Adam Smith, often heralded as the father of economics, made significant contributions to our understanding of market dynamics, particularly the spontaneous order of market-driven economies. However, not all of his theories have stood the test of time. Among his notable missteps, shared by his contemporaries, including Karl Marx, is the flawed labor theory of value (LTV) that attempts to define the worth of goods based solely on the labor involved in their production.
The LTV posits that the value—and by extension, the price—of a commodity is determined by the labor invested in its creation. Sometimes, this theory is expanded to include other production inputs, morphing into what’s known as the cost of production theory. The fundamental flaw in all these interpretations is that they view the value of goods as a direct reflection of their production costs. Modern economic thought has shifted away from this perspective, embracing a subjective theory of value. This modern approach understands value as the individual assessments of the utility of goods and services in fulfilling personal desires. The shift towards a subjectivist and marginalist understanding of value, akin to Copernicus revolutionizing our view of the cosmos, demonstrates that labor’s worth is a derivative of the value consumers place on the goods produced. In this analysis, I will explore Smith’s views before outlining the modern theory of value and its superiority over the labor theory.
In his seminal work, The Wealth of Nations, Smith articulates his belief that labor is the source of value. For instance, in Chapter 5, he asserts:
The value of any commodity, therefore, to the person who possesses it, and who means not to use or consume it himself, but to exchange it for other commodities, is equal to the quantity of labor which it enables him to purchase or command. Labor, therefore, is the real measure of the exchangeable value of all commodities.
He reinforces this notion later in the same chapter:
Labor alone, therefore, never varying in its own value, is alone the ultimate and real standard by which the value of all commodities can at all times and places be estimated and compared. It is their real price; money is their nominal price.
Smith acknowledges the complexity of measuring labor value within a monetary exchange system. He points out that not all labor is equivalent, making it difficult to gauge the effort behind producing a commodity merely by counting labor hours. He suggests that the market’s “higgling and bargaining” will eventually balance these disparities. Nonetheless, he remains adamant that labor is the “ultimate and real” standard for comparing value.
As Smith continues, he differentiates between a good’s “real” value, determined by labor, and its “nominal” price, mediated by money. In a barter economy, goods could be exchanged more directly in relation to the labor required for their production, as illustrated in his deer and beaver analogy. Yet, in a monetary economy, the money price serves merely as an estimate of labor’s ultimate value. Smith posits that labor’s value possesses a stability that fails to account for the fluctuations in nominal prices driven by changes in money value. Nevertheless, he maintains that labor is the common thread in determining the value of all goods and services.
Although classical economists, including Smith, did not dismiss the concept of utility, they struggled to reconcile it with their labor-centric view of value. This struggle is epitomized by the infamous “water-diamond paradox,” which questions why an essential resource like water is inexpensive, while luxury items like diamonds command high prices. This disconnect between utility and value highlighted the inadequacies in classical economic thought, particularly in measuring value based solely on labor inputs.
These challenges were addressed during the 1870s by three economists—William Stanley Jevons, Leon Walras, and Carl Menger—who independently discovered the fundamental insight that value is determined “on the margin.” This breakthrough, known as the Marginal Revolution, revealed that value is not derived from the total supply of a good but rather from the marginal utility of the specific unit being considered for exchange. It clarified the water-diamond paradox: the worth of a good hinges on its marginal utility, not its overall utility. Water’s marginal unit is a small fraction of the total supply, leading to lower prices, while diamonds, being scarcer, command higher values.
The concept of “thinking on the margin” has become central to economic reasoning. It entails evaluating the additional benefits and costs associated with a decision, focusing on the specific context rather than overarching totals. For example, when a student contemplates skipping a class, the relevant comparison centers on the value of that particular hour, rather than the entire course or the education as a whole. It is the marginal utility of that specific hour of class that ultimately matters.
While this approach resolves the water-diamond paradox, it poses a challenge to the labor theory of value. The emphasis on marginal benefits and costs suggests that value assessments are personal and subjective, rather than dictated by an objective standard linked to labor. This perspective aligns with the subjective theory of value, which emerged in 19th-century discussions about how individual choices dictate value based on perceived utility. The contributions of Jevons, Walras, and Menger were instrumental in weaving together the ideas of marginalism and subjectivism into a coherent theory of value.
Menger’s work, in particular, emphasizes the subjective nature of value. He defines goods based on their perceived ability to satisfy wants, distinguishing economic goods—scarce resources that cannot meet all desires—from non-economic goods. He argues that value is not an inherent quality of goods but rather a judgment made by individuals about the importance of those goods for their well-being. According to Menger, value exists only within human consciousness, shaped by our perceptions and the specific quantities of goods at our disposal.
To illustrate, consider the varying uses of a gallon of water: for drinking, watering plants, washing clothes, or cleaning a car. The perceived value of each use can vary, leading to different assessments of worth for additional gallons. The concept of diminishing marginal utility explains how the value of each successive unit decreases as it satisfies less urgent needs. This understanding aligns with the principles behind the modern downward-sloping demand curve.
In sum, the contrast between modern subjectivism and marginalism and the labor theory of value becomes readily apparent. The labor and cost of production theories of value are retrospective, attempting to find worth in the production process itself. In contrast, modern value theories underscore that value emerges from consumer perceptions about how goods satisfy future wants. As consumers, we assign value to goods, unlike the labor theory, which posits that value flows from inputs to outputs. Menger poignantly illustrates that the value of a diamond is unaffected by whether it was discovered or laboriously extracted; rather, its worth is contingent upon our beliefs about its ability to satisfy our desires.
This paradigm shift mirrors Copernicus’ revolutionary reorientation of our understanding of the universe. For Smith and others clinging to the labor theory, value was rooted in input costs. After the 1870s, however, the causality was inverted: we value goods for their potential to satisfy our needs, which in turn attributes value to the inputs involved in their creation. Thus, it is not the chef’s labor that defines the worth of a gourmet meal; it is the meal’s perceived value that renders the chef’s efforts meaningful.
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This piece was first posted at AdamSmithWorks, part of the Liberty Fund network. For more from AdamSmithWorks about the Labor Theory of Value, check out Eric Schliesser’s piece, Smith’s Labor Theory Thought Experiment.
