The Labor Theory of Value was one of the early attempts to explain how market prices form. It followed the idea that the main driver for goods’ value is the labor necessary to produce them.
Under the theory, the labor hours it takes workers to produce a commodity is the source of its value.
The underlying concept argues that we can determine the economic value of a product or service by the total hours of labor it takes to produce the good or render the service.
We commonly link the theory to Marxian economics, but it appears earlier in Adam Smith and David Ricardo’s works. And later, similar concepts are discussed within the premises of anarchist economics.
Smith saw an item’s price as the labor hours the buyer has to expend to get the item.
The concept later became central to Marxist economics, where the working class is exploited under the capitalist and doesn’t associate price and value.
The Labor Theory of Value was a dominant theory for some time in the late 18th to 19th century but then gave way to the Subjective Theory of Value. It is rarely supported in modern economics, but it’s a good starting point to understand how values work.
Understanding the Labor Theory of Value
In theory, the ‘value’ includes the value of direct labor and all labor that created the capital we use for production. By this, we mean that if you use tools or a machine to produce the goods, you should include the wear of these tools and machines in the product’s value, alongside the direct labor. This wear is a proportion of the labor value that produced the tools and machines, spread equally over all goods we create with said tools and machines.
Sign Up for our Newsletter
And Get a FREE Benchmark Analysis Template
The Labor Theory of Value suggests two products will have the same market price if they require the same amount of labor to produce.
Otherwise, their prices will have a ratio equal to the ratio between the value of labor input.
For example, if it takes one hour to create a bar of soap and 5 hours for a jar of jam, then one jar should trade for 5 bars of soap.
The thought exercises around the labor theory started with the ancient Greek philosophers. Adam Smith and David Ricardo later expanded it, but only as a limited experiment treating humanity as representing only simple goods production.
This experiment was a stepping stone to expand later and create a more refined version of the theory. The initial concept did not account for the class distinction between landlord, worker, and capitalist. As we now know it, the idea of capital wasn’t initially considered, just a simple two-commodity economy.
Adam Smith focused on how the prices and values are derived, describing the Labor Theory of Value concepts and principles.
On the other hand, Ricardo focused on prices influence each other. He and Karl Marx tried to quantify all labor elements to arrive at the goods’ natural value.
Problems with the Labor Theory of Value
There has been a lot of criticism of the theory over the years, which eventually resulted in economists refusing it and switching to the Subjective Theory of Value.
Under the theory, it is impossible to use a large amount of labor and produce something of little or no value. However, this happens all the time in reality.
Often goods requiring the same amount of labor to produce end up with very different selling prices, which should also be impossible under the Labor Theory of Value.
These are the two main issues with the theory that ultimately lead to it being largely discredited.
Consider the example mentioned above. The production of a soap bar takes one hour at a €10 income per hour, while producing jars of jam takes five hours at €10 pay per hour – 3 hours for the jar and 2 hours for the jam itself.
If there’s no balance in the market, then we may have the following situation:
If this is the case, people will start moving from jam production to soap production, generating more profit. If the market underestimates the natural price, people will have an incentive to sell more of the good, and vice versa. This will introduce competition, which will bring the relative prices back to the natural ones over time, and re-introduce an equilibrium.
The labor we use to produce the goods determines their value and market prices, defining the natural value.
Adam Smith’s Labor Theory of Value
Smith suggested a good was worth the labor we’d have to ‘spend’ to get it (value in trade), or the work we can ‘save’ by consuming the good (value in use), or both.
His view on the concept doesn’t look at past labor that went into producing the goods. Smith only focuses on the amount of labor that the commodity can ‘save’ for someone else (the buyer).
The idea is that if no one wants to acquire a particular item, it’s worthless, no matter how much labor was spent during production.
Value in Use vs. Value in Trade
Value in use is the value we get out of a commodity that we use or consume, while Value in Trade is the purchasing power to acquire other goods with this commodity’s possession.
Adam Smith mentions the controversy of the relationship between those two. Often, they are mismatched. Take money, for example. Its value in trade is high, but the bills have a low value in use. Without the meaning and promise attached to it, money is nothing more than pieces of paper.
In Smith’s theory, the value in trade relates to the amount of labor. Take a man who owns a product they do not intend to consume but rather use in an exchange. The value of this product to them is the number of labor hours they can purchase with it.
Therefore, in the Wealth of Nations (1776), Smith defines labor as the real measure for the value in trade of all goods.
How Labor Creates Value
The Labor Theory of Value mentions the ‘socially necessary abstract labor’ embodied in a commodity. As workers perform this labor with average skill and average productivity, we can say that a good’s value only increases proportionally to the completed work.
If workers are more skilled and more productive, they generate more value by creating a larger quantity of finished products. However, each product still has the same value within its class of goods.
Sloppy or unskilled workers produce less value, increasing the average labor time needed to create a single unit. But we cannot sell those at a higher price than their natural value, and they will remain the same value in exchange.
Calculating the Worth of Commodities
Creating commodities involves additional means of labor – materials, tools, machinery, and others. These means of production are usually the product of another labor process.
Performing labor also requires other means that hold no value, like land, water, daylight, and others. However, we still need these for the process. Under the Labor Theory of Value, we treat those as zero-value even if they’re critical to the whole process.
Production means whose value we use in the current labor process have a constant magnitude of value for each production unit. This is in line with the concept of constant capital.
We can represent this with the following formula:
- C – constant capital – materials and the depreciated portion of production capacities over a period;
- L – the quantity of labor (at average skills and productivity) to produce the finished goods;
- W – the worth, or value, of the produced goods.
We can calculate the value per item by dividing the worth (W) over the produced quantity.
The Labor Theory of Value also divides the labor we add during production (L) into two separate values:
- V – the portion of value equal to wages we pay to the workers. For example, if we pay 1,000 for a day, then the labor to add 1,000 to products (while preserving the constant capital) is the necessary labor portion, which can also be denoted as NL;
- S – the remainder of the value, which we consider the surplus portion of the labor, is also denoted as SL (surplus labor).
The value to purchase labor power from workers is variable capital, which can add value in the labor process compared to constant capital, depending on the workers’ skill, productivity, and the duration of the process.
Using this breakdown of the labor we add during production, we can extend the formula to:
The two versions of the extended formula look at value (worth) from different perspectives but are essentially the same.
Relation Between Value and Price
One of the central questions the Labor Theory of Value faces is determining the relationship between the value quantities of labor and the selling prices for commodities.
Some thought schools argued that labor value in a product acts as a gravity center for its price. However, General Theory states that pricing usually experiences fluctuations. Prices include a ‘charge’ for the employed capital (profit).
Adam Smith wrote that we could measure each part of the price as the quantity of labor it can purchase. This means labor is a measurement not only for the portion of the price that resolves into labor but also for the part that represents the profit.
Karl Marx’s view on the theory
Marx never refers to his theory as a ‘labor theory of value.’
While Smith sees the value of a product as relative to labor it can command or save, Marx sees it as proportional to the labor for production.
In Marx’s theories, the relation between value and price is known as the transformation problem. The issue is to define an algorithm where we can trace the magnitude of labor value (considering duration and intensity) after the value is distributed through prices reflecting an equal rate of return on the employed capital.
In his work in 1865, Karl Marx sums up the problem. If supply equals demand, market prices of goods will correspond to their natural prices, which we determine by labor quantities for their production.
Smith theorizes that labor values are the measure of exchange for direct producers like farmers, fishers, and others. However, Marx says that goods must have a standard measurement element to be comparable, arguing that this common substance is labor.
Marx was drawn to the Labor Theory of Value because, for him, labor was the only shared property between all goods and services exchanged on the market.
He based his critique against the classical free-market economists based on the theory. Marx asked – if we sell all goods for prices reflecting their real value, and all values come from labor hours, how can capitalists profit unless they pay workers less than the actual value of their labor. This became the basis of Marx’s exploitation theory of capitalism.
Under the theory, capitalists exploit workers by paying them for fewer hours than they work, thus extracting ‘surplus value.’ For example, if you pay someone for an 8-hour workday, and they end up working 12 hours (which was quite common back then), the extra 4 hours are ‘surplus value’ for the capitalist.
While Marx tried to use the labor theory to challenge capitalism’s teachings, he ended up exposing the theory’s inherent weaknesses. Although widely popular, by the late 19th century economists started to reject the Labor Theory of Value. Modern economics believes capitalists now profit by postponing current consumption in favor of potentially higher returns in the future and by taking risks, not by exploiting their workers.
It is essential to understand that the theory originated more as a thought experiment. One of the main reasons it still holds some popularity today is that Marx wrote a lot about it. And his views are still popular among many modern economists.
Hi! I am a finance professional with 10+ years of experience in audit, controlling, reporting, financial analysis and modeling. I am excited to delve deep into specifics of various industries, where I can identify the best solutions for clients I work with.
In my spare time, I am into skiing, hiking and running. I am also active on Instagram and YouTube, where I try different ways to express my creative side.
The information and views set out in this publication are those of the author(s) and do not necessarily reflect the official opinion of Magnimetrics. Neither Magnimetrics nor any person acting on their behalf may be held responsible for the use which may be made of the information contained herein. The information in this article is for educational purposes only and should not be treated as professional advice. Magnimetrics and the author of this publication accept no responsibility for any damages or losses sustained as a result of using the information presented in the publication. Some of the content shared above may have been written with the assistance of generative AI. We ask the author(s) to review, fact-check, and correct any generated text. Authors submitting content on Magnimetrics retain their copyright over said content and are responsible for obtaining appropriate licenses for using any copyrighted materials.