less to output than the 59th unit, then we can assert that marginal productivity declines with increasing use of any particular factor of production. Marginal productivity behaves much like marginal utility. The firm will not hire a factor of production if the cost of hiring it is greater than its marginal productivity: if the 200th hour of labour adds $15.24 to total production but costs $15.25, don't do it. But if it adds $15.26 and costs $15.25, do it.

The main point about the marginalist theories is that they switched the focus of attention from the average or normal price, value or cost to the price, value or cost of the marginal item, that is the item just inside or just beyond the edge of what is actually produced or sold. I suppose the term came from agriculture: marginal land is either land at the edge of settlement as it spreads, or (sometimes the same thing) the land which it is just profitable to cultivate - the land that will go out of cultivation first if prices fall.

Let us consider first the consumer's evaluation of a commodity. It is very seldom, if ever, the case that a consumer will want as many items of a given type as he or she can get, and with equal intensity. Some people want peanuts like that, but no-one would buy a second appendix operation no matter how low the price fell. At any given price, if you buy several items there will be one or a few just worth having at that price - if the price had been a little higher you would have done without that item. It is the marginal item at that price. If the price were higher, and you did buy fewer, then at that higher price there would again be one or more marginal items - ones you would not buy if the price rose higher still. Even if you buy only one, at some price that one would be marginal.

The same idea applies if we think of things you make or do for yourself, rather than buying or selling. Some of the things you do are just barely worth doing. The contribution they make to your total satisfaction or wellbeing just barely justifies the trouble. These are your marginal activities: if life became a little harder you'd leave them out. Consider this notion of satisfaction or well being for a moment: this should be taken in a sense that is open to whatever interpretation your value system calls for. "Satisfaction' for a hedonist means pleasure. For a religious person it might mean peace of conscience, or something like that.

No matter what are your values or priorities there are activities which just barely earn their place on your agenda and commodities which just get onto your shopping list.

Let us look at this idea now from the viewpoint of the producer of commodities. At a given selling price there will probably be some items just barely profitable to produce. The cost of production per item almost certainly varies with the volume of production. To produce just one may be very expensive because of the need for an initial investment in equipment and for learning how to do it. If you produce another thousand you may not have to spend much more on equipment or learning, so cost per item falls. But eventually it rises again - you get to the point, as production increases, where buildings need extensions, new machinery is needed, new workers have to be hired and taught, and so on. In other words, as production expands, you may come to the point when all resources are strained, and the last increase in production is barely profitable. The items barely worth producing are at the margin.

Now another idea basic to this theory, the idea of substitution. Look at it first from the consumer's point of view. If margarine becomes more expensive you think of using butter instead. If butter becomes too expensive to buy you think of making your own. If movies become too expensive you stay home and make your own drama, and so on.

Look at substitution also from the producer's point of view. Suppose the farmer of a mixed farm finds that some produce fetches such a low price that he makes no profit: he can divert his effort and resources into some other line. It is not so easy to reallocate highly specialized equipment to another line; but over time the firm can reorient its activities - it can cut back on maintenance, or sell off some of its present equipment, to make it possible to switch to some other line of production.

Note that the reorganization of production takes time: it will be necessary to accept a lower level of production of one commodity, and therefore less profit, for the present, to achieve a higher level of production of another commodity, and a higher profit, at a later date. The producer has to choose between more now and more later.

A consumer will maximize his or her overall satisfaction, and a producer will maximize net income, by substituting an item or items of one commodity for an item or items of another. If an item of one type not at present on your agenda or shopping list would contribute more than an item of another type just inside the margin, then the latter should be deleted and the former added. You delete some of the items you up till now thought barely worth having, to make room for other things you would now rather have instead. You can't just add the other things, if you are fully extended, with no spare time or money; so you give up some activities or purchases to make room for something else. And the things you give up are things at the margin. When all such substitutions have been made - when it is no longer possible to do better by deleting and substituting - then satisfaction or income is at as high a level as you can reach.

On this account the 'cost' of an item (its cost not in money, which after all you rationally want only for what it can buy, but cost in real terms - its cost in terms of what money can buy) is any one of the range of items that could be had instead if this one were deleted. To get this I have to go without that. Goods which are not commodities such as leisure, or freedom from bother, can be considered along with commodities. So the cost of a commodity may be the leisure I have to forego to earn the money to by it, or it may be some other commodity I could buy if I deleted this one.

The viewpoints of consumer and of producer can be combined: a producer is also a consumer, and a consumer may be a producer or potential producer. A person decides whether and what and how much to produce, and what to buy with income from products he sells (or from other sources), by making substitutions at the margins between various items including leisure. And if you can't be bothered making all these substitutions, then apparently a certain freedom from bother is a good you prefer to others you could have if you calculated more carefully. So bother, lack of leisure, hard work, as well as commodities, are possible equivalents to express the real cost of any commodity. And this of course is the plausibility of the labour theory of value: it treats labour, the foregoing of leisure, as the cost of anything, in the last analysis. But this is not the only cost. And insofar as it is one of the costs, it finds a proper place in the marginalist theory. The marginalist theory finds a place for labour as a cost, but also for other costs the labour theory does not acknowledge.

The facts that reorganization of production takes time, and that meanwhile income/satisfaction is reduced, can also be incorporated into this scheme. The items I survey when deciding what substitutions to make must be dated: I must consider whether so many items of X in a year's time will contribute more to my 'overall satisfaction' (over time) than however many items of Y I have to do without in the meantime. I must of course take into consideration the uncertainty of the future - I may be dead before the investment pays off. And perhaps it is rational (though many deny it) to give some preference to present good over future. So taking into account these points, I must decide whether so many items of X in a year's time are worth the Ys I have to do without meanwhile to have them.

Now a technicality: a 'demand' or "Supply' schedule for a given consumer or supplier is a statement of how many items of each commodity he or she would buy or supply at various hypothetical prices. This will depend of course partly on the prices of other things. If margarine is on special this week buy so many extra - unless there is an especially good special on cheese: then spend the money on that. No-one has a fully-worked-out set of demand or supply schedules: we work out only enough to cover likely price movements - not even that much, if we can't be bothered. Each person has his or her own set of demand and supply schedules - their "Shape' differs from one person to another, and for a given person from one time to another. How much of what will be demanded and supplied in a market on a given date at a given price depends on the "Shapes' of everyone's demand and supply schedules.

In a competitive market, prices fluctuate with demand and supply. The price of an item moves until demand at that price and supply at that price are equal. Where that will be depends upon the shapes of the many demand and supply schedules of the various individuals who participate, or could participate, in the market. It does not depend only on quantities of labour required, as if leisure were the only thing people go without to have this item; they also go without other commodities. The equilibrium point is never actually attained. Anyway, it keeps shifting. People's demand and supply schedule's change all the time, partly for subjective reasons (changes of knowledge, of taste, of mood, of fashion etc.), partly because of the fluctuations in the availability of natural resources, partly because of technological changes: but not only because of technological change, i.e. change in the amount of socially necessary labour. It may be true that for years at a time houses will be worth on average so-many times a pair of shoes, because people's demand and supply schedules may change only slowly in respects which affect the relative prices of houses and shoes, or because there is not much change in technology or in the availability of relevant natural resources.

Marginalism vs Labour Theory

(1) Marginalism is a theory not of value but of prices. Value in Marx's theory is the main determinant of long run price. Exponents of the marginalist theory have no use for a notion of 'value' as of something such as congealed labour that commodities have, the more they have the higher their long run price. What determines price is not what is in the commodity, but the complex continually shifting interrelations of everyone's demand and supply schedules. Marginalists have no theory of value as distinct from price: exchange value and price are synonymous, as far as they are concerned.

(2) There is in the marginalist theory no reason to dismiss use-value in discussing exchange value. Exchange values are a function of the uses people find for the commodity, and of the uses they would find for the goods they have to do without to get the marginal item of that commodity. Which goods those are depends on availability of natural resources and technology. If air has no exchange value, although it is very useful, that is because it is so abundant that we do not have to go without other things to get it, or go without it for other purposes if we use it for this one.

(3) The marginalist theory attaches no special importance to human labour as the sole source of 'value', or as a cost. Leisure, or freedom from toil, is a good which has to be considered in deciding what to substitute for what, but it has no special place among the possible alternatives.

Suppose natural resources were all state-owned, so that no individual was giving up anything that was his in allowing these things to be used: still, the use of a scarce natural resource would have to count as a cost. If we use oil, for example, as if it had no value (apart from the labour put into bringing it to the user), then eventually we will have to do without things for which oil is needed: these things, at future dates, are the cost, in addition to labour, of present use of this oil.

It may be that no natural resource is absolutely non-renewable and indispensable: the cost of using it wantonly will then be what has to be invested to make some alternative available, or what has to be done without if we fail to make that investment.

(4) Marx's references to 'normal' methods seem unsophisticated to exponents of the marginalist theory. It may be (and usually is) the case that what is supplied is produced by a mixture of methods, some obsolescent, some inefficient. Some of what is actually supplied is produced by the marginal supplier (the one who would go out of production if prices fell slightly), or by the marginal component in some producer's plant (e.g. an old machine on the point of replacement or closure). If the price is not enough to keep the marginal producer or machine in operation the supply will fall, the price may then rise, demand may fall (as marginal purchases are deleted), and so on. It is these adjustments at the margin, against the background of everyone's demand and supply schedules, that determine price, not the 'normal' or 'average' method of production.

(5) There is part of Marx's theory that takes into account the fact that industries are more or less labour-intensive. (The Transformation Problem described above.) Marx appealed to value and surplus value to explain long-run prices and profit, but in his theory there is another important factor behind price, namely the ratio of constant to variable capital, i.e. the proportion of total capital that can be used to buy the right to use labour power. If a type of commodity requires a lot of machinery to produce, then in Marx's theory its price will be above value (even in the long run), and the capitalists' profits will be above the corresponding amount of surplus value that capitalists in that industry extract. He has to say this, because rates of profit tend to be equal across all industries - otherwise capital would move out of unprofitable and into profitable industries. If a less labour-intensive industry could get profit only from surplus value produced by its own workers, then its rate of profit would be low. So Marx says that competition in the market for capital, labour and commodities transfers surplus value from more to less labour-intensive industries. The commodities of capital intensive industries sell at above the value that corresponds to the quantity of labour they actually embody. Competition between industries for capital and for workers tends to equalize rates of profit and wages. If the product of some capital-intensive industry is demanded strongly enough to keep such businesses going, then its price must be enough to yield about as high a rate of profit as is got in labour-intensive industries: therefore the price must be above value, and exchanges at this price must transfer surplus value from other capitalists. (These exchanges are either directly with firms in labour-intensive industries, if the product exchanged is a means of production, or indirectly if it is a consumer good: the workers in other industries, in their role as consumers, buy it at an over-value price, and their wages must therefore be higher: so value is transferred from capitalist in labour intensive industries by way of higher wages and higher prices of consumer goods to the capitalist in the less labour-intensive industries.) Notice that all this falls back on the mechanism of competition and supply and demand. So to deal with the fact of unequal ratios of constant to variable capital Marx must fall back on the 'competition-supply-and-demand' theory (of which Marginalism is a sophisticated version): whereas the marginalists never need to resort to the labour theory. (This illustrates again that the marginalist theory can explain whatever the labour theory can, whereas the labour theory at some points has to be supplemented by the supply-and-demand theory.)

(6) There is a disagreement about profit. In one sense profit is just the difference between the firm's income and expenses. But economists sharpen up the notion. Suppose one person saves the capital, manages the firm, and does some work at the bench. Then part of what he calls his profit is interest on his savings, part of it is the equivalent of a salary paid to a manager, part equivalent to a wage paid to a tradesman. The rest is profit in the strict and proper sense. And in fact there may not be any profit in that sense. Now what is this profit in the narrow sense? Marx says it is the charge the owner of the means of production levies on workers for access to the means of production and thereby to the market. The marginalists may acknowledge that that is a component, but typically they regard that as a kind of rent, and in talking about profit emphasize something else, corresponding to Marx's notion of exceptional profits made by selling a product at a value set by the normal methods of production when your actual method of production requires less than the normal labor. In other words, profit in part is the return got by the innovator - the entrepreneur. And this 'entrepreneurial' profit may in fact be got by anyone who makes any sort of innovation, not only by an owner or employer, and not only by technological innovation. It might be a new method of selling, that increases the commission earned by a salesman. Now in comparison with Marx's theory there is here not only a difference in terminology, but also a conceptual difference. The modern economist groups things together differently: what Marx calls profit he puts together with other kinds of rent, and he calls 'profit', and gives great salience to, something that comes under a different part of Marx's theory, namely his account of the dynamics of capitalism.

(7) There is a fundamental difference in the explanations for the source of profit. In Marx's labour theory accounting, the profit comes from the difference between what the capitalist pays his labourers in wages, and the labour-value of the commodities that the socially necessary labour time has produced - what he calls "Surplus value". Or, alternatively from a global perspective, the difference between the labour required to produce all those commodities necessary to sustain the population, and what the labour force actually produces - what he calls "Social surplus". The unavoidable ethical implication of this accounting approach, is the conclusion that the source of profits is labour-time. And it is not surprising that those who do not understand the arbitrariness of definitions involved, would conclude that therefore the labourer in some manner should "own" more of the profit that his labour has produced.

The modern Utility theorists, however, would provide a different explanation. And one much simpler to understand, since it aligns more directly with the sense in which profits is the difference between income and expenses. A producer can sell some item for a price greater than his costs, and thus make a profit, if and only if there is a consumer in the market who is willing to pay the price asked. Assuming that there is no alternative product available at a lower price, a consumer will pay the price asked if and only if he considers the product being acquired to have a greater utility to him (than any other product that could be acquired with that money). Thus, the source of profit is the excess utility (in excess of the alternatives) that has been provided to the consumer through the process of production. The unavoidable ethical implication of this accounting approach, is the conclusion that the source of profits is the production process that made this particular product more useful to the consumer than some alternative. And the logical corollary is that the contributor of the organization, initiative, innovation and creativity that created the excess utility in some manner should "own" more of the profit that his efforts have produced.

(8) There is the problem of explaining the level of wages. The wage is the price of the right to use labour power, and this price in Marx's theory is in the long run a function of value - of the labour required to produce and maintain a labourer. Marx expects the long-term wage to be below value for various reasons, e.g. because the gale of innovation creates and recreates a reserve army of unemployed. But marginalists say there is no reason why there should be any particular relation between wages and the quantity of labour needed to produce the labour, unless it is assumed that labourers are produced like other commodities are, to make a profit: and then the relation will be explained best by the interaction of supply and demand as the marginalist theory explains it. It is to some extent true that labourers are produced as commodities for profit (supply of their training, recreation, and so on may be influenced by commercial considerations), but not true enough to make the labour theory of value realistic as an account of wages.

Further, the labour theory cannot explain why more talented workers get a higher wage. The additional value of a trained worker's labour power may be due to the extra labour required to produce it, i.e. in training; but talent is not deliberately produced in this way, as a commodity, yet fetches a higher return. This requires no special explanation in the supply-and-demand theory, and labour theorists can deal with it only, once again, by falling back on supply-and-demand.

(8) The essential long-run conclusions of Marx's theory seem to be those concerned with the dynamics of capitalist society, with how such a society is likely to develop over time. These are the predictions about (a) the falling rate of profit; (b) the centralization of capital; (c) the immiseration of the working class; and (d) the likelihood of frequent and intense crises. Marx's argument to these conclusions starts essentially at the point where he explains why capitalists introduce machinery and seek foreign markets. He explains that the capitalist who has a new method which requires much less labour than the normal method will introduce it because the exchange value of the commodity produced will still be set by the amount of labour necessary by the normal method.

But at this point modern economists will make an objection not especially connected with the marginalist theory, but relevant on either theory. That is that there is no reason to suppose that every innovation must increase the ratio of constant to variable capital, or for any other reason lead to a fall in the rate of profit. Some innovations (e.g. replacement of steam engines with electric power, and innovations in communications and electronics, and the green revolution) make it possible to produce or do more with less investment in machinery. It seems impossible to predict any overall trend in one direction or another. We can't say in advance whether in future more, or less, capital will be tied up in the production of the commodities we know about, or in others yet to be invented. (What is invented depends not just on what ideas people happen to have, but also on what needs are perceived, which depends partly on perceived possibilities of making profit.)

If there is no trend to a higher ratio between constant and variable capital, then there is no reason even on Marx's theory to predict a falling rate of profit. The modern economist will add that in any case what he calls profit does not depend on the ratio of labour to other factors of production. There will be profit as long as there is the possibility of innovation, and as far as we know there is no fixed ceiling of possible innovation. Profit in this sense will still do what profit does in Marx's system, namely motivate new investment; so the difference in meaning here makes no difference: assuming that there will always be possibilities of innovation there is no reason to expect the capitalist economy to stagnate.

Neither is there any reason to expect increasing centralization. This expectation rested on the assumption that innovation would make industry more and more capital intensive, and that the falling rate of profit would make larger and larger investment necessary to yield the same absolute return: small people would increasingly not be able to make a living as owners of businesses and employers. In every crisis some of them would be swallowed up by larger rivals. But if there is no trend to greater capital intensiveness, no trend to lower profit rates, there is no reason why smaller business should disappear. It may be a true generalization that in a given line of business small businesses amalgamate or are taken over, but there is not just a finite number of lines of business. Innovation may at any time open a new kind of possibility, which small capitalists may move into. (E.g. the beginnings of the computer industry: no chance these days of starting up your own coal mine, cotton mill, iron works, the growth industries of the early 19th century; but there are new possibilities not anticipated then.)

And contrary to any trend to an immiseration of the working class, the economic history of capitalism over the past 200 years clearly indicates a strong trend in the other direction. Marx suggests that pressures on capitalists to maintain their profit levels will result in efforts on their part to reduce the proportion of the labour-value that is returned to working class as wages. Marx also suggests that as a consequence of the pressures to increase the proportion of fixed capital employed, there will be a tendency to relegate more of the labour force to the unemployment lines. But neither of these trends, or the suggested underlying pressures, have appeared in the historical record. And Marx's theories have difficulty in easily explaining the dramatic dis-immiseration of the working classes. Whereas the existence of such a trend, and the presence of those pressures on capitalists that create this trend, are the obvious and easily understood consequences of the Utility theory of value.

Capitalists want to maximize profit (both Marx and the Utility theorists agree). Profit is excess utility (excess over the alternatives). To maximize profits is to maximize utility. To create profit is to create utility. So to make a profit, the capitalist must orchestrate the creation of more utility for his consumers than any available alternative. But utility is by definition just the relief of misery, the alleviation of discomfort, the creation of happiness and satisfaction. And the consumers are also, by strength of numbers, the working-classes. So other words, capitalists want to maximize the dis- immiseration of the working classes.

Instead of having to explain what economic forces are taking place to reverse an anticipated trend towards the immiseration of the working class, the Utility theory of value predicts a trend to the dis-immiseration of the working class.

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References

(A collection of some of the sources for the material contained herein.)

Capital (Volumes I, II, and III); by Karl Marx; Vintage Books Edition, 1977.

The End of Capitalism and the Triumph of the Market Economy; by James C. Bennett;
an excerpt from Network Commonwealth: The Future of Nations in the Internet Era.

The Marginalist Theory; by B.J. Kilcullen; Macquarie University, POL264 Modern Political Theory.

The Wealth of Nations; by Adam Smith. Random House, 1994.

The Principles of Political Economy and Taxation (1817), by David Ricardo.

Essay on the Principle of Population; by Thomas Malthus.

Principles of Political Economy (1848); J.S. Mill.

Economic Calculation: The Austrian Contribution to Political Economy; by Peter J. Boettke, New York University.

Human Society and the Global Economy; by Kit Sims Taylor; (Chapter 6 - Theories of Value).

Communism: A New Critique and Counter-Proposal; author unknown.

The Labour Theory of Value - An Analysis; by Don Ernsberger, Edited by Jarret B. Wollstein

Utilitarianism; by Gareth McCaughan

What is Individualism; by Raymie Stata

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Boettke, Peter, and Prychitko, David., eds. (1996) Advances in Austrian Economics, Vol. 4: 3-91.

Buchanan, James M. (1969) Cost and Choice: An Inquiry in Economic Theory (Chicago: University of Chicago Press, 1978).

Dobb, Maurice (1973) Theories of Value and Distribution Since Adam Smith: Ideology and Economic Theory, Cambridge University Press, 1973.

Hayek, F. A. (1935a) "The Nature and History of the Problem," in F. A. Hayek, ed., Collectivist Economic Planning (New York: Augustus M. Kelley, 1975[1935]).

Hayek, F. A. (1935b) "The Present State of the Debate," in F. A. Hayek, ed., Collectivist Economic Planning (New York: Augustus M. Kelley, 1975[1935]).

Hayek, F. A. (1940) "The Competitive "Solution'," in F. A. Hayek, Individualism and Economic Order (Chicago: University of Chicago Press, 1980[1948]).

Hayek, F. A. (1945) "The Use of Knowledge in Society," in F. A. Hayek, Individualism and Economic Order (Chicago: University of Chicago Press, 1980[1948]).

Hayek, F. A. (1988) The Fatal Conceit: The Errors of Socialism (Chicago: University of Chicago Press).

Hayek, F. A. (1994) Hayek on Hayek: An Autobiographical Dialogue, Stephen Kresge and Leif Wenar, eds. (Chicago: University of Chicago Press).

Heilbroner, Robert (1988) Behind the Veil of Economics: Essays in the Worldly Philosophy, W.W. Norton, 1988.

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Mises, Ludwig. (1912) The Theory of Money and Credit (Indianapolis: Liberty Fund, 1980).

Mises, Ludwig. (1920) "Economic Calculation in the Socialist Commonwealth," in F. A. Hayek, ed., Collectivist Economic Planning (New York: Augustus M. Kelley, 1975[1935]).

Mises, Ludwig. (1922) Socialism: An Economic and Sociological Analysis (Indianapolis: Liberty Fund, 1981).

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Salerno, Joseph. (1996) "A Final Word: Calculation, Knowledge, and Appraisement," Review of Austrian Economics, 9, no. 1: 141-42.

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