Saturday, January 24, 2009

Smith's Theory of Value

Isaac Moorehouse writes in The Prometheus Institute Blog an interesting article on Adam Smith’s theory of value HERE (23 January):

Was Adam Smith wrong?’

”Indeed, Adam Smith, in his depiction of the division of labor in a pin factory and his timeless prose on the invisible hand and the self-interest of the butcher, offers some of the greatest explanations and defenses of capitalism ever written, even some 230 years later. I consider Smith a great thinker, and a hero of liberty. That doesn’t mean he was never wrong; particularly when it comes to the question of value.

Smith’s thoughts on the derivation of value in his Wealth of Nations laid the groundwork in this area for later thinkers like David Ricardo (another brilliant mind who was right about many other things) and eventually Karl Marx.

Smith essentially, though somewhat confusedly, argued that the value of any good was ultimately derived from the amount of labor it took to produce. Money or commodity prices reflected only the nominal but never the real value of a good. In this way he described the different prices of different goods as a simple formula:

“If among a nation of hunters, for example, it usually costs twice the labor to kill a beaver which it does to kill a deer, one beaver should naturally exchange for or be worth two deer.” (The Wealth of Nations, Book I, Chapter VII)

Smith elaborated further by describing other costs of producing a good, including the role of the entrepreneur and capitalist and the profits they require.

The problem with Smith’s analysis is not that the cost of production has no link to the value or money price of a good – indeed, the two are closely connected. He merely had the relationship backwards.

In reality, prices reflect the money equivalent of the value a buyer places on a good. That is to say, an individual who wishes to have a good places an entirely subjective value upon that good as compared to other goods, and the difference is typically expressed in terms of money. If in Smith’s example no one cared for beavers, the cost of killing a beaver wouldn’t matter; the beaver would sell for little or nothing. There is no one value of a good, but each individual values each good differently, as compared to other goods. It is the same for Smith’s supposedly changeless measure of value, labor. An hour of the same kind of labor may be valued (or disdained) to different degrees by different people.

It is for this reason that price is merely the reflection of the amount of money an individual was willing to give up to obtain a given good in the most recent exchange.

However, Smith was correct in seeing a relationship between the cost of production and price: Once a producer or entrepreneur has an indicator of what someone was willing to pay for a good, he can speculate how much others will be willing to pay in the future. He may be incorrect, but he will start with an estimate based on past experience and hope to get an equal or higher price. It is the estimated price (which reflects the value others place on the good) that will dictate how much he can spend on production.

Smith correctly saw that the various costs which go into production must be paid by the sale price of the final good. What he failed to see is that the costs of production do not create the price of the final good or imbue it with some objective value, but that the subjective value that each consumer places on the good sends signals backwards to producers and tells them how much they can expend on production without suffering a loss.

That Smith saw the factors which go into the production of a good as the cause of the price, rather than the effect, may seem like a small error. But economics, like all attempts to study the behavior of human beings, is a subtle science which requires great attention to the correct logical progression of actions. A misunderstanding between cause and effect can be fatal.


Comments
“Adam Smith, in his depiction of the division of labor in a pin factory and his timeless prose on the invisible hand and the self-interest of the butcher, offers some of the greatest explanations and defenses of capitalism ever written, even some 230 years later.”

Comment 1:
his timeless prose on the invisible hand and the self-interest of the butcher” is problematic. He used this particular metaphor once and it becomes ‘timeless prose’.

Compare his use of another metaphor: ‘The judicious operations of banking, by providing, if I may be allowed so violent a metaphor, a sort of waggon-way through the air; enable the country to convert, as it were, a great part of its highways into good pastures and cornfields, and thereby to increase very considerably the annual produce of its land and labour’ ( WN II.ii.86: p 321).

This metaphor is surely more important than the invisible hand, yet it is not regarded as a ‘theory’, or a ‘concept’. Nor is it, surprising, regarded to offer a great explanation.

Smith essentially, though somewhat confusedly, argued that the value of any good was ultimately derived from the amount of labor it took to produce. Money or commodity prices reflected only the nominal but never the real value of a good. In this way he described the different prices of different goods as a simple formula:

“If among a nation of hunters, for example, it usually costs twice the labor to kill a beaver which it does to kill a deer, one beaver should naturally exchange for or be worth two deer
.” (WN I.vi.1: p 65)

Comment 2: This is the first of several misunderstandings of Smith on value, which is shared with many economists and many more casual readers.

Smith discusses society before the ‘accumulation of stock and the appropriation of land’, that is in primitive society when the only factor of production (using modern terminology) is the labour of the hunter. There are no owners of capital stock and no owners of land. How is the exchange value to be determined in these circumstances. The two hunters have only the products of their hunting endeavours available for exchange.

The exchange value of each item, Smith argues, can only be determined by how much of one item is exchanged for the other. It is the ratio of beaver/deer or what amounts to the same, the deer/beaver exchange ratio that is to ‘higgled and bargained’ by the two hunters. Nobody else is involved, because nobody else has any claim on the property of the two hunters.

Smith asserts that the only variable relating one good to the other is the time (effort) required to acquire the kill.

Because both hunters are in the same position, turning to each hunter’s subjective value, either as ‘buyer’ or a ‘seller’ (actually which is which?), is not a solution – that is a recipe for a long haggle! On its merits, whatever exchange ratio they settle upon, their ‘toil and trouble’ (a phrase Smith uses elsewhere for a different purpose) is likely to be an important consideration.

In reality, prices reflect the money equivalent of the value a buyer places on a good. That is to say, an individual who wishes to have a good places an entirely subjective value upon that good as compared to other goods, and the difference is typically expressed in terms of money. If in Smith’s example no one cared for beavers, the cost of killing a beaver wouldn’t matter; the beaver would sell for little or nothing. There is no one value of a good, but each individual values each good differently, as compared to other goods. It is the same for Smith’s supposedly changeless measure of value, labor. An hour of the same kind of labor may be valued (or disdained) to different degrees by different people.

It is for this reason that price is merely the reflection of the amount of money an individual was willing to give up to obtain a given good in the most recent exchange
.”

Comment 3
In bargaining transactions neither the buyer nor the seller unilaterally determines the outcome of the eventual bargain, but Isaac Moorehouse tends to present his critique of Smith from the buyer’s point of view. He has also introduced money into the transaction, which represents an entirely different mode of subsistence from that of crude transactions between hunters before other owners came into Smith’s account of exchange value.

In ‘early and rude society’, labour certainly was the unambiguous property of the labourer. He shared it with nobody else. Natural Law theory, incidentally, also dictated this to be the case (though such a theory carried no weight in such times). Ian states that “each individual values each good differently” – absolutely correct and that very essence of the bargained transaction never changed before and after the invention of money.

But I think Ian has made the same conclusion that most readers come to in the rather confusing switch back and forth among ‘early and rude society’ and those modes of subsistence, which came later in historical time, where other property owners were present.

In short, too much is made of the labour theory of value (LTV) implied in Smith’s example of the hunters. And, again briefly, there is some confusion with Smith’s use of the phrase, ‘toil and trouble’ as a psychological de-motivator, with its possible (though unintended) meaning as a sort of ‘embodied’ component of the so-called inherent value of an owned product of other property owners, landlords, labourers and stock holders.

No product, beyond ‘rude’ society has inherent value; there is only exchange value – what each party is prepared to give to get whatever else in transacted with the other. It is only in ‘rude’ society that their labour is the value of a product in exchange as far as the parties to the transaction are concerned. It is what each argues for that counts towards their subjective perception of what their own product is worth in exchange for the other’s product.

Societies moved on to the existence of property owned by others. The landlord owned the forest and all that was in it, and charged what we call rent for her permission to hunters or farmers to enter her land. The stock owner (provider of subsistence and tools) charged labourers (deducted from wages) for whatever they needed to complete their work that replaced the capital stock he had laid out, plus his profit, otherwise there was no point advancing his stock to one labourer merely to have that amount returned and nothing more – when he preferred to advance his stock to other labourers to have it returned plus a profit.

In the transactions to sell the products of the owners of the factors, land, labour, and stock, sellers are mindful of the costs that must be met for successive transactions (if they lose out in money terms, they withdraw from future transactions) and the buyers, unconcerned, because unaware, with the sellers’ costs are focussed on acquiring products that they value more than what they give up to acquire them. The ratio of what is given up to what is acquired is the exchange value of the product. Careful reading of the relevant chapters (not strings of quotations, often out of context) shows that this is Smith’s theory of exchange value and not some crude version of LTV.

Smith correctly saw that the various costs which go into production must be paid by the sale price of the final good. What he failed to see is that the costs of production do not create the price of the final good or imbue it with some objective value, but that the subjective value that each consumer places on the good sends signals backwards to producers and tells them how much they can expend on production without suffering a loss.”

Comment 4
In societies beyond ‘rude’ subsistence, Smith did not have a cost of production theory. He offered the psychological motivation of people preferring and thereby labouring to acquire the means of buying – money from rent, wages or profits – what they required or fancied because from such transactions they avoided the ‘toil and trouble’ of making them for themselves, contrasted with the hunter in the forest who laboured for his families food, for their animal-skin clothing, and for their wooden shelters. He didn’t have enough time in a day to do more than that which satisfied his and his families immediate needs.

The social evolution of ‘truck, barter, and exchange’ where it was established as a behavioural habit began to widen the availability of goods that saved them the ‘toil and trouble’ and simultaneously raised their subsistence quality.

The avoidance of the toil and trouble of making all the things they wanted was the true worth to them of other people’s products, and, crucially, what became available to them in ‘higher’ modes of subsistence which became by many quanta far more numerous than ever was available in the forest.

Brad Delong calculated that the differences between the ‘toil and trouble’ facing the Yanomamo tribe of stone-age hunters, who live beside the Orinoco River in South America, compared to the modern-age tribes of New Yorkers, who live along the Hudson River in North America, was worth in modern money about $90 for the Yanomamo hunters and about $36,000 for New Yorkers. In modern retailer’s Stock Keeping Units the Yanomamo hunters access several hundred SKUs; New Yorkers access tens of billions of SKUs (quoted in my Adam Smith: a moral philosopher and his political economy, pp105-6, Palgrave Macmillan, 2008).

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