The theoretically most interesting and problematic of the doctrines of the Classical Political Economists is their explanation of how prices are determined in a laisser-faire capitalist economy. Why, you may wonder, is that so important a question? Well you may ask. I myself asked that same question of John Eatwell [currently Baron Eatwell and President of Queen's College, Cambridge], when as a young man in his thirties he taught a brilliant graduate course on Value Theory in the UMass Economics Department in the semester when I was first acquainting myself with economic theory. He was rather startled by the question, not anticipating that a total naif would be sitting in on his very advanced seminar, but the answer is quite simple. The two great questions of Classical Political Economy are, First, how is the annual social product [the "wealth of nations," in Smith's words] divided up among the three classes of society -- the landed aristocracy, the entrepreneurs, and the laboring class? and Second, what are the conditions of sustained economic growth? Growth and distribution are the alpha and omega of the classical school. It is what makes their theories, otherwise so out of date, interesting today. Now, in a laisser-faire money economy, the social product is apportioned to each class by the intermediation of money. Each class receives a share of the social product in the form of the money that it manages to lay its hands on. The landed aristocracy is paid a price for the use of its land -- we call it rent. The entrepreneurial class is paid a price for the use of its capital -- we call it profit. And the laboring class is paid a price for its laboring [or, as Marx will say, for the use of its Labor Power -- but that gets ahead of our story.] -- we call it wages. These prices -- rent, profits, and wages -- determine the distribution of the annual social product. The same processes of competition that determine the prices of corn and iron, cloth and coal, eggs and cattle fodder also determine rents, profits, and wages.
Confronted with this question, Adam Smith makes a series of brilliant conceptual moves that virtually define the discipline of economics ever after. [Aside: I have just re-read Chapter Two of my book, UNDERSTANDING MARX, in which I set forth Smith's innovative conceptual moves in some detail. If anyone is really interested in this subject, I strongly recommend looking at what I have written there. It is simply too detailed to reproduce here.]
He begins by observing that there is an ambiguity in the term "value," for sometimes we mean by the value of a good its usefulness to us in satisfying some want or enabling us to advance some undertaking. Water slakes our thirst. Cloth protects us from the elements. This aspect of any good Smith calls its "value in use," or, as we have learned to say, its use value. But goods may also be exchanged for other goods, and this aspect of them Smith calls their "value in exchange," or exchange value. When we consume some good, it is its use value that concerns us -- will this apple satisfy my hunger? Will that lump of coal burn well and provide warmth or energy to drive a machine? But in the marketplace, our concern is for the exchange value of a good. How many apples can I get in exchange for this bolt of cloth? How many bushels of corn for a ton of coal?
Drawing on the notion of nature as a system of universal laws -- an idea well-established in the late eighteenth century as a consequence of the manifest success of Newton and others in articulating that system in elegant mathematical form -- Smith suggests that society is a second nature, governed, as is physical nature, by universal laws. Instead of gravitation as the key to these laws, Smith offers the universal tendency of men to "truck and bargain" in the marketplace. [See David Hume's TREATISE OF HUMAN NATURE for a similar conceptual move -- in Hume's case, the principle of the association of ideas. Hume and Smith, of course, were good friends.]
We observe, Smith says, that in any given neighborhood or marketplace, there is a customary or usual price at which goods sell, and also a customary or usual wage paid to laborers, rent paid to land owners, and profit earned by entrepreneurs. These customary or usual prices may, of course, vary on a particular day as a consequence of momentary factors, such as a glut of corn one day or a scarcity of cloth the next. Smith, like Ricardo and Marx after him, was quite aware of what have come to be called the "laws of supply and demand," but he, as did they, considered these to be ephemera, not underlying determinants of the system of society. To those customary prices Smith gives the name "natural prices," calling the momentary fluctuations "market prices." The natural prices act, he says, like centers of gravity, drawing the fluctuating market prices to them [you see the influence of Newton.] From that day forward, one of the central tasks of Economics became the discovery of the determinants of natural price. Those of you who have studied economics will be familiar with the notion of natural price under its modern label, equilibrium price.
What then determines the natural price of a good in the market? Smith is actually rather confused about this question, and offers three answers without seeming to understand that they are different from, and in fact incompatible with, one another. One source of his confusion is his belief, which Ricardo shared, that in order to understand what happens when the relative prices [exchange ratios] of two goods change, one needs to find in the circle of exchanging goods one whose natural price never changes, so that any change can be traced to some alteration in the conditions under which the other good is produced. All of this is fascinating, but much too complex to go into here. [Once again, see my book.]
What matters is that Smith advances a seminal idea, on which all subsequent Classical Political Economy rests. The natural price of a good, Smith proposes, is determined by the amount of labor that is required to produce it.
Now, a small but important terminological matter. In the eighteenth and early nineteenth centuries, the term "value" was used interchangeably with "natural price." The value in exchange, or exchange value, of a good in the market was called either its natural price or its value. Thus, when Smith advanced the hypothesis that the natural price of a good is determined by the quantity of labor needed to produce it, he was offering a Labor Theory of Natural Price, or, what was to him the same thing, a Labor Theory of Value. That, just so you know, is the origin of this famous and controversial phrase.
In support of his hypothesis, Smith now sketches a little story in which is actually embodied a theorem in rational choice theory. Here is the entire passage, from Book I, Chapter 6 of WEALTH OF NATIONS.
"In that early and rude state of society which precedes both the accumulation of stock and the appropriation of land, the proportion between the quantities of labour necessary for acquiring different objects seems to be the only circumstance which can afford any rule for exchanging them for one another. 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.
And there it is! The Labor Theory of Value, in its first appearance on the world stage. It won't do in the form in which he presents it, of course, and Smith knows that. Indeed, in the very first phrase of the first sentence, he indicates why it won't do. This simple theory may hold for situations in which there is no accumulation of stock [hence no tools, farm animals, or other inputs into production] and no appropriation of land [hence no rent charged for the use of the land], but in the real world, all economic activity relies upon both "the accumulation of stock" and the "appropriation of land."
Just so we are clear, let me spell out the problem, even at the risk of being a trifle tedious. Suppose the deer hunters use bows and arrows to hunt the deer, while the beaver hunters use beaver traps to catch the beaver. [Bows and arrows and beaver traps are "stock."] Now, it takes labor to make a bow and arrows and also to make a beaver trap. Clearly, in deciding in what ratios they will exchange the deer for the beavers, both groups of hunters need to take into account that labor as well as the actual labor of hunting or checking the traps. It might be, for example, that beaver traps take only a few moments to make, but really can be used only once [the beavers wreck them trying to escape], whereas bows and arrows take many days to make, but can be re-used for years. In some way or other, this indirectly required labor will have to be taken account of if the two groups of hunters are to succeed in making rational decisions when they enter into bargaining with one another.
Smith pretty much gave up on this problem, and there things stood for forty-one years. Enter David Ricardo, arguably one of the three or four greatest economists of all time. The solution to the problem, Ricardo proposed, is to think of the stock -- the tools, raw materials, etc. used in the process of production -- as though they had embodied in them the labor that had been expended at an earlier time in making them or gathering them. When workers use those tools and machines as they worked up the raw materials into the finished products ready to be sold in the marketplace, we can think of them as transferring that embodied labor, along with their own labor, to the finished product. Thus, the natural price, or value, of the end product is really determined by the sum of the labor directly required in the production process and by the labor indirectly required in earlier periods of production. The sum -- of embodied labor and direct labor -- is the true determinant of natural price or value. This in a nutshell is Ricardo's version of the Labor Theory of Value, and it is, as we shall see, a dramatic advance on Smith's hypothesis, even though it is still not quite right.
At this point, I am going to stop, because in the next Part, I must incorporate some little systems of equations into the text, and despite the helpful suggestions of a number of you, I have not quite figured out how to do that. Also, I must lecture this afternoon to my graduate seminar, and I think I ought at least to make a show of preparing for my lecture. See you all tomorrow, if I succeed in sorting out the technical details of incorporating equations into the text.