One opinion, often heard on the streets, is that things have "natural" prices. In Russia the government dictates the "natural" price for bread. The French government does the same for French bread, and has for centuries. Why? Because that is how it should be, they say. The set price reflects what the bread is worth, its "value." Any talk like this of the essential, internal, "natural" worth of something is a moral theory of value. The value of a good is whatever it is "really" worth.
The moral theory of value came first. Aristotle, one of the very first economists (so to speak), wrote in the fourth century before Christ that merchants should charge a fair, natural, or "just" price. For twenty centuries or so after Aristotle the philosophers for the most part followed his moral emphasis, urging merchants to charge the just price, and recommending that the government enforce it with punishments.
Caption: Idealized painting, by Raphael, of Aristotle (384-322 BC), whose theory of value could not resolve the water/diamond paradox.
But why would 10 florins for a young horse be a "just" price? And what about 10 pennies for a loaf of bread? The Spanish scholastic philosophers in the 16th century, and then the Scottish moral philosophers in the 18th century, reopened the question. Adam Smith in 1776 suggested that the amount of labor used in the production of a good was a measure of its value. "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." Smith's theory was called the labor theory of value. It pointed to an objective determinant of the value of a commodity, namely the amount of labor that went into its production. It's trying to find something inside a deer or a diamond that makes them "really" worth so many dollars.
Smith's labor theory of value immediately started running into logical difficulties, as even Smith realized. For starters, one hour spent hunting by a good hunter is clearly worth more than an hour spent by a slow hunter with poor aim. So you have to adjust somehow for the quality of the labor hours. Furthermore, and more troubling, how do you account for the use of the tools, called in economics the "capital"? Often a hunter with a modern gun will be more effective than a hunter with a bow-and-arrow. The capital of the gun is apparently worth something. Hunting costs hours of labor, yes, true. But the tools used have to figure in the cost, too.
In the early nineteenth century David Ricardo and then Karl Marx — himself inspired by a now little-known thinker and writer for The Economist magazine, Thomas Hodgskin (1787-1869) — elaborated on Smith's labor theory of value and tried to answer the doubts. They argued that the hunter's gun, his capital, is itself produced in turn by labor and hence "embodies" it. And the machine that helped make the gun-making machine is also produced by labor. And so on back to the beginning. The value of the gun reflects all the embodied labor, they said. They thought they had saved the labor theory of labor. Ricardo and Marx and Hodgskin still have followers among some economists, who find the source of value on the supply/cost side of the market — in the amount of labor expended, whether directly in time hunting or indirectly in the time used to make the gun.
Most later economists, however, have abandoned the labor theory of value. At first they proposed something like the opposite of the labor theory. The best way to think about value, the economists started thinking in the 1870s, is a subjective theory. "Subjective" in this context means "having to do with people's feelings," as against the "objective" fact that hunting a beaver takes more hours than hunting a deer. Accordingly, the value of a commodity is determined by those who want to consume it, and not by what labor or capital went into its production. In the case of beavers and deer the point would be that beavers had uses in making hats for gentlemen while deer were only a source of meat.
This idea of subjective value occurred in the 1870s to many people. That many economists thought of it independently more or less at the same time suggests that it is correct. Simultaneous discovery is quite common in science — the most famous example is that Alfred Wallace, another British naturalist, came up with the theory of evolution independently of Charles Darwin. In economics in the 1870s the time was ripe for the next step in value theory. William Stanley Jevons, for example, a British physicist, philosopher, meteorologist, and economist — a most amazing man — wrote in 1871: "Repeated reflection and inquiry have led me to the somewhat novel opinion, that value depends entirely upon utility." "Utility" is merely a fancy word for the use, or subjective feelings, that people have for things.
But modern thinking puts the two — the "what it costs" and the "how people feel about it" — into a single, unified argument. Alfred Marshall, as we've noted, pointed the way in the 1880s with his supply/demand diagram. Economists had long realized that something like "supply and demand" fixed marketed prices, but until Marshall they waffled between the two in confusion. Marshall's diagram cleared it up. He argued correctly that both resource-cost and subjective value figure — those "two blades of a scissors" we quoted earlier. It would be silly to say that "the top blade of a scissors does all the work." You need both to cut a sheet of paper. Likewise, labor value alone, or even subjective value alone, are not enough. The supply/demand theory alerts us to the two sides of the issue: the household demand side with the assigning of subjective utility to desired commodities, and the company supply side with the seemingly objective factors that go into the production of the commodity.
Maria: Why did you say "subjective" when referring to the values of household demand and "seemingly objective" when referring to the company supply?
Ziliak: It's an advanced point, Maria. Economists wanted to be known as objective and scientific so they adopted the so-called "positivist" vocabulary. They came to believe that things you can look at, such as "capital input," were "objective," like the chair you're sitting on. Non-observable entities, such as "expectations" or "tastes," were "subjective," such as your taste for ice cream But nowadays most economists understand that the supply side is just as subjective as the demand side -and, for that matter, the demand side just as objective. Producers desire profits and expect sales and guess at costs just like a supposedly "subjective" household. And more deeply the "objective" costs are determined ultimately by the subjective value of what you had to give up to incur them. It is known as an "Austrian" argument, dating from Karl Menger of Vienna (1840-1921; his major work the Grundsätze, the Principles, appeared in that banner year of 1871), but all economists admit it is true. Economics is subjective, about mental states, all the way down. And it's objective, too, about seeable prices. Both.
As a result of Marshall's solution, nowadays economists tend not think in terms of "value" at all. They think only about price, a price determined by supply and demand, Marshall's scissors. The modern theory of supply and is part of neoclassical economics.
The neoclassical theory of supply and demand combines the objective and the subjective theories of value into one - with the conclusion that value equals price.
Concept Check 1: Maria complains about the high salaries of doctors. Paul replies that doctors deserve every penny they earn because they work hard for it. What theory of value is implied by Paul's answer? And what would an economist say in response?