Understanding the Labor Theory of Value: Economics Insight

What Is the Labor Theory of Value?

The labor theory of value, introduced by economists like Adam Smith and David Ricardo, posits that a commodity’s value is determined by the labor hours needed for its production. Though replaced by the subjective theory of value, it played a crucial role in economic thought and influenced figures like Karl Marx.

In-Depth Look at the Labor Theory of Value

The labor theory of value suggested that two commodities will trade for the same price if they embody the same amount of labor time, or else they will exchange at a ratio fixed by the relative differences in the two labor times. For instance, if it takes 20 hours to hunt a deer and 10 hours to trap a beaver, then the exchange ratio would be two beavers for one deer.

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

In their example using beaver and deer, if producing deer is more profitable, people would move from beaver to deer production. More people producing deer would lower deer income, while beaver income rises due to fewer producers. Self-producers' incomes depend on the labor time needed for production. Smith wrote that labor was the original exchange medium for all commodities, and therefore, the more labor employed in production, the greater the value of that item in exchange with other items on a relative basis.

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

Practical Example of Labor Theory of Value

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

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

Although the market price may fluctuate often due to supply and demand at any given moment, the natural price acts as a center of gravity, consistently attracting the prices to it—if the market price overshoots the natural price, people will be incentivized to sell more of it, while if the market price underestimates the natural price, the incentive is to buy more of it. Over time, this competition will tend to bring relative prices back into line with the natural price. This means that the labor that is used to produce economic goods is what determines their value and their market prices because it determines the natural price.

How Marxism Utilizes the Labor Theory of Value

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

Marx favored the labor theory because he thought human labor was the common factor in all goods and services trade. For Marx, however, it was not enough for two goods to have an equivalent amount of labor; instead, the two goods must have the same amount of "socially necessary" labor.

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

Criticisms and Limitations of the Labor Theory of Value

The labor theory of value has issues. One problem is that a lot of labor can be spent on making a product that has little to no value. However, a closer reading points to the fact that commodities conforming to the LTV would have both a use-value and an exchange-value, and be reproduceable. Therefore something that has no demand in the market or with little or no use-value would not be considered a commodity according to the LTV. The same would go for a unique object such as a work of fine art, which would too be excluded. It may take one person longer than another to produce some commodity. Marx's concept of socially necessary labor time does also get around this problem.

Another issue is that products needing similar labor time often have very different market prices. Moreover, the observed relative prices of goods fluctuate greatly over time, regardless of the amount of labor time expended upon their production, and often do not maintain or tend toward any stable ratio (or natural price). According to the labor theory of value, this should be impossible, yet it is an easily observed, daily norm.

However, market price and value are two different (although closely-related) concepts. While market price is driven by the immediate supply and demand for a commodity, these prices act as signals to both producers and consumers. When prices are high, it incentivizes producers to make more (increasing the supply) and discourages buyers (reducing demand), or vice-versa. As a result, over the long run, prices should tend to fluctuation around the value.

The Rise of the Subjective Theory Over Labor Theory

The subjective theory of value solved the labor theory's problems by stating exchange value is based on personal judgment of a good's usefulness. Value emerges from human perceptions of usefulness. People produce economic goods because they value them.

This discovery also reversed the relationship between input costs and market prices. The labor theory said input costs set final prices, while the subjective theory showed input value depends on potential market prices. The subjective theory of value says that the reason people are willing to expend labor time producing economic goods is for the usefulness of the goods. In a sense, this theory is the exact reverse of the labor theory of value. In the labor theory of value, labor time expended causes economic goods to be valuable; in the subjective theory of value, the use value people get from goods causes them to be willing to expend labor to produce them.

The subjective theory of value was developed in the Middle Ages by priests and monks known as the Scholastics, including St. Thomas Aquinas and others. Later, three economists independently and almost simultaneously rediscovered and extended the subjective theory of value in the 1870s: William Stanley Jevons, Léon Walras, and Carl Menger. This watershed change in economics is known as the Subjectivist Revolution.

The Bottom Line

The Labor Theory of Value (LTV) asserts that the value of goods is derived from the labor required to produce them. It was notably supported by economists like Adam Smith, David Ricardo, and Karl Marx. Despite its historical significance, the theory is now largely replaced by the Subjectivist Theory of Value, which bases value on individual perceptions of usefulness. The transition to the Subjectivist Theory marked a significant evolution in economic thought, recognizing that market prices fluctuate due to supply and demand rather than labor alone. Understanding these theories helps explain the development of economic value concepts, highlighting the shift from labor-based valuation to one focused on subjective human preferences.