What Is the Labor Theory Of Value?

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.

Key Takeaways

  • 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.

Understanding the Labor Theory Of Value 

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 10 hours to hunt a deer and 20 hours to trap a beaver, then the exchange ratio would be two beavers for one deer.

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.

Here is an example where beaver production, initially, is more profitable than that of deer:

  Labor Time Needed Income/hr. ($) Income for 20 hrs. of Work Cost of Production
Deer Trap(12) + Hunt(8) = 20 $11/hr. $220 $220.00
Beavers Bow & Arrow(4) + Hunt(6) = 10 $9/hr. $180 $90.00

Because it's more profitable to produce beaver, people will move out of deer production and choose instead to produce beaver, creating a process of equilibration. The labor time embodied indicates that there should be an equilibrium ratio of 2:1. So now the income of beaver producers will tend to drop to $10 an hour while the income of deer producers will tend to rise to $10 an hour as the cost of production drops in beaver and rises in deer, bringing back the 2:1 ratio so that the new costs of production would be $200 and $100. This is the natural price of the commodities; it was brought back in line due to the arbitrage opportunity that presented itself in having the income of beaver producers at $11, causing the profit rate to exceed the natural exchange ratio of 2:1.

Although the market price may fluctuate often due to supply and demand at any given moment, the natural price acts as a center of gravity, consistently attracting the prices to it—if the market price overshoots the natural price, people will be incentivized to sell more of it, while if the market price underestimates the natural price, the incentive is to buy more of it. Over time, this competition will tend to bring relative prices back into line with the natural price. This means that the labor that is used to produce economic goods is what determines their value and their market prices, because it determines the natural price.

Labor Theory and Marxism

The labor theory of value interlaced nearly every aspect of Marxian analysis. Marx's economic work, Das Kapital, was almost entirely predicated on the tension between capitalist owners of the means of production and the labor power of the proletariat working class.

Marx was drawn to the labor theory because he believed human labor was the only common characteristic shared by all goods and services exchanged on the market. For Marx, however, it was not enough for two goods to have an equivalent amount of labor; instead, the two goods must have the same amount of "socially necessary" labor.

Marx used the labor theory to launch a critique against free-market classical economists in the tradition of Adam Smith. If, he asked, all goods and services in a capitalist system are sold at prices that reflect their true value, and all values are measured in labor hours, how can capitalists ever enjoy profits unless they pay their workers less than the real value of their labor? It was on this basis that Marx developed the exploitation theory of capitalism. 

Problems with the Labor Theory of Value

The labor theory of value leads to obvious problems theoretically and in practice. Firstly, it is clearly possible to expend a large quantity of labor time on producing a good that ends up having little or no value, such as mud pies or unfunny jokes. Marx's concept of socially necessary labor time was an attempt to get around this problem. Secondly, goods that require the same amount of labor time to produce often have widely different market prices on a regular basis. According to the labor theory of value, this should be impossible, yet it is an easily observed, daily norm. Thirdly, the observed relative prices of goods fluctuate greatly over time, regardless of the amount of labor time expended upon their production, and often do not maintain or tend toward any stable ratio (or natural price).

The Subjectivist Theory Takes Over

The labor theory's problems were finally resolved by the subjective theory of value. This theory stipulates exchange value is based on individual subject evaluations of the use value of economic goods. Value emerges from human perceptions of usefulness. People produce economic goods because they value them.

This discovery also reversed the relationship between input costs and market prices. While the labor theory argued input costs determined final prices, the subjectivist theory showed the value of inputs was based on the potential market price of final goods. The subjective theory of value says that the reason people are willing to expend labor time producing economic goods is for the usefulness of the goods. In a sense, this theory is the exact reverse of the labor theory of value. In the labor theory of value, labor time expended causes economic goods to be valuable; in the subjective theory of value, the use value people get from goods causes them to be willing to expend labor to produce them.

The subjective theory of value was developed in the Middle Ages by priests and monks known as the Scholastics, including St. Thomas Aquinas and others. Later, three economists independently and almost simultaneously rediscovered and extended the subjective theory of value in the 1870s: William Stanley Jevons, Léon Walras, and Carl Menger. This watershed change in economics is known as the Subjectivist Revolution.