Adam smith value theory

2. ADAM SMITH’S
THEORY OF VALUE
Prof. Prabha Panth,
Osmania University, Hyderabad,
India

Theory of Value:
The theory of value analyses what regulates
exchange values, as well as the elements that
govern the exchange value of commodities.
Objective: to discover the laws that govern a self
regulating market economy.
28-05-2017 Prabha Panth 2

Adam Smith’s concept of Value
THE DIAMOND WATER PARADOX:
Adam Smith distinguishes between (1) Value in use and (2) Value in
exchange.
1) Value in Use: Goods are consumed because they have some use,
or utility. E.g. bread, milk, cars, etc.
2) Value in Exchange: But all useful goods cannot be exchanged for
other goods, for e.g. air or water are very useful, life cannot exist
without them, but they cannot normally be exchanged for other
goods.
Whereas diamonds are not essential for life, but they have great
value in exchange. (The explanation for this paradox was given
many years later by Alfred Marshall).

According to Smith,
First condition: for a commodity to have value in exchange, it
should have some Use value as well.
This is a necessary, though not a sufficient condition.
 The second condition: the commodity should be scarce,
relative to its demand. But supply should not be rigid (like a
rare painting), but should increase with production
Use value vs. Exchange value

Market price vs. Natural price
According to Adam Smith:
Market Price: observed short run price – determined by supply
and demand for the commodity. Market price fluctuates with
changes in supply and demand conditions, and other random
variables.
Natural Price: is the central or long run price towards which
market price gravitates or moves. It is the price that exists in
the absence of outside disturbances. It is based on the cost of
production.
 Natural Price: is the Price that would exist in the absence of any
outside disturbances. It is the long run price.

Market price vs. Natural price
 How is Natural Price determined, and how should it be
measured?
 What determines its level?
According to Smith, Value is a measure of wealth.
Sources of wealth = land, labour, and capital stock.
 Wealth therefore consists of the sum of the average value of
wages + rent+ profits  the three original sources of all
exchangeable values.
Smith’s theory of value is based on the Cost of production
approach.

 What regulates the Exchange value of goods?
According to Smith, a suitable “measure of value” should have the
ability to “command other commodities.” In other words, it
should have value in exchange.
Adam Smith asks:
 How to determine the real measure of exchangeable Value or
Real P?
 What should be the unit of measurement of Value?
 What are the different parts that Value is made up of?
 At what level should the value be fixed? Absolute value.
 Why is there a divergence between Natural P and Market P?
Theory of Value

Smith’s simple model
 Assumptions:
1) Early and rude state of society,
2) Labour is the only factor of production.
3) Bare hands production, no capital good inputs. Capital is non
existent, or negligible.
4) No appropriation of land.
5) No gestation lag in production.
 In such a society, if two goods are produced, how to determine their
rate of exchange?
 According to Smith, the proportion of labour embodied in the two
goods provides the rate at which they should be exchanged.
 So: the Measure of Value is in terms of labour embodied in them.

Rate of Exchange based on Labour values:
 Assume that there are two hunters, A and B.
 There are no other factors of production, they use their bare hands in
hunting. Hunter A hunts beavers.
Hunter B hunts deer.
 At what rate should they exchange their products?
If it takes 2 hours to hunt a beaver, and 1 hour to hunt a deer, then
their relative values are:
1 beaver (2 hours) = 2 deer (1 hour x 2deer)
This is based on the amount of time spent in hunting each of the two
animals, i.e. labour embodied in hunting each animal. So 1 beaver will
exchange for 2 deer, the value of 1 beaver is = 2 deer.

Labour values:
1) Rate of exchange:
Thus labour values = exchange values, i.e. the value of a
commodity is equal to the amount of labour embodied in it.
Labour embodied in a commodity determines its rate of
exchange.
2) Cause of Value:
Exchange of goods is actually exchange of other people’s
labour.
3) Source of Value: is due to the labour embodied in the
commodity.

4) Measure or Level of Value: is the amount of labour that can be
bought with the commodity.
 It is the ability of a commodity to command labouring activity of other
people.
 Purchasing power is depicted in terms of labour.
 Thus measure of value = labour commanded. For example, if X
purchases a beaver, he has actually purchased 2 hours of labour. If he
wants to hire labour for 2 hours, he can either pay in terms of 1
beaver, or 2 deer.
 But this exchange would depend on the wage rate, and rate of profit.
 In other words, it is the amount of labour which a commodity’s
natural price can command, i.e. the labour embodied in a commodity,
when profits = 0.
 If there is bare hands production, then labour embodied = labour
commanded.

Adam Smith realised that in a “rude and early” state of society,
when production was with bare hands, then
Labour embodied = Labour exchanged.
In other words, in the previous example, the value of a beaver
is twice that of a deer, due to the number of hours embodied
in hunting it.
Thus a beaver can command 2 hours, and a deer can command
or exchange for anything worth one hour’s worth of labour
embodied in the production of the exchanged good.

 But Smith realised that this explanation cannot apply
to a situation when other factors of production are
used, such as capital and land.
In that case, the value of output produced by labour,
has to be shared with the capitalists and landlords.
In such a situation, labour embodied  labour
commanded.

An example:
1 2 3 4 5 6 7
Q Kgs L hours w rate
(Kg/hour)
Total W
(2 x 3)
Surplus
(1-4)
Lab emb.
(2)
Lab comm.
(1/3)
100 kgs 300 hours 0.33 kg 100 kg 0 300 hrs 300 hrs
Case 2: But if capitalists are paid for the use of capital stock = 25 kgs, then w↓ when Pr > 0
100 kgs 300 hours 0.25 kg 75 kg 25 kg 300 hrs 400 hrs
(100/0.25)
 Case 1. Bare hands production, no capital, profits = 0.
 Let the real wage rate = 0.33.
 300 hours of labour produce 100 Kg of corn

Divergence between the two labour values:
 In case 1, it takes 300 hours to produce 100 kgs of
corn.
 That is the Labour embodied in production. This is the
source of value of the output produced.
 If the wage rate is 0.33 Kg/ hour, with 100 Kgs of corn, you
can command or buy 300 hours of labour (100 kgs/ 0.33).
This is the exchange value of the corn produced.
 Labour embodied (source of value) = Labour commanded
(value in exchange)

In case 2. 100 kgs of corn are still produced by 300 hours of
labour, but now it is not bare hands production. Some capital is
used, so profits have to be paid. Say 25 kgs of corn.
If profits have to be paid, then wage rate has to be reduced to
generate surplus to pay profit.
So wage rate has to comes down, to 0.25 Kg per hour.
Labour embodied = 300 hours,
Labour commanded = 100/0.25 = 400 hours. In other words,
when the wage rate falls due to payment of profit, with the
same output, more labour can be commanded.
Therefore, Labour commanded  labour embodied.
Because of this divergence, Smith rejected the embodied
labour explanation of Labour commanded theory of value.

In other words:
Smith wanted to find a suitable measure of value.
He felt it is the ability of a commodity to command other
commodities.
As there is division of labour, exchange of commodities
produced by different professions, is exchange of labour time
embodied in them.
When there is only labour, then labour commanded = labour
embodied.
But when land and capital inputs are also to be paid, then
labour commanded  labour embodied.

 Profits are not used up, but are accumulated and reinvested
by capitalists.
Natural price is determined by the 3 main components of price
–> wages + rent + profits, each representing the social average
rate of income accruing to the three main classes in capitalist
society.
However, rent and profits are deductions from the output
produced by labour.
But accumulated surplus leads to Growth of the economy, and
increase in employment of labour.

What then regulates the natural price of a commodity?
According to Smith = w + r + pr (wages + rent + profits)
How are these rates –> wage rate, rate of profit, and rent
fixed?
Smith did not have a proper theory to explain how these
factor prices are fixed.

Limitations:
Measurement of Labour embodied becomes complicated
when other factor inputs such as land and capital are included.
So value cannot be due to labour alone, but includes value of
capital and land (i.e. interest and rent).
When wage rate falls, labour commanded increases, as surplus
is generated.
This surplus if invested leads to accumulation and growth.
Smith could not explain how the Natural Price is fixed, and at
what level it is fixed.

Circularity in Argument :
 Cost of production determines value of output.
 But unless value is know, heterogeneous goods cannot
be aggregated and distributed as wages, rent, and
profit.
 Therefore there is circularity in his argument.
Smith was not able to explain how the measure of
value should remain invariant to other changes in the
economy.

References:
Adam Smith: An Inquiry into the nature and causes of the
Wealth of Nations, (Modern Library, New York, 1937)
Kamala Subramaniam and Prabha Panth: The Macro
theories of Value and Distribution, (New Age International,
Secunderabad, 1995)
Peter Lichtenstein: An Introduction to Post-Keynesian and
Marxian Theories of Value and Price, (M.E.Sharpe, 1983)

Adam smith value theory

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