September 22, 2024

By Stephen Stofka

This week’s letter is about value. Is there a true value and how is it determined? Does the value of something depend on its usefulness or is it an unchanging abstract quality? What is the difference between true or intrinsic value and exchange value? What is the diamond-water paradox? Is there a true price P* of exchangeable goods, or a true price of money, the interest rate r*? Is there such a thing as a fair wage? Whenever government sets a price for something, it does so to correct a perceived distortion in the market price for that good. Governments pass rent control policies to set the price of housing, or establish a minimum wage. A central bank sets a benchmark interest rate that determines the price of borrowed money. Is there an intrinsic value to tradeable goods?

In Chapter 4 of The Wealth of Nations, published in 1776, Adam Smith (1723 – 1790) discussed the two different meanings of the word value: value in use, and value in exchange. Like others of his time, Smith limited his concern to the value and price of commodities, not the scarce artisanal goods that only the wealthy could afford. “Nothing is more useful than water: but it  will purchase scarce anything…A diamond, on the contrary, has scarce any value in use; but a very great quantity of other goods may frequently be had in exchange for it.” Smith sought the “real measure of this exchangeable value” as well as the components of this real measure that he called the “natural price.” Lastly, how did circumstances affect the market price so that it differed from the natural price? This investigation, he warned the reader, would require three chapters of the book to fully explore. “I am always willing to run some hazard of being tedious in order to be sure that I am perspicuous,” he wrote, begging the reader’s patience.

Smith determined that the exchange value of a commodity is the “toil and trouble of acquiring it.” If Mary wants to exchange commodity A for commodity B, then the exchange value of A is the toil and trouble it will save Mary to get or make B. When Smith concluded that “Labour is the real measure of the exchangeable value of all commodities,” he is referring to the labor saved by the buyers of a commodity. The natural price of a good, Smith later concluded, was the average of many different individual valuations within a region, varying by both region and country.

Smith’s theory of value differed from an earlier writer, Richard Cantillon (1680 – 1734) whose Essay on the Nature of Commerce was not published until 1754, a decade before the publication of Smith’s Wealth of Nations. “Land is the source … from whence all wealth is produced,” Cantillon wrote, voicing a view held by a prominent school of philosophers, the Physiocrats, although he was not a member of that school. The basis of wealth was agricultural, the difference between what was produced and the sum of the inputs. The fertility of the land provided that difference in value. Cantillon believed that “there is never a variation in intrinsic values” but that a mismatch between supply and demand can cause market prices to differ from their intrinsic value. In well-organized societies where production and consumption are more constant, Cantillon observed that there were only small variations between the market price and the intrinsic value.

David Ricardo, John B. Say and Karl Marx promoted economic theories where goods had both an intrinsic and market value, based on the labor needed to produce the goods. The debate over intrinsic value was an arbitrary set of definitions that could not be resolved. Finally, the Marginalist school of economists in the late 19^th century rejected the idea of an intrinsic value as an economic concept. It was a speculative concept of philosophers and political scientists, not economists. There was no intrinsic value to a worker’s wage other than the marginal product of that labor. To an employer, the value of that labor input is only as much as the change in the output.

In The Distribution of Wealth published in 1899, John Bates Clark challenged the idea of marginal productivity as the basis for a worker’s wage. The problem was that the surplus supply of goods and labor played a key part in determining the value of the entire supply of that good. In Chapter 7 Clark noted that the price of all the wheat grown by farmers in the northwest United States was determined by the price of whatever surplus wheat there might be when all the wheat reached the marketplace. Why should the marginal surplus determine the price of an entire crop? In Chapter 8, he wrote that a worker’s wage was not based on a worker’s marginal productivity but the marginal loss to the employer if an employee left or wasn’t there. Clark called it a zone of indifference and within that zone were expendable workers. Should the wages of expendable workers become the standard for the wages of other workers, he asked.

The Marginalist economists separated Political Economy into two fields of study, describing transactional relations with mathematics to bring greater precision, clarity and scientific discipline to the study of economics. They disregarded what are called allocational inefficiencies,  flaws in the pricing system that distorted the distribution of goods and services. History, past policy, demographics and the local environment form a less flexible landscape that does not adjust to price signals in some markets. Governments try to correct those flaws, only to introduce other distortions into the pricing system that can be worse than those of a free market.

The real estate market in New York City is an example. In a free market, developers would respond to market demand, buying up single family homes, and “scraping” them to build two-plex and four-plex residences. Zoning regulations championed by local politicians and supported by existing homeowners interfere with that free market dynamic. Next week I will review the distortions that such zoning regulations and rent control introduce to the housing market.

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Photo by Evergreens & Dandelions on Unsplash

Clark, J. B. (1965). The distribution of wealth: A theory of wages, interest and profit. Augustus M. Kelley. There are several Kindle versions of this work for about $1 at Amazon.

Keywords: marginalist, Labor Theory of Value, fair wage, rent control