Labor cost theory in a primitive society.

In the early and rude state of society which precedes both the accumulation of stock [i.e., capital] 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.¹⁶

According to Smith's labor cost theory, the exchange value, or price, of a good in an economy in which land and capital are nonexistent, or in which these goods are free, is determined by the quantity of labor required to produce it. This brings us to the first difficulty with a labor cost theory of value. How are we to measure the quantity of labor required to produce a commodity? Suppose that two laborers are working without capital, that land is free, and that in one hour laborer Jones produces one unit of final product and laborer Brown produces two units. Assume that all other things are equal—or, to use the shorthand expression of theory, ceteris paribus —so that the only cause of the differences in productivity is the difference in the skills of the workers. Does a unit of output require one hour of labor or two? Smith recognized that the quantity of labor required to produce a good cannot simply be measured by clock hours, because in addition to time, the ingenuity or skill involved and the hardship or disagree-ableness of the task must be taken into account.

At this point Smith encountered a difficulty that all labor cost theories of value have encountered and that has not been successfully solved by subsequent writers. If the quantity of labor is a function of more than one variable, then

¹⁶Ibid., p. 47.

we must find a means of stating the relative importance of all the variables. Suppose we have the following information about the production of good A and good B:

Time Hardship Ingenuity

Good A 1 hour X 2Y

Good В 2 hours 2X Y

How does one compare the quantity of labor required for good A with that required for good B? The units for measuring time are clock hours, but the units for measuring ingenuity and hardship are not given. Though it is not crucial to know these units for the problem at hand, it is essential to be able to measure the differences in the amount of hardship and ingenuity required to produce the two goods. Smith tried to solve this problem of reducing time, hardship, and ingenuity to a common denominator by maintaining that differences in time, hardship, and ingenuity are reflected in the wages paid to labor. If laborer Brown receives wages of $2 per hour and laborer Jones wages of $1 per hour, these wage payments reflect differences in their skill or ingenuity. If they work in different industries, their wages will also reflect (in part) varying degrees of unpleasantness or hardship.

Smith's suggestion merely restates the problem rather than providing a solution. The purpose of his value theory is to explain those forces that determine relative prices, but wages themselves are one of the many prices in an economy that his theory must explain. When he concluded that the wage paid to labor is a measure of the relative amounts of time, hardship, and ingenuity required to produce a commodity, he was begging the question. He was saying that a good has value according to the wages paid to labor, not according to the quantity of labor contained in the good. This is circular reasoning. Smith used one set of prices, namely wages, to explain another set of prices.

Labor command in a primitive society. Now that we have worked through the labor cost theory of relative prices for a primitive economy, the labor command theory will be smooth sailing. According to Smith, under the labor command theory, the value of a good "to those who possess it, and who want to exchange it for some new productions, is precisely equal to the quantity of labour which it can enable them to purchase or command."¹⁷ If it requires two hours to capture one beaver or two deer, Smith concludes that two deer will be equal to one beaver in the market, or the price of beaver will be twice the price of deer, IB = 2D.

¹⁷Ibid., pp. 30-31.

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Labor theory in an advanced economy. Smith's model for an advanced so­ciety differs from his primitive economy model in two important respects—capi­tal has been accumulated and land appropriated. They are no longer free goods, and the final price of a good also must include returns to the capitalist as profits and to the landlord as rent. Final prices yield an income made up of the factor payments of wages, profits, and rents.

Cost of production theory of relative prices. Smith wrestled with develop­ing a labor theory of value for an economy that included more than labor costs in the final prices of goods, but finally abandoned the idea that any labor theory of value was applicable to an economy as advanced as that of his times. Once capital has been accumulated and land appropriated, and once profits and rents as well as labor must be paid, the only appropriate explanation of prices, he seems to have found, was a cost-of-production theory. In a cost theory the value of a commodity depends on the payments to all the factors of production: land and capital in addition to labor. In Smith's system, the term profits includes both profits as they are understood today and interest. The total cost of producing a beaver is then equal to wages, profits, and rent, ТСв = Wr + Pr + R%; likewise for a deer, TCd = Wd + Pq + Rq. The relative price for beaver and deer would then be given by the ratio of TCb/TCd- Where Smith assumed that average costs do not increase with increases in output, this calculation gives the same relative prices whether total costs or average costs are used. Where Smith assumed that average costs change with output, prices depend upon both demand and supply. However, in his analysis of the determination of long-run natural prices, Smith emphasized supply and cost of production, even when the supply curve was not assumed to be perfectly elastic. Where competition prevails, he maintained, the self-interest of the businessman, laborer, and landlord will result in natural prices that equal cost of production.

DISTRIBUTION THEORY

The personal distribution of income depends on the prices and quantities of factors of production sold by individuals. Labor is the only factor of production owned by most households; so a household's income generally depends upon the wage rate and the number of hours worked. The amount of property income received by those households that do own property depends on the quantity of capital and land held by the household and the prices of these factors. Because wages, profits, and rents are prices in an economy, their relative values—along with the quantities of labor, capital, and land that individuals bring to the market—determine the distribution of income. Although distribution of income was not of prime concern to Smith, he did offer several different and sometimes contradictory theories of wages, profits, and rents. We shall confine ourselves to mentioning some aspects of his analysis that anticipate later writers and illustrate both his insights and his misunderstandings.

Wages

Smith offered a number of theories to explain wages. In Chapter 8, Book I, he suggested a subsistence theory of wages, a productivity theory, a bargaining theory, a residual claimant theory, and a wages fund theory. Apparently he was not disturbed by the contradictions among these positions, and in other parts of his book he explicitly rejected some of his own propositions. However, two aspects of his discussion of wages deserve further comment.

Smith pointed out that labor is at a disadvantage in the wage-bargaining process. Because there are fewer employers than employees, he said, employers can more easily join together to strengthen their position. Furthermore, the law permits these employer combinations but prohibits employees from forming unions. Parliament has many acts against raising wages, according to Smith, but none against lowering them. Finally, employers have ample resources that make it possible for them to live even if they employ no labor during a strike or lockout. On the other hand, "many workmen could not subsist a week, few could subsist a month, and scarce any a year without employment."¹⁸ In these passages Smith weakened his case for the beneficent working of market forces and appears to have recognized that his assumption of perfectly competitive markets is subject to qualifications.

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