Classical Value Theory (Part 3 of 5)

Smith chose labor employed as the common denominator of the supply side elements of price determination (i.e., valuation.) It is worth noting that Smith’s value theory (and Ricardo’s, too) only fits the case where long run costs of production are constant and not increasing or decreasing (Ekelund & Hébert, 1997). Wages vary between different types of jobs and skills -- especially between services and commodities. Smith did not produce a satisfactory explanation of the theory of determination of wages, rent, and profit. Unfortunately, too, Smith’s theory of natural value (like Ricardo’s) is circular in that it explains prices of goods with prices of factors of production, some of which are goods themselves. On the other hand, a complete theory of value should explain the cause and determination of payments for labor, capital, rent, and profit. Smith effectively argued that in a mobile and communicative society, that efficiency of the market arises and these forces have a significant effect on the actual market price. On the subject of market forces, Smith noted that effectual demand is different than regular demand in that it represents aggregate desire to purchase plus purchasing power. Effectual demand is the total demand of buyers who are willing to pay the natural price. With respect to value, unlike the Physiocrats, who lacked a coherent theory of value, Smith’s economic system rested on sound microeconomic foundations.

Ricardo argued for a real cost theory of value that emphasized labor as the primary cost. With this position, he could base his value theory and economic system on a single dominant variable that would allow for sweeping general conclusions. He thought that each unit of labor applied toward the production of a good should be reflected in the value of the good. Each unit of labor not applied would of course lower the value of the good. Scarce or non-reproducible goods were exceptions to this rule because they possessed value in exchange possibly without the associated labor. Investments in factors of production such as capital equipment were viewed by Ricardo as embodied labor that added value to the good. Ricardo understood that capital employed at different times should have the time value of money considered in its application. Ricardo did not adjust the value of labor (i.e., wages) for qualitative differences such as ingenuity. Furthermore, Ricardo, like Smith, seemed to miss the point that the relative measurement of qualitative differences and changes in the market price for labor would affect exchange value. In that sense, he was thinking of the short term effects instead of the long-term effects. Probably the most obvious mistake by Ricardo was that he did not consider the role of demand in determining prices for non-commodity goods. Within a demand framework, competition affects prices and actual value.

Smith and Ricardo both viewed long run costs or production to be constant and did not allow for the continual adjustments in the markets for differences in wage costs. Some labor may be less skilled than other labor. Still, some of the labor may be more easily obtained than other labor. Ricardo assumed constant average costs of production, primarily labor, in the long run. Where Ricardo also failed was in not realizing that not all labor involved with the production of a good or service produces an increase in utility value (i.e., demand.) All of these assumptions led to a system that pegged value measurement at the point of long run costs of production while ignoring the effect of short-term economic realities. In summary, Smith’s theory of value treats a special case where a firm, in general, faces static long-term costs of production. Note that labor as a cause of value might actually be under or overvalued in this instance.

Reference

Ekelund, R. B., Jr., & Hébert, R. F. (1997). A history of economic theory and method (4th ed.). New York: McGraw Hill.