As values, all commodities are only definite masses
of congealed labour time.
- Karl Marx
The value of a thing is just as much as it will bring.
- Samuel Butler
One of the enduring questions of economics is "Where do profits come from?" One of the ways in which economic philosophers have tried to answer it is by first answering the question of value. At the center of most economic paradigms is a Theory of Value. The classical political economists found value to be determined in production; since most of the cost of production could be reduced to labor, this approach was refined into the Labor Theory of Value. Neoclassical economists looked for value in the market act of exchange and developed the Marginal Theory of Value. Both of these theories are currently under challenge by the post-Keynesians with their Sraffian Theory of Value [1: Note], which, like the labor theory of value, is based on production rather than exchange. Any theory of value in economics is an extremely abstract formulation: in fact, value theory is the major intersection between economics and philosophy. In other words, this chapter is not easy reading. [2: Note]
But it is essential reading. Theories of value are at the heart of two of the major themes identified in Chapter 1: the distribution of wealth and income and the maintenance of microeconomic order. If we were all self-sufficient in our material lives there would be no problem of economic value. I would produce and consume what I value and you would produce and consume what you value. But most of what each of us produces is consumed by others and most of what each of us consumes is produced by others. So the value of what you produce in terms of the conditions under which it can be exchanged for the things you consume will determine the level of your material life.
What is the source of profit? The philosophers and others now
known as the classical political economists started by investigating
two central economic questions: what causes an economy to grow;
and what determines the distribution of income into
its three forms of wages, rent and profit. Profit is certainly
a factor in economic growth. Economic growth requires investment.
Profit is both the goal of most investment activity and
a major source of investment funds. And, since profit
is itself one of the three forms of income, we cannot go very
far in an investigation of either the distribution of income or
economic growth without a grasp of the sources of profit.
Value vs. Price
Profit occurs when a firm sells a good or service for more than it cost to produce. So we should be able to understand profit by understanding the prices of the goods and services the company sells and the prices of the inputs, including labor, that the company buys. However, the term price usually connotes something temporary. Price may rise or fall based on temporary shifts of demand or even on changes in the weather. It did not take a professor of Moral Philosophy to analyze how a weather-induced reduction in the wheat crop drives up the prices of wheat and bread. Nor was it necessary that the wheat farmer had read The Wealth of Nations in order to understand that this year's wheat prices were exceptionally high. In fact, the wheat farmer probably held some concept of what the 'normal' price of wheat would be, absent the fluctuations that can be attributed to war, weather or other temporary factors.
It is that 'normal' price that begs for explanation, not the day-to-day price. So economists need a term that embodies the concept of the price that something would be if it were not for all these troublesome variations in demand, weather and so forth. A twentieth century economist might use long-run equilibrium price to express this concept. Other terms that have been used are natural price (Adam Smith), value-in-exchange, exchange value, exchangeable value and prices of production. Generally, after warning the reader that we mean value in terms of what other things the good could be exchanged for (value-in-exchange) and not the inherent usefulness of the good in terms of meeting our needs or desires (value-in-use, or use value), we use the term "value."
One way to grasp the difference between value and market price is to think of the water level in the ocean at a particular time as a price. It goes up and down with the tides. It is also subject to the more random movement of waves and other disturbances, yet these movements will gravitate around the level determined by the tides. The tides, then, are analogous to value, even though the actual price at any moment will be higher or lower than the value.
Value lies at the core of the economic adjustment process. If the actual price of something were above the value, the extra profits to be made would attract more firms into that industry leading to a greater supply and - eventually - lower prices; conversely, if the actual price of something were below the value, the losses - or sub-normal profits - would drive firms out of that industry leading to a smaller supply and - eventually - higher prices. Thus value was identified as the element which organized the economic life of society, as the basis for deciding what to produce, how to produce it and who gets it. The problem, of course, was to understand how value itself was formed.
The search for a theory of value is really a search for a consistent foundation for economic theory. It may have limited immediate worth in answering questions of economic policy or understanding the day-to-day or even the month-to-month movements in various prices. In fact, we can accomplish much of this without a consistent theory of value. A house without a foundation is of more immediate use than a foundation without a house. But the classical political economists were looking at the economy over the long term and thought it important to start with a solid foundation.
Before examining different theories of value, it is useful to
state our objectives. What do we want our foundation to do for
The starting point of theories of value, at least of the theories of value we are examining here, is a capitalist economy in long-run equilibrium. By long-run equilibrium we mean that all firms, workers and consumers have been able to adjust their output and/or their purchases to any and all changes in technology or tastes. Of course this is unrealistic. In any real economy, shifts in demand and changes in technology occur before firms have fully adjusted to the last changes. But it allows 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. The student of human anatomy can investigate human structure by examining an actual human skeleton. Lacking cadavers, economists must hypothesize the skeletal structure of capitalism. The selection and logical analysis of appropriate stylized facts is our substitute for an X-ray photograph of the skeleton of living capitalism.
We will also assume sufficient competition so that the rate of profit will be the same in all industries. Again, this is terribly 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 which are 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. Our defense for making sufficient competition part of our set of stylized facts is twofold. First, we are trying to understand what forces give rise to profit in general. The differences in profit rates among firms or industries is a somewhat different problem. Certainly we expect to find higher rates of profit in the industries where there is the least effective competition. Second, if we cannot understand how prices and profit rates are formed under the simplest of conditions, we cannot hope to understand them under more realistic conditions. The anatomist must develop a concept of an ideal skeleton before being able to use skeletal remains to identify disease or malnutrition.
The core of all our models is a highly simplified capitalism. It is an economy that is sufficiently competitive that all firms will have fully adjusted their outputs and use of inputs to all demand and technological conditions.
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 labor was itself equal to the value of the goods and services that a working-class family needed in order to get by.
Adam Smith found 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, labor 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. [3: Source]
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. [4: Source]
By "quite different principles," Smith means that the worker is paid by the hour of labor 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. [5: Source]
The real value, then, of any commodity, will be the sum of the labor cost and the profit plus any rent. Even though the capitalist purchases raw materials as well as labor, the raw materials - and anything else the capitalist purchases from other capitalists - can in turn be broken down into labor, profit and rent.
Adding Up of Costs We can fabricate a simple example along the lines suggested by Smith. A capitalist in the pig-raising business produces 1,000 pigs per year. Their value can be determined by adding up the capitalist's normal costs. There are 50 laborers at £20 per year each, for a total direct labor cost of £1,000 per year. Raw materials run £600 per year. Replacement of worn out tools and building repair (depreciation) comes to £50 per year. This enterprise requires 100 acres of land at £2 per acre per year, or £200 per year in land rent. The capitalist will need to have a total of £1,500 tied up in the business. Some of this will represent investment in buildings and tools, but most of it will be operating capital - workers and suppliers have to be paid before the capitalist sells the pigs. If the normal profit rate is 10%, our capitalist will need to get £150 per year as "compensation" for having £1,500 tied up in the business. Since the total costs, including the £150 of profit, come to £2,000 per year, the natural price of pigs will be £2 per pig.
Note that labor makes up most of the cost. In this example, direct labor is only half of the total cost. But if we opened the books of the businesses that supplied the raw materials and replaced the worn out tools we would find their costs can also be broken down into labor, profit, rent and supplies. Then we could look into the costs of their suppliers, and so on. About one-third (actually, 32.5%) of the costs in this example - raw materials and replacing worn out equipment - are subject to this process. If the costs in these supplier industries are proportional to the costs in the pig industry, [6: Note] then half of these supply costs could be attributed to labor, then half of their supply costs, then half of those firms' supply costs. When we add it all, we find that labor costs are close to 75% of total costs; considerably higher than the 50% figure that we get by only looking at direct labor costs.
The Value of Labor The next step is to investigate the value of labor 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. [7: Source]
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 labor 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. [8: Source]
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 neighbors 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. [9: Source]
Yet there were sometimes forces leading wages upward. Rapid economic growth can create a shortage of labor. 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 labor and the supply of labor will eventually be won by the supply of labor and wages will once again fall to the "lowest rate which is consistent with common humanity."
Additionally, labor of greater skill or difficulty will itself take on a natural price in terms of common labor:
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. [10: Source]
The Role of Value Value, or "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 labor costs,
rent and profit. Labor has its natural price, which is the cost
of the goods and services the workers need in order to work and
raise families. But how is the natural rate of profit determined?
Or the natural rate of rent? Smith has not provided us with
either an economic or sociological principle which would establish
either of these rates. He leaves us with an incomplete theory
Ricardo's Labor 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. [11: Source]
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 labor 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... [12: Source]
Ricardo planned to develop a rigorous theory of value. Rather than make his theory fuzzy enough to encompass the value of all goods, he would exclude 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. [13: Source]
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. [14: Source]
Ricardo was much more consistent than Smith. Smith had identified labor as the major factor responsible for natural price. But Smith's measure of labor itself varied from chapter to chapter. Sometimes it was the amount of labor needed to produce the product; sometimes it was the amount of labor that could be hired for an amount of money equal to the value of the product; sometimes it was the value of the goods and services that the worker could purchase with his wages.
A Measure of Value 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 labor itself. If new farming and/or baking technology reduce the value of bread, then the value of labor will also fall since the worker's capacity to work can be "produced" at a lower cost. [15: Note]
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. Remember, Ricardo's project was to discover which economic forces determined the distribution of income. The best candidate for such a measure was labor. If profits rose and wages fell, or if profits fell and rents increased, it would still require the same amount of labor to weave a bolt of cloth or to build a ship.
The Level of Wages Ricardo's theory of wages was similar to Smith's, but much more severe. Thomas Malthus, Ricardo's good friend, 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 (and 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. [16: Source]
The Theory of Rent 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 labor 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 labor 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 labor 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 differences in costs reflect differences in the amount of labor required.
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 which will be developed in Chapter 7. For now, we must understand how this theory of rent fits into Ricardo's labor theory of value. Ricardo was able to show that the value of agricultural commodities, just like the value of manufactured commodities, is determined by the amount of labor it takes to produce them. The difference is that, with agricultural commodities, the value is governed by the amount of labor required under the most unfavorable circumstances - that is, by the amount of labor 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.
A Labor Theory of Value It all fits together into a fairly complete and consistent theory of value. Value is determined by the amount of labor needed for production, including, of course, the labor 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 labor 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 labor 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 labor theory of value. It would only work well as a theory of natural price if the ratio of labor costs to capital costs was the same in all industries. Labor could not be an invariant standard of value when some industries used lots of labor and little capital while others used lots of capital and little labor, 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. We will return to it later in this chapter. Nonetheless, Ricardo's labor 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. [17: Source]
For the most part, Karl Marx worked within the framework of David Ricardo's labor theory of value. The two most important differences were Marx's emphasis on fixed capital and his use of the labor theory of value to identify the source of profit. However, Marx used the labor theory of value to project capitalism's path in a way not anticipated by Ricardo: this aspect of Marx's thinking will be examined in Chapter 11.
Like Ricardo, Marx started by adding up all of the direct and indirect labor used. The value of something that requires 10 hours of direct labor plus raw materials that took 12 hours of labor to produce plus 1/1,000 of the life of a machine that took 5,000 hours of labor [including raw materials and tools] to make would be 'worth' 10 [labor] + 12 [materials] + 5 [depreciation of capital] hours of labor, 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 labor, 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.
The Value of Labor Labor is different. If the value of anything is the amount of labor it took to produce it, we need to ask: What is the value of labor? The value of labor is itself the amount of labor 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, labor 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 labor is the money equivalent of just that-6 hours of labor. And the value of his labor 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 labor.
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 labor 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 labor, she could
still only sell it for the equivalent of 27 hours of labor because
that is how much labor 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.
The Transformation Problem
Still, Marx had not been able to resolve Ricardo's difficulty with using labor as a standard of value. Even if Marx's version of the labor theory of value was useful at a macroeconomic level, in that it could presumably identify the forces that determined the total amount of profit that the economic system would generate, it still had a major failing as a theory of natural price. Let us compare two industries. One, shirtmaking, uses a lot of direct labor and very little capital equipment. The other, petroleum refining, uses lots of capital and very little labor. If we tried to apply Marx's version of the labor theory of value in these instances, the natural price in each case would be equivalent to the total amount of labor used. The profit would be equal to the value of the direct labor 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 shirtmaking firm would generate a lot of profit, and since it required little investment, the profit rate would be high indeed.
Of course this couldn't happen. Even if it did, it 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 capitalism. Moreover, the differences in surplus value between the industries in the example above 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 labor-intensive industry, simply because the most capital-intensive industries are usually oligopolistic.
Marx certainly recognized the problem. Unlike Ricardo, Marx was also investigating the effects of technological change on a capitalist economy. So differences across industries in labor or capital intensity (which Marx called the "organic composition of capital") could not be ignored. Labor values (the adding-up of the amount of labor 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 labor 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 labor 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 labor 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 labor value of that industry's output. In a labor-intensive industry such as shirt-making, a normal return on investment will occur when the product price is below the labor value. We can envision an "average" industry - average in terms of the mixture of labor and capital - in which labor 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 labor, produce goods and sell them. Industry 'A' purchases goods which took 80 hours to produce and hires 20 hours of labor to produce the finished good. It will have a value of 100 hours of labor. Industry 'B' purchases goods which took 20 hours to produce and hires 80 hours of labor to produce the finished good. It also will have a value of 100 hours. Using the labor theory of value, good 'A' is equal in value to good 'B.'
But how much does each capitalist get? If the cost of labor is 60% of its value, that is if the capitalist can hire 10 hours of labor by paying the worker enough to buy goods and services that took 6 hours to produce, then the direct labor costs of these two capitalists vary considerably. Remember, their suppliers sold the inputs at their full value. If the value of one hour of labor is $1.00 (but the purchase price of one hour of labor is $0.60) the capitalists of industry 'A' each earn a profit of $8.00 by paying $12.00 for labor 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 labor 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 labor). They earn a 9% return. The captains of industry 'B' only invest $68.00 ($20.00 for materials and $48.00 for labor). 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 labor intensive industry is earning a higher profit rate than the more capital intensive industry.
Marx thought that he could arithmetically "transform" labor 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 labor 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.
Many mathematically-inclined Marxists have found ways to transform labor values into long-run prices, but each method requires its own set of assumptions. All are quite complex. None are particularly flexible. The most elegant solution of the problem posed by different "intensities" of capital and labor is the Sraffian solution which will be examined later in this chapter. But Sraffa's solution, while it shares much of its structure with Ricardo's and Marx's formulations, is decidedly not a labor theory of value.
The neoclassical paradigm has many roots. One is the difficulty, as noted above, of actually using the labor theory of value as a theory of long-run relative prices. Additionally, the labor theory of value looked like a hodgepodge of not quite comparable elements. There was the main theory which covered easily reproducible goods and services. There was another version - the theory of rent - that had to be used for the products of farms and mines. Some items were of fixed supply - first editions of Ricardo's The Principles of Political Economy and Taxation for example - and their pricing was completely outside the orbit of the labor theory of value. And then there was labor itself. By the 1870s, 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 was no longer sensible.
Nor could the ideological implications that some drew from the labor theory of value be ignored. Many turned the term itself into an assertion that labor created all value and was therefore entitled to all value, or at least entitled to a much larger share than labor 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. Class was posed against class in a struggle over income. The economic gains of one class were the losses of another. The times were ripe for a new theory of value.
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 landrent 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. 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. We have encountered this sort of activity in Chapter 4 while examining the operation of markets. The only difference is that there we were investigating how these forces work as an adjustment process, to adjust output to changes in demand or to changes in technology. In this chapter, we are exploring how the neoclassical economists used these forces as the foundation of a theory of value.
On the surface, at least, this is much simpler than the labor theory of value. 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 labor theory of value. What you see is what you get. The value to the consumer of the last unit consumed (the marginal unit) - 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.
Another requirement of this theory is that supply and demand forces be completely independent of each other. The only connection between supply and demand is price. This does not usually present a problem when we are studying the value of one good at a time. An increase in the utility that we derive from owning refrigerators can only affect the supply of refrigerators through the prices we are willing to offer. The marginal theory of value is at its best in what is called a "partial equilibrium" framework: we examine the formation of value in one market at a time while assuming that all other markets are changeless.
A Single Theory of Relative 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. It also shifted the attention of economists away from social classes to individuals. 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 labor, the use of 160 acres of Iowa farm land for a year, or the use of a million dollars for a year, 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 marginal theory of value fit well with the shift of economics to a narrower focus. Instead of originating in production, value now emerged from exchange - from demand intersecting with supply, from the two blades of the scissors in Alfred Marshall's famous metaphor. The adoption of the marginal theory of value allowed economists to more closely examine the little question of price but steered them away from the big questions of income distribution and economic growth that had been at the center of classical economics.
Joan Robinson, one of the 'big question' economists of the 20th century - who had herself been one of Alfred Marshall's students - noted the link between theories of value and the questions we ask:
For Ricardo the Theory of Value was a means of studying the distribution of total output between wages, rent and profit, each considered as a whole. This is a big question. Marshall turned the meaning of value into a little question: why does an egg cost more than a cup of tea? It may be a small question but it is a very difficult and complicated one. It takes a lot of time and a lot of algebra to work out the theory of it. So it kept all Marshall's pupils preoccupied for fifty years. [18: Note]
The same marginal concept can be applied to the distribution of income. A business hires labor, 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 labor, 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 labor, land and capital. If we can assume that the 200th hour of labor per week by the workers in a small firm adds less to output than the 199th hour of labor; 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 labor 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.
From the perspective of an individual firm this makes some sense, -assuming that the firm actually can calculate the marginal productivities of all factors of production at all feasible levels of output. But when we apply this to the economy as a whole, we run into more serious problems. As an example, let the marginal productivity of labor fall for some reason (in the overall economy). This will reduce the demand for labor and, according to this theory, wages will fall. But as wages fall, demand for products falls, and the marginal productivity of labor will fall further. When we deal with aggregate markets, such as the market for labor in general, it is impossible to maintain the "all other things remaining the same" conditions that are so useful when we look at one little market at a time. This is one of the reasons that John Maynard Keynes invented macroeconomics in the 1930s.
A further difficulty with using the marginal theory of value as a theory of the distribution of income occurs when we look at profits. The profit rate, according to this theory, should be equal to the marginal productivity of capital - that is, to the value of the additional output that comes from employing the last (or marginal) unit of capital. It was not until the 1950s, when Joan Robinson asked her famous question "What the #### is a unit of capital?" that the inherent meaninglessness of this concept was realized. Measuring the marginal value of anything requires that we have a physical measurement. We can measure labor in hours or land in acres. But there is no physical unit in which we can measure capital. This is one of the reasons that Robinson and others started developing post-Keynesian economics.
Piero Sraffa (1898-1983) was intrigued by Ricardo's failure to find an invariable standard of value and spent much of his working life on that problem. He had been an early critic of neoclassical economics. In a 1926 article he demonstrated both the illogic and the irrelevance of one of the foundation blocks of neoclassical economics, the assertion that costs increase as output increases. [19: Source] At Cambridge in the 1930s, Sraffa became part of the inner circle, known as "the circus," that included John Maynard Keynes and Joan Robinson. In the process of editing the ten volume Works and Correspondence of David Ricardo, Sraffa discovered some long-lost notes which represented Ricardo's final explorations of the value problem. After a 30-year gestation period, Sraffa's own solution finally appeared in 1960 as a thin book full of equations with the off-putting title of Production of Commodities by Means of Commodities.
Aside from providing an elegant solution to a problem that neither Ricardo nor Marx had been able to resolve, Sraffa's theory of value quickly took center stage in several ongoing economic debates. The post-Keynesians had just begun an attack on the misconceptions underlying the neoclassical formulations of capital: Sraffa provided a more depictive construction. Institutionalists had long claimed that social and political factors - political power in particular - were major determinants of the distribution of income: Sraffa provided a logical model which showed the distribution of income to be exogenous.
The Nature of Capital Capital is essentially past labor. Marx had recognized that when he called it "dead labor." But there is a bit more to it. Capital is a product of labor that has been held over time. Consider an oak cask for the aging of rum. The cask-maker must purchase oak, apply some labor, allow the oak to age, then apply more labor in order to finish the cask. For the cask-maker, it is a final product. But to the rum distiller it is a piece of capital. The distiller purchases the cask, the sugar cane, much other equipment, and labor. Six years later, the distiller purchases bottles and some more labor and is able to sell the product. The cask, the cane-grinding equipment and the distilling and bottling equipment are all forms of fixed capital. They are all also products of labor. The unaged rum is also a product of labor, but a product which cannot realize any return for six years. The distillery workers will have to be paid when they squeeze the cane and distill and cask the rum. Lets say that this comes to 100 worker-days of labor. The final price-of-production of the rum will take into account this wage bill and the going rate of profit compounded over six years. If labor is $5 per day and the profit rate is 8%, the value of that labor six years hence is $500 x (1.08)6 or $793.44.
We could repeat the same exercise with the cask. This gets a little more complicated, since at the end of six years we still have a - now slightly used - cask. The grinding and distilling equipment is even more complicated since it has presumably been used in the interim to produce many batches of rum. But the idea is the same: products of labor held through time become capital. The capital may be all "used-up" when the rum is sold, as in the case of the labor used to crush the cane, distill the juices, and fill the casks. Or the capital may only be partially used-up (depreciated) when the rum is sold.
Stylizing Time The difficulty in working this conception of capital into a theory of value is in how to characterize time. Sraffa started with a hypothetical "period of production." We can be arbitrary and call it a year. At the beginning of the period of production firms purchase all of the factors of production, including labor. At the end of the period of production they sell the goods and services that have been produced. In the simple example below there is no fixed capital - all factors of production are used up in the production process. Fixed capital, however, can be incorporated into this model. For now, it is best to keep everything extremely simple in order to better visualize the structure of this stylized economy.
Inputs and Outputs The first step in building this hypothetical economy is to specify the inputs and outputs. In this example, firms will use steel, wheat, pork, coal and labor to produce steel, wheat, pork and coal. All are measured in strictly physical units: tons for the commodities and worker-years for the labor. Note that no values have yet been assumed for either labor or any of the four commodities. This not a labor theory of value.
The inputs and outputs can be placed in a grid:
So far, we have an input-output table which indicates how much of each commodity is produced and what inputs go into each commodity. The "Steel" row (set in boldface in the table), for example, tells us that steel firms use 200 tons of steel plus 50 tons of wheat plus 25 tons of pork plus 1,000 tons of coal plus 500 worker-years of labor to produce 1,500 tons of steel. The "Steel" column (also set in boldface) shows us that the steel industry uses 200 tons of steel, the wheat industry uses 300 tons of steel, the pork industry uses 50 tons of steel and the coal industry uses 500 tons of steel. In all, 1,050 tons of steel are used by these four industries. Since 1,500 tons of steel are produced in a "year," that leaves a net output of 450 tons of steel. This 450 ton net product is available to meet consumer demand or investment demand, as are the net products of the other three industries.
Nothing we have done so far is reflective of economic relationships. We have identified what are primarily technical relationships among industries. Input-output tables such as this, but on a much larger scale, were pioneered by Wassily Leontief (Nobel Prize, 1973) in the 1930s and are widely used today. Leontief's tables were used by the U.S. during World War II for economic planning purposes. When government economic planners set a target for ship production, the tables would show how much more steel would be needed to produce the ships, how much more coal would be needed to produce the steel, how much more cement would be needed to produce the coal, and even how much more steel would be needed to produce the cement needed by the coal industry to produce more steel for the shipbuilding industry.
The Economic Model To turn this into an economic model, rather than simply a technical model, some additional stylized facts must be added. The usual assumption of a single rate of profit throughout the economy will be adopted. For mathematical simplification we will assume that the capitalist needs enough money to pay for all raw materials and labor at the start of the period of production. This sum of money is his "capital." Profits are realized at the end of the period of production when the commodities are sold. This simple model has six economic variables: the profit rate (r), the wage rate (w), and a price for each of the four commodities (PS , PW , PP , PC ). Prices, wages and a profit rate allow us to turn the input-output table into a set of four equations:
(1+r)(PS·200+ PW·50 + PP·25 + PC·1000+ w·500) = PS·1500
(1+r)(PS·300+ PW·250+ PP·75 + PC·200 + w·2000)= PW·2500
(1+r)(PS·50 + PW·600+ PP·100+ PC·100 + w·600) = PP·800
(1+r)(PS·500+ PW·150+ PP·50 + PC·400 + w·1900) = PC·3000
This gives us a structural picture of the stylized economy. The capitalists in each industry start with a "capital" sufficient to purchase the inputs, including labor. If one starts with $10 million - with the period of production being one year - and then sells the output for $12 million, the profit rate is 20%.
The problem is that there is not enough information to solve this set of equations for the four prices, the wage rate and the profit rate. There can only be a unique solution to such a set of equations when the number of equations is equal to the number of unknowns. [20: Note] Here there are four equations with six unknowns. One of the unknowns can be easily eliminated. It is relative prices that we are after. So we can arbitrarily use any one of the commodities as a standard of price. By declaring the price of steel to be equal to 1, all other prices can be expressed relative to steel. Now we have five unknowns, but still only four equations.
Returning to the example above, we could arbitrarily pick steel as a standard: simply define the price of a ton of steel as $1,000. We can then solve the equations for the other prices as long as we first pick either a wage rate or a profit rate. If we use a profit rate of 10%, we can solve for the wage rate and for prices of production of the commodities. In this example, the wage is $589.36 per period of production, the price of wheat is $867.52 per ton, pork is $1,584.78 per ton, and coal is $785.96 per ton. [21: Note] Other profits rates will result in a different set of prices. We can also calculate the value of the total net product. In this case (with a 10% profit rate) it comes to $3,601, 279. Of this, 82% goes to workers as wages and 18% to capitalists as profits.
Thus far, Sraffa has offered a powerful critique of neoclassical economics. According to neoclassical theory, we should be able to solve this system of equations for profits, wages and prices. But we cannot. The neoclassical economists claimed that if we took an economy's final demand and technologies of production as givens, a particular distribution of income between labor and capital would result; that is, that there was only one 'permissible' distribution of income for any given system of demands and technologies; the distribution of income is fully determined by demand and technology. Sraffa's model provides us with technology and demand as givens. But the system as it stands is not determinant.
Income Distribution is Exogenous The solution is obvious. It is only the neoclassical insistence that the distribution of income is endogenous that gets in the way. If we accept the precept that some non-economic forces determine how the net product gets divided between capitalists and workers, the problem disappears. Pick a wage rate - remember, classical political economy assumed wages would tend toward a socially determined subsistence - and there are four unknowns and four equations. Or pick a rate of profit. Once we bring in either the wage rate or the profit rate from outside the economic model, a bit of tedious math solves this set of equations for the prices of production. We can also use this model to solve for certain limiting cases. Set the profit rate at zero, and we get a wage rate and set of prices which allow the workers to purchase all of the net product. Set the wage rate at zero and we get a profit rate and set of prices which delivers the entire net product to the capitalists.
Sraffa's theory of value also has sufficient flexibility that we can make it more realistic. Fixed capital can be included by treating it as a joint product: the capitalist purchases a bulldozer, for example, at the start of the period of production. At the end of the period of production the firm has produced a one-year-old bulldozer along with the commodity that it normally produces. Or we can use different processes for producing the same product, such as different qualities of land that give rise to rent. Or we can test the effects of different profit rates in oligopolistic and competitive industries. Unfortunately, as we add realism, we lose transparency - it becomes even more difficult to visualize the structure of our model economy as it becomes more complex - leaving us still more dependent on the results achieved through the mathematical manipulation of matrices.
How close does the Sraffian theory of value come to meeting the
criteria of an ideal theory of value?
Most schools of economic thought have a theory of value at the heart of their paradigm. In addition to identifying the forces that form prices (aside from the accidental forces that have only a temporary effect), the theory of value reveals the basic structure of the paradigm. All of the theories of value that we have examined here include as part of their underlying structures the stylized fact of a tendency toward a single rate of profit as capitalist firms adjust their output to changes in demand or technology.
Both the oldest (the labor theory of value) and the newest (the Sraffian theory of value) theories find the fundamental forces of value determination to be the technology of production and the distribution of income. The current mainstream theory, the marginal theory of value, finds the determination of value in the intersection of the demand force of utility and the supply force of cost.
Ricardo and Marx used the labor theory of value to seek an understanding of the distribution of income and of economic growth. But there were serious difficulties in using it as a theory of normal price. The marginal theory of value seemed to explain normal price quite easily, but requires a huge leap of faith when used as a theory of the distribution of income. The Sraffian theory of value plays both roles well, but its structure is more difficult to comprehend. One implication of the Sraffian theory of value is that the distribution of income is caused by non-economic - presumably social and political - forces: that has made it even harder to swallow no matter how impeccable its logic since many modern economists believe that practically everything can be incorporated into the economic models themselves.
1. What are the major differences between production-based economic theories and exchange-based economic theories?
2. In what ways is a theory of value different from a theory of price? In what ways are they similar?
3. Can you think of a better name for the Sraffian Theory of Value?
4. What are the major ideological differences between the labor theory of value and the marginal theory of value?
5. Can you define a unit of labor? A unit of land? A unit of
Terms Introduced in this Chapter
Labor Theory of Value
Marginal Theory of Value
Prices of Production
Sraffian Theory of Value
Marx's works, along with those of his friend, editor and sometimes co-author Engels can be found electronically on the Marx/Engels Internet Archive. These two were prolific writers so it will be awhile before the archive is complete, but it grows daily. The archive includes an excellent search mechanism, photographs and other biographical material. This is an exceptionally well-organized website.
David Ricardo's The Principles of Political Economy and Taxation are online along with several of his essays.
Smith's The Wealth of Nations (complete text) is available online.