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A comparison of adam smith and david ricardos labor theory of value

Profits, Prices and Value What is the source of profit? The philosophers and others now known as the classical political economists started by investigating two central economic questions: Profit is certainly a factor in economic growth. Economic growth requires investment. Profit is both the goal of most investment activity and a major source of investment funds. And, since profit is itself one of the three forms of income, we cannot go very far in an investigation of either the distribution of income or economic growth without a grasp of the sources of profit.

Price Profit occurs when a firm sells a good or service for more than it cost to produce. So we should be able to understand profit by understanding the prices of the goods and services the company sells and the prices of the inputs, including labor, that the company buys.

However, the term price usually connotes something temporary. Price may rise or fall based on temporary shifts of demand or even on changes in the weather.

It did not take a professor of Moral Philosophy to analyze how a weather-induced reduction in the wheat crop drives up the prices of wheat and bread.

Nor was it necessary that the wheat farmer had read The Wealth of Nations in order to understand that this year's wheat prices were exceptionally high. In fact, a comparison of adam smith and david ricardos labor theory of value wheat farmer probably held some concept of what the 'normal' price of wheat would be, absent the fluctuations that can be attributed to war, weather or other temporary factors.

It is that 'normal' price that begs for explanation, not the day-to-day price. So economists need a term that embodies the concept of the price that something would be if it were not for all these troublesome variations in demand, weather and so forth. A twentieth century economist might use long-run equilibrium price to express this concept.

Other terms that have been used are natural price Adam Smithvalue-in-exchange, exchange value, exchangeable value and prices of production. Generally, after warning the reader that we mean value in terms of what other things the good could be exchanged for value-in-exchange and not the inherent usefulness of the good in terms of meeting our needs or desires value-in-use, or use valuewe use the term "value. It goes up and down with the tides. It is also subject to the more random movement of waves and other disturbances, yet these movements will gravitate around the level determined by the tides.

The tides, then, are analogous to value, even though the actual price at any moment will be higher or lower than the value. The Search for a Foundation Value lies at the core of the economic adjustment process.

If the actual price of something were above the value, the extra profits to be made would attract more firms into that industry leading to a greater supply and - eventually - lower prices; conversely, if the actual price of something were below the value, the losses - or sub-normal profits - would drive firms out of that industry leading to a smaller supply and - eventually - higher prices. Thus value was identified as the element which organized the economic life of society, as the basis for deciding what to produce, how to produce it and who gets it.

The problem, of course, was to understand how value itself was formed. The search for a theory of value is really a search for a consistent foundation for economic theory. It may have limited immediate worth in answering questions of economic policy or understanding the day-to-day or even the month-to-month movements in various prices. In fact, we can accomplish much of this without a consistent theory of value.

  • It will have a value of 100 hours of labor;
  • Such talents can seldom be acquired but in consequence of long application, and the superior value of their produce may frequently be more than a reasonable compensation for the time and labour which must be spent in acquiring them;
  • In other words, the capitalist is able to appropriate the social surplus because the capitalist owns the very machinery that allows the social surplus to be as large as it is.

A house without a foundation is of more immediate use than a foundation without a house. But the classical political economists were looking at the economy over the long term and thought it important to start with a solid foundation. An Ideal Theory of Value Before examining different theories of value, it is useful to state our objectives. What do we want our foundation to do for us?

Value should bear some relationship to relative prices, or to what relative prices would be in the absence of day-to-day disturbances. The fundamental idea is to examine the forces behind relative prices in a causal sense; it is not as important to analyze them quantitatively.

A theory of value should identify the factors that determine the distribution of income. If it cannot identify the magnitude of profit, a theory of value should indicate which forces external to the economic system determine the magnitude of profit. A theory of value should help us identify the forces responsible for economic growth.

All theories must start with a set of simplifying assumptions.

We must take care to not assume away the problem we are studying. That is, we must start with a set of 'stylized facts' that reflect the essence of our subject of study. Furthermore, the structure of our model economy should identify the factors that are truly part of the economic system itself endogenous factors and the factors that affect the economy but are not themselves caused by fundamentally economic forces exogenous factors.

The relationships among the stylized facts should reveal the structure of our stylized economy without resorting to obscure mathematical formulations. The simplified model economy which we create from our stylized facts should be highly transparent. We would like to be able to explain and present the model in a manner which allows for easy visualization. The theory should allow us to relax the less realistic assumptions.

For example, if we start with a single profit rate in all industries as one of our stylized facts, we should later be able to alter the theoretical structure to incorporate higher profit rates in more oligopolistic industries.

Stylized Facts Common to all Theories of Value The starting point of theories of value, at least of the theories of value we are examining here, is a capitalist economy in long-run equilibrium. Of course this is unrealistic. In any real economy, shifts in demand and changes in technology occur before firms have fully adjusted to the last changes.

But it allows us to investigate certain fundamental aspects of the economic system that are difficult to pick out from all the day-to-day movements of prices and output. The student of human anatomy can investigate human structure by examining an actual human skeleton.

Lacking cadavers, economists must hypothesize the skeletal structure of capitalism.

  • For wheat and similar products, value is determined by the amount of labor needed for production on the poorest land;
  • Masters are always and everywhere in a sort of tacit, but constant and uniform, combination, not to raise the wages of labour above their actual rate;
  • Ricardo and Marx used the labor theory of value to seek an understanding of the distribution of income and of economic growth.

The selection and logical analysis of appropriate stylized facts is our substitute for an X-ray photograph of the skeleton of living capitalism. We will also assume sufficient competition so that the rate of profit will be the same in all industries.

Labour theory of value

Again, this is terribly unrealistic. Certainly, when there are no barriers to entry or exit, capital will flow from low profit industries to high profit industries. Output will increase in industries which are attracting new capital, just as output will decrease in industries from which capital is fleeing. Prices in both industries will adjust until the profit rates are in the same range.

But there are barriers to entry and exit in many industries. Our defense for making sufficient competition part of our set of stylized facts is twofold. First, we are trying to understand what forces give rise to profit in general. The differences in profit rates among firms or industries is a somewhat different problem. Certainly we expect to find higher rates of profit in the industries where there is the least effective competition.

Second, if we cannot understand how prices and profit rates are formed under the simplest of conditions, we cannot hope to understand them under more realistic conditions.

The anatomist must develop a concept of an ideal skeleton before being able to use skeletal remains to identify disease or malnutrition. The core of all our models is a highly simplified capitalism.

  • Nothing we have done so far is reflective of economic relationships;
  • The philosophers and others now known as the classical political economists started by investigating two central economic questions;
  • But the idea is the same;
  • In speaking, then, of commodities, of their exchangeable value, and of the laws which regulate their relative prices, we mean always such commodities only as can be increased in quantity by the exertion of human industry, and on the production of which competition operates without restraint;
  • Moreover, as a theory of relative prices, it is not limited to reproducible goods as is the labor theory of value;
  • What do we want our foundation to do for us?

It is an economy that is sufficiently competitive that all firms will have fully adjusted their outputs and use of inputs to all demand and technological conditions. Classical Theories of Value The classical political economists shared three major points in their approach to developing a theory of value. First, all the classical economists thought it necessary to start their investigations of capitalism with the question of value.

Second, all the classical economists searched for value in the conditions of production. It was in the workshop or the factory, not the marketplace, that goods acquired their particular values. Third, although they had somewhat different reasons, all the classical economists subscribed to one form or another of a subsistence theory of wages.

That meant that the cost of labor was itself equal to the value of the goods and services that a working-class family needed in order to get by.

Adding-Up of Costs Adam Smith found value - which he called "natural price"- by adding the costs of production. In a society without private ownership of land and which used only the simplest of tools, labor would make up the entire cost of production: If among a nation of hunters, for example, it usually costs twice the labour to kill a beaver which it does to kill a deer, one beaver should naturally exchange for, or be worth two deer.

It is natural that what is usually the produce of two days' or two hours' labour, should be worth double of what is usually the produce of one day's or one hour's labour.

Classical Theories of Value

Source] But this simple measure of value is not sufficient for the more complex production processes and property ownership patterns of capitalism. When the worker is hired by a capitalist, uses equipment owned by the capitalist, and works with raw materials purchased by the capitalist, there will normally be profit: In the price of commodities, therefore, the profits of stock [capital] constitute a component part altogether different from the wages of labour, and regulated by quite different principles.

Source] By "quite different principles," Smith means that the worker is paid by the hour of labor while the capitalist is "paid" by the amount of capital and the length of time that the capital is engaged in that production process. Whenever a product involves the use of land, there will be a third component included in its price: As soon as the land of any country has all become private property, the landlords, like all other men, love to reap where they never sowed, and demand a rent even for its natural produce.

The wood of the forest, the grass of the field, and all the natural fruits of the earth, which, when land was common, cost the labourer only the trouble of gathering them, come, even to him, to have an additional price fixed upon them. He must then pay for the licence to gather them; and must give up to the landlord a portion of what his labour either collects or produces.

This portion, or, what comes to the same thing, the price of this portion, constitutes the rent of land, and in the price of the greater part of commodities makes a third component part. Source] The real value, then, of any commodity, will be the sum of the labor cost and the profit plus any rent.

Even though the capitalist purchases raw materials as well as labor, the raw materials - and anything else the capitalist purchases from other capitalists - can in turn be broken down into labor, profit and rent. Adding Up of Costs We can fabricate a simple example along the lines suggested by Smith. A capitalist in the pig-raising business produces 1,000 pigs per year. Their value can be determined by adding up the capitalist's normal costs. Some of this will represent investment in buildings and tools, but most of it will be operating capital - workers and suppliers have to be paid before the capitalist sells the pigs.

Note that labor makes up most of the cost.

Labor Theory Of Value

In this example, direct labor is only half of the total cost. But if we opened the books of the businesses that supplied the raw materials and replaced the worn out tools we would find their costs can also be broken down into labor, profit, rent and supplies. Then we could look into the costs of their suppliers, and so on. About one-third actually, 32. If the costs in these supplier industries are proportional to the costs in the pig industry, [6: Note] then half of these supply costs could be attributed to labor, then half of their supply costs, then half of those firms' supply costs.