.. he riddle and the resulting relationship between use-value and use-exchange, by mistakenly focusing on total rather than marginal utility. His confusion is further shown in his experimentation with three value theories. He provided a labour cost and a labour command theory of value for a primitive society and finally a cost of production theory for an advanced one. In his “Nation of hunters” analogy, Smith’s notion of labour cost of value is determined by the quantity of labour which is measured by wages which is also extended to his labour command theory- “Value of any commodity…..to the person who processes it and who means not to use or consume it himself, but to exchange it for other commodities, is equal to the quantity of labour which enables him to purchase or command” . However, when he perceived that if wages were not the same proportionate part of final prices of all goods, he then realised that his labour theory of value for an advanced economy would not hold.
Instead, it appears that he opted for a cost of production value theory consisting of land, labour and capital value theory. Up to this part, I have tried to give a brief history of Theory of Value before David ricardo. Now, I will try to explain Ricardian Theory of Value in detail. First of all, I would like to give some information about David Ricardo. His Life and Times David Ricardo was born 4 years before the publication The Wealth of Nations. His world was the world of the industrial revolution, his England the nexus of world trade and finance. He was the third child of a well-to-do family of Sephardic Jews, from whom he was astringed at the age of 21, on the occasion of his conversion and marriage to Quaker.
His success as a stockbroker allowed him to devote his attention to questions of public policy, which in turn led to a successful carer as a Member of Parliament. His writings also led to a correspondence with Thomas Malhus, a correspondence into a personal friendship, although they disagreed on many of the fundamental economic issues of their they. He died in 1823 at the age of 51. Contibutions One of Ricardo’s fundamental contributions is the comparative advantage theory of trade, which explains international trade as the result of relative rather than absolute differences in productivity across countries. This implies that countries can benefit by specializing in the production of goods that they produce most efficiently, relative to the rest of world, and trading them for goods that are most efficiently produced elsewhere in the world.
The theory of comparative advantage suggests that trade is beneficial to all trading partners and provides a formal rationale for free trade policy. It discredits the merchantilist view of trade, which sees the accumulation of export surpluses as the means to benefit from rate. Also of particular interest to industrial economists is the Ricardian notion of rent. Ricardo developed his theory of rent in his analysis of the returns to agricultural land, when such land differs in location or degrees of fertility. In the long run, the price of grain will be just sufficient to cover the cost of production (including a normal rate of return on investment, the opportunity cost of inducing the farmer to retain in the market) and transportation to market of the least productive (or most distant) farm the output of which is needed to balance supply and demand.
But if the least advantaged farmer earns only a normal rate of return, then those who work more fertile farms, or farms from which the transportation cost is less, will earn an above-normal rate of return. This excess return, an income that cannot be competed away that is a return a unique asset(fertility, location) is an example of an economic rent. Ricardo’s Labor Theory of Value In the preface of The Principles of Political Economy and Taxation (1817), David Ricardo laid out the goal of his work. He was setting out to uncover the laws that regulate the distribution of the produce of the earth – all that is derived from its surface by the united application of labour, machinery, and capital .. among [the] three classes of the community, namely, the proprietor of the land, the owner of the stock or capital necessary for its cultivation, and the labourers by whose industry it is cultivated. The Principles of Political Economy and Taxation [Preface].
The first step of this project was to understand the laws of value. As the heading of Chapter 1, he gives us the foundation of what came to be called the labor theory of value: The value of a commodity, or the quantity of any other commodity for which it will exchange, depends on the relative quantity of labour which is necessary for its production.. The Principles of Political Economy and Taxation, Chapter 1, Section 1 Ricardo planned to develop a rigorous theory of value. Rather than make his theory fuzzy enough to encompass the value of all goods, he would exclude goods such as “rare statues and pictures, scarce books and coins, wines of a peculiar quality, which can be made only from grapes grown on a particular soil,” since their value is wholly independent of the quantity of labour originally necessary to produce them, and varies with the varying wealth and inclinations of those who are desirous to possess them. These commodities, however, form a very small part of the mass of commodities daily exchanged in the market. The Principles of Political Economy and Taxation, Chapter 1, Section 1 This theory of value would be limited to the goods and services that were typical products of competitive capitalism: In speaking, then, of commodities, of their exchangeable value, and of the laws which regulate their relative prices, we mean always such commodities only as can be increased in quantity by the exertion of human industry, and on the production of which competition operates without restraint.
The Principles of Political Economy and Taxation, Chapter 1, Section 1 Ricardo was much more consistent than Smith. Smith had identified labour as the major factor responsible for natural price. But Smith’s measure of labour itself varied from chapter to chapter. Sometimes it was the amount of labour needed to produce the product; sometimes it was the amount of labour that could be hired for an amount of money equal to the value of the product; sometimes it was the value of the goods and services that the worker could purchase with his wages. A Measure of Value But Ricardo was searching for an “invariable measure of value.” This is truly an impossible goal.
When the technology of production of a good or service changes, its value will change. All theories of value are in agreement on this. Even gold and wheat, two candidates for such a measure that were rejected by Ricardo, will alter in value as the technology of production changes. The same is true, in a more roundabout way, of labor itself. If new farming and/or baking technology reduce the value of bread, then the value of labor will also fall since the worker’s capacity to work can be “produced” at a lower cost. (The Principles of Political Economy and Taxation, Chapter 1, Section 1.) It might be possible, Ricardo thought, to find a measure of value which would not vary as the distribution of income changed, even thought it would certainly vary with technological change. Ricardo’s project was to discover which economic forces determined the distribution of income.
The best candidate for such a measure was labour. If profits rose and wages fell, or if profits fell and rents increased, it would still require the same amount of labour to weave a bolt of cloth or to build a ship. The Level of Wages Ricardo’s theory of wages was similar to Smith’s, but much more severe. Thomas Malthus, Ricardo’s good friend, had published his famous Essay on the Principle of Population in 1798. While Adam Smith had noted a tendency for population to increase when wages were high, Ricardo (and Malthus) turned this tendency into a ruthless certainty: The natural price of labour..depends on the price of the food, necessaries, and conveniences required for the support of the labourer and his family. With a rise in the price of food and necessaries, the natural price of labour will rise; with the fall in their price, the natural price of labour will fall.
.. It is when the market price of labour exceeds its natural price that the condition of the labourer is flourishing and happy, that he has it in his power to command a greater proportion of the necessaries and enjoyments of life, and therefore to rear a healthy and numerous family. When, however, by the encouragement which high wages give to the increase of population, the number of labourers is increased, wages again fall to their natural price, and indeed from a reaction sometimes fall below it. When the market price of labour is below its natural price, the condition of the labourers is most wretched: then poverty deprives them of those comforts which custom renders absolute necessaries. It is only after their privations have reduced their number, or the demand for labour has increased, that the market price of labour will rise to its natural price, and that the labourer will have the moderate comforts which the natural rate of wages will afford.
(The Principles of Political Economy and Taxation, Chapter 5) The Theory of Rent Agricultural products presented a particular difficulty. Smith’s solution had been to make land rent one of the components of natural price and simply add it onto labour costs and profits to get value. Ricardo started by examining how agriculture was different from manufacturing. When the demand for shovels increases, manufacturers can build more factories. There is no reason that these new factories cannot be as productive as the existing factories. That is, the amount of labour needed to produce a shovel will not change when we double or triple shovel production by building new shovel factories. When the factory is a farm, however, we have a different problem.
Land varies greatly in its productive qualities. It is usually the best land that is first drawn into agricultural production. Therefore, when the demand for wheat increases, it will take more than the average amount of labour to produce and transport the additional wheat. Ricardo’s example supposes that there are three grades of land. On the best land it costs 3 to produce 10 bushels of wheat and deliver it to the town market.
This cost includes the necessary amount of profit to get someone to farm the land. On the middle grade of land it costs 4 to produce the same amount of wheat and transport it to the town market. On the poorest land, it costs 5 to produce and transport 10 bushels of wheat. The differences in costs reflect differences in the amount of labour required. With a small population, the demand for wheat can be met by farming only the best land.
The price of wheat will be 3 per 10 bushels. But as population grows, some of the middle grade land will be brought into cultivation. Now the price of wheat will rise to 4 per 10 bushels. If I own some of the best land and you farm that land, I can charge you a rent of 1 per 10 bushels of wheat. If I own some of the middle grade land, I cannot collect any rent since the cost of production on that land is the same as the price of the wheat.
As population continues to grow, cultivation is extended even to the poorest land and the price of wheat rises to 5 per 10 bushels. Now the owners of the best land will enjoy a rent of 2 per 10 bushels and the owners of the middle grade land can collect a rent of 1 per 10 bushels. This rising rent has important implications. For now, we must understand how this theory of rent fits into Ricardo’s labour theory of value. Ricardo was able to show that the value of agricultural commodities, just like the value of manufactured commodities, is determined by the amount of labour it takes to produce them.
The difference is that, with agricultural commodities, the value is governed by the amount of labour required under the most unfavourable circumstances – that is, by the amount of labour needed on the poorest quality land which the level of demand causes us to bring into production. Taking issue with Smith, Ricardo argued that “rent is not a component part of the price of commodities.” Smith had claimed that high land rents drove up the price of wheat. Ricardo showed that high wheat prices – which themselves were caused by a growing population – drove up rent. Rent was the consequence, not the cause, of high food prices. A Labor Theory of Value It all fits together into a fairly complete and consistent theory of value.
Value is determined by the amount of labour needed for production, including, of course, the labour used to produce the raw materials and the ‘worn out’ part of the capital equipment. For wheat and similar products, value is determined by the amount of labour needed for production on the poorest land. Wages are determined by the values of the goods and services that a working class family needs to survive and reproduce. The capitalist pays his suppliers, repairs or replaces his worn out equipment, pays the workers and sells the product for a price determined by the amount of labour it took to produce it. Whatever is left over is profit.
If the price of bread is high, wages will also be high and there will be little profit, but agricultural landowners will collect high rents. If the price of bread is low, wages will also be low and there will be high profits and little rent. Note that profit and rent are incorporated into this value theory, not added on as a cost as Smith had done. There was still one major problem with the labour theory of value. It would only work well as a theory of natural price if the ratio of labour costs to capital costs were the same in all industries. Labor could not be an invariant standard of value when some industries used lots of labour and little capital while others used lots of capital and little labour, since a change in the distribution of income between wages and profits would alter costs in different industries by different amounts.
Ricardo was still pondering this problem when he died. Nonetheless, Ricardo’s labour theory of value was something of a sensation. Thirty years after Ricardo’s Principles of Political Economy, John Stuart Mill, in his own Principles of Political Economy (1848) saw little reason to modify Ricardo’s foundation of economics: Happily, there is nothing in the laws of Value which remains for the present or any future writer to clear up; the theory of the subject is complete: the only difficulty to be overcome is that of so stating it as to solve by anticipation the chief perplexities which occur in applying it. Mill, John Stuart. Principles of Political Economy, Book 3, Chapter 1 Karl Marx’s (1818-1883) approach to value was essentially Ricardo’s labour theory of value. According to Marx, the values of “All commodities are only definite masses of congealed labour time.” As an advocate of Ricardo’s original theory, he also followed and built on his solutions to the labour value theory’s inherent deficiencies. Although Marx used the classical concepts of value he applied his vast philosophical and sociological knowledge to reach conclusions in Capital that diverged radically from them. In his labour theory, he developed his original rate of exploitation (s’=s/v) and its resulting critique of capitalism-“Derriere le phenomene du profit se cache la realite do surtravail.” Like Aristotle, exchange of value or more appropriately exchange of ‘just’ value had for Marx, moral and judicial implications as well as economic ones.
Despite John Stuart Mill’s (1806-1873) claim to the continuity of Ricardo’s labour theory of value, his work in retrospect was closer to Marshall and to the approaching neo-classical school. Mill gave up the classical-Ricardian search for absolute value for his belief that “The value which a commodity will bring in any market is no other than the value which, in that market, gives a demand just sufficient to carry off the existing supply.” Although lacking the tools of the supply and demand schedules, Mill clearly recognised the effects of demand on the supply in different time periods of a value theory. Although he acquired a more advanced comprehension on the subject of value than his contemporary theorists did, unfortunately it led him to prematurely and embarrassingly state in 1848 that “Happily, there is nothing in the laws of value which remains for the present or any future writer to clear up; the theory of the subject is complete.” Neo-Classical Thought Although the origins of modern utility theory can be traced back to Mountifort Longfield in 1834 at Trinity College Dublin it was William Jevons (1835-1882) with his Theory of Political Economy and Carl Menger’s (1840-1921) Principles of Economics who both developed the new tool of marginal analysis in 1871 as a means of understanding value. For the rising neo-classical school in the 1870s, the classical cost of production theory of value seriously lacked generality – especially in determining value of goods with inelastic supply curves. Instead, Jevons and Menger separately formulated their marginal utility theory, in which it was calculated that “Value depends entirely on utility.” Like Davanzati in the 16th century, they felt that no matter what costs were incurred in producing a good, when it arrived on a market its value would depend solely on the utility the buyer expects to receive.
Menger used his marginal utility table to explain the old water / diamond paradox. The value of diamonds was greater than the value of water because it was marginal utility and not total utility that determines consumer choice and hence value. From this they also argued that value comes from the future and not past production. Henceforth, the factors of production are not price determining but price-determined, as Jevons clearly states- “Cost of production determines supply, supply determines final degree of utility, final degree of utility determines value.” Jevons and Menger like their predecessors before, erred in trying to find a simple one-way, cause and effect relationship between value, and in their case utility. It took the intellect of Leon Walras and Alfred Marshall to see that both the cost of production (supply) and utility (demand) were interdependent and mutually determinant of each other’s values.
Leon Walras (1834-1910) also independently discovered the concept of marginal utility although he went beyond Jevons and Mengers application of it to merely a utility value theory. He did not see their simple and direct causal link from subjective utility to value. Instead, he saw a complex interrelated and interactive economic system. In his Elements of Pure Economics, he created his theoretical model of General Equilibrium as a means of integrating both the effects of the demand and supply side forces in the whole economy. This mathematical model of simultaneous equations concluded that “In general equilibrium everything depends upon everything else”.
Meanwhile, Alfred Marshall (1842-1924) was also amalgamating the best of classical analysis with the new tools of the marginalists in order to explain value in terms of supply and demand. He acknowledged that the study of any economic concept, like value, is hindered by the interrelativeness of the economy and varying time effects. As a result, Marshall who differed from Walras’ general schema, instead used a partial equilibrium framework, in which most variables are kept constant, in order to develop his analysis on the theory of value. Marshall divided his study into four time periods. Firstly, in the market period where time is so short that supply is fixed, value of a good is determined by its demand.
Secondly, in the short-run period, firms can change their production but cannot vary their plant size, which allows supply as well as demand to have an effect on value. In the long-run periods where plant size can be altered, the large effects of the supply side on value depends on whether the industry of a particular good has constant, increasing or decreasing costs to scale. Finally, in the secular period in which technology and population are allowed to vary, the supply side conditions dominate value. For Marshall a correct understanding of the influence of time and interdependence of economic variables would resolve the controversy over whether it was the cost of production or utility which determines value. In general, however he felt that it was fruitless to argue whether demand or supply determines value as “we might as reasonably dispute whether it is the upper or under blade of a pair of scissors that cuts a piece of paper, as whether value is governed by utility or costs of production.” Any attempt to find one single cause of value as others had unsuccessfully attempted in the past, were doomed to failure.