Question

1. Briefly explain the labor theory of value. Is the labor theory of value consistent with the supply and demand model developed by Alfred Marshall?   

Answer 1

The labor theory of value (LTV) was an early attempt by economists to explain why goods were exchanged for certain relative prices on the market. It suggested that the value of a commodity was determined by and could be measured objectively by the average number of labor hours necessary to produce it. In the labor theory of value, the amount of labor that goes into producing an economic good is the source of that good's value. The best-known advocates of the labor theory were Adam Smith, David Ricardo, and Karl Marx. Since the 19th century, the labor theory of value has fallen out of favor among most mainstream economists.

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 (LTV) states that the value of economic goods derives from the amount of labor necessary to produce them.
• In the labor theory of value, relative prices between goods are explained by and expected to tend toward a "natural price," which reflects the relative amount of labor that goes into producing them.
• In economics, the labor theory of value became dominant over the subjective theory of value during the 18th to 19th centuries but was then replaced by it during the Subjectivist Revolution.

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.

They took the simplified example of a two-commodity world consisting of beaver and deer. If it is more profitable to produce deer than beaver, there would be a migration of people into deer production and out of beaver production. The supply of deer will increase in kind, causing the incomes in deer production to drop—with a simultaneous rise in beaver incomes as fewer choose that employment. It is important to understand that the incomes of the self-producers are regulated by the quantity of labor embodied in the production, often expressed as labor time. Smith wrote that labor was the original exchange money 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 exchange 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.

Marshall enriched the analysis of the demand curve, with rigorous definitions of elasticity and consumer surplus. He preferred to focus on the case of partial equilibrium, thus invoking numerous ceteris paribus conditions so as to isolate cases of comparative statics. Money income, for example, was held constant, as were the prices of all other commodities. Such simplifications, while unrealistic, were nonetheless insightful. To Marshall's credit, he struggled throughout his life with the trade-off between theory and empirical veracity, and left numerous accounts of these inquiries.

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.