Introduction to Economic Reasoning - Chapter 5: The Labor Theory of Value

Dr. Gordon begins by clarifying an apparent contradiction from the last Chapter. In the beginning of that chapter Dr. Gordon noted that even though one can know that two actors will benefit from an exchange, one cannot determine at what ratio an exchange will take place until it actually does take place.

Later in the chapter, Dr Gordon showed that if one knows the preference scales of the actors involved in an exchange (also illustrated with Demand and Supply curves) one can determine the ratio at which an exchange will take place.

It appears these statements are contradictory. The first statement says one cannot know the ratio at which an exchange will take place. The second statement says one can.

Actually, the two statements are not contradictory. The first is categorical and says given only preferences one cannot determine an exchange ratio. The second is hypothetical. It says if one knows the preference scales of the actors, then one can determine the ratio of exchange prior to it taking place. The second statement is conditional based whether or not one has the information and therefore does not contradict the first statement.

If one need only know the supply and demand curves prior to a transaction in order to determine its exchange ratio, then why doesn’t one just use them? One could, if one had them, but preference scales need not exist prior to a transaction. One cannot derive from the logic of action (praxeology) that a preference scale must be known by the actor prior to a transaction. It might not be known to the actor until the transaction is under way. One cannot derive from the logic of action whether preference scales are known ahead of time or at the point of the transaction.

A further point is made about the seemingly contradictory statements made earlier. Regarding the first statement, though the ratio of exchange is indeterminate to an outside observer, it does not follow that it is in fact indeterminate. Some economists believe that all preference scales are fixed at the time a transaction takes place. In this view even the actor may not know his own preference scale prior to the transaction. Again, though, one cannot determine whether this is the case from the logic of action. The logic of action cannot tell us anything about how preference scales are formed or when they are actually know. All we can know is that an exchange took place at a given ratio when it does.

Dr. Gordon has argued the Austrian Economists case that value is subjective. This notion of value contradicts the theories of classical economists (Adam Smith, David Ricardo), who argued value was based on the cost of production. Karl Marx, who created ‘scientific socialism’, based his theories upon the classical economist’s notion of value. Dr. Gordon turns to the basis of Marx’s system and shows why it is wrong.

Marx described the idea that prices are determined by individual preferences as ‘vulgar economics.’ According to him, the point of science is to discover the underlying laws that govern behavior, and in this case the laws underlying the behavior of prices. Marx, however, did agree with a kernel of the theory he attacked. He acknowledged that to be valued goods must have some utility. Thus he agreed that mud pies, which are not useful, would not be valuable no matter how long one spent making them.

Marx believed that goods did not only possess value solely based on their utility. He believed this because he recognized that such a value, being subjective, could not be measured. If one could not measure value objectively then it could not serve as a basis for developing any sort of science.

To remedy the problem, Marx held that goods not only had use value, but also exchange value. Besides valuing a good for a ‘use’ one also values a good based on what one could gain by exchanging it. Furthermore, one can measure the exchange value of a good by simply noting what other goods could be obtained for it. Having established a property of a good’s value that one could measure Marx argued one could begin developing a science from it.

The first problem with Marx’s idea of exchange value is that the actors exchanging goods do not view their values as equal. Their values are unequal; the value of the good exchanged is valued less than the good for which the exchange is made. Marx responded to this criticism saying that this shows the utility values are not equal, but the exchange values are equal.

The idea that some sort of exchange value exists on its own apart from any use value the good has is problematical. It implies that there is an exchange value that exists completely separate from a ‘use’ value. In fact, a good is valued in exchange precisely because it is valued for its use somewhere else.

Marx might suggest Gordon is just attached to a subjective value theory. So be it; Marx must still show how exchange value exists separately from use value. Anticipating this Marx also responded that there must be an exchange value which can be measured otherwise there can be no scientific basis for why goods exchange the way they do. There must be some underlying feature of value that makes goods identical. According to Marx this feature was labor. Two goods exchange because the labor used to produce them is identical.

Eugen von Bohm-Bawerk criticized Marx’s labor theory in his works Capital and Interest and Karl Marx and the Close of His System. For the sake of argument, von Bohm-Bawerk acknowledged that there was such a thing as exchange value. Given that, why should labor aside from all other factors be the basis of this value? Furthermore, there are many goods in which labor is but a fraction of the total value of a good. The value of wine, for example, depends more upon its aging than the amount of grape picking.

Another problem with labor was its heterogeneity. Different people are more efficient at making certain goods than others. Should the products they make, though identical, be valued differently then?

Marx had a response to this last criticism. He said that the labor to make a product is based on the ‘socially necessary’ labor needed to produce it. Bohm Bawerk argued that to avoid an arbitrary definition of ‘socially necessary’ labor Marx must use market prices as the means for establishing what is ‘socially necessary’. Marx therefore reasoned in a circle; the market price of a good should be based on the value of labor used to make it, the amount of the labor used to produce a good is based on the socially necessary labor needed to produce it, and the socially necessary labor needed to produce the good is based on market prices. Marx was proving that market prices should be used to determine market prices.

Furthermore, how did Marx’s theory explain how different types of labor, i.e. brain surgery vs. house painting, could be compared? Marx again responded they could be compared using ‘socially necessary’ labor. Again, this demanded the use of market prices.

Marx faced another problem. As he himself admitted, his theory did not in fact explain prices as they existed on the market. That is, goods did not exchange at their labor prices on the market. Nevertheless, he insisted, his theory did explain how actual market prices come about and what “the ‘laws of motion’ of capitalism really are”. Bohm Bawerk, using arguments beyond the scope presented so far, again show Marx to be wrong. Even without referring to Bohm Bawerk’s argument however, all Marx’s theory showed was that two goods exchanged because their exchange values were equal. There is no underlying law of motion.