Ricardo Labor Cost Theory Definition

Ricardo's Labor Cost Theory of Value

Ricardo began his book with a chapter on value, which starts by clearly distinguishing his views from those of Adam Smith: "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, and not on the greater or less compensation which is paid for that labour."5 Ricardo italicized the opening sentence because he wanted to stress the fact that he was not caught in the confusion and circular reasoning that had trapped Smith in his formulation of a labor cost theory of relative prices. Smith had solved the problem of measuring the quantity of labor necessary to produce a commodity (the skill, hardship, ingenuity question) by concluding that the wages paid to labor were a measure of the necessary labor time. Ricardo saw that this was circular reasoning, so in his opening sentence he explicitly stated that value depends upon the quantity of labor necessary for production, not on the wages paid to labor.

Ricardo then addressed the confusion over value in use and value in exchange that Smith had illustrated in the diamond-water paradox. Unlike Smith, who saw little connection between use value and exchange value, Ricardo held that use value is essential for the existence of exchange value, though not its measure. In modern terminology, he was saying that before a commodity will have a positive price in the market, a demand must exist, but demand is not the measure of price. The price of commodities that yield utility derives from two sources: their scarcity and the quantity of labor required to produce them.

Some commodities, however, have a price that is determined by their scarcity alone. These are commodities that are not freely reproducible and-whose supply, therefore, cannot be increased—in modern phrasing, those that have a perfectly inelastic (or vertical) supply curve, such as rare pictures, books, coins, and wines. He said of these goods that "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.6 What Ricardo was saying, in effect, is that given a fixed inelastic supply curve, the position of the demand curve will determine price, and the demand curve's position is a function of individuals' preferences and income.

Competitively Produced Goods

Ricardo excluded those scarce, not freely reproducible commodities from his labor theory of value without much concern, because they "form a very small part of the mass of commodities daily exchanged in the market."7 His value theory therefore applies only to commodities that are freely reproducible and produced in perfectly competitive markets. He assumed that the supply curve of goods produced by the manufacturing sector of the economy is perfectly elastic, which is another way of saying that for manufacturing he assumed constant costs. For agriculture he assumed increasing costs, so these supply curves slope up and to the right, exhibiting elasticities greater than zero but less than infinity.

After analyzing Smith's explanations of the determinants of relative prices, Ricardo discarded the labor command and cost of production theories of value in favor of a labor cost theory of value. Whereas Adam Smith had rejected a labor cost theory for an economy in which capital and land received returns, Ricardo maintained that this theory was appropriate to the economy of his own time. In literature that ranks among the most difficult to comprehend in all of economics, Ricardo attempted to prove his labor cost theory of value.

Difficulties of a Labor Cost Theory of Value

Ricardo encountered some of the problems that had led Smith to abandon the labor cost theory, but he saw clearly difficulties that Smith had only vaguely perceived. He wrestled with these theoretical issues, trying in various ways to surmount them. A number of historians of economic ideas (with whom we tend to agree) believe that the labor theory of value received its most mature treatment in the works of Ricardo, that Ricardo developed the theory to its limit, and that Marx added little to our understanding of the theoretical difficulties of develop­ing such a theory. Some even refer to Marx as a minor Ricardian, but because Marx's vast contributions to economics and the social sciences have little connection with his analysis of the problem of relative prices through a labor theory of value, he hardly deserves such an epithet.

Our next task is to indicate Ricardo's solutions to five fundamental problems that confront any theoretician developing a labor theory of value: (1) to measure the quantity of labor, (2) to reflect the fact that labor skills vary, (3) to account for capital goods as a factor influencing prices, (4) to account for land in price determination, and (5) to account for profits in price determination.

A measure of the quantity of labor. Smith was unwilling to use clock hours, or time, as a measure of the quantity of labor necessary to produce a good because he reasoned that the skill of the laborer and the hardship of the job were also relevant. He argued that the value of skill and hardship were settled by the "higgling and bargaining" in the market, and that the wage rates paid to different laborers would reflect their skills and the hardship of their jobs. Ricardo saw that Smith's logic was faulty and, as we have already observed, stated explicitly in the first sentence of his Principles that it is the quantity of labor that determines relative prices, not the wages paid to labor. Ricardo's solution is to measure the quantity of labor by the amount of time involved in producing a good, that is, by clock hours alone.

The differing skills of labor. Using clock hours as a measure of the quantity of labor embodied in a commodity creates the same problem for Ricardo that Smith was trying to avoid. We call this the skilled-labor problem; it results from the fact that labor is not a homogeneous product, so one hour of labor time may produce different amounts of output. Assume that two laborers are working under the same conditions with the same quantities of land and capital to assist them. If one laborer produces two deer per hour and the other produces one deer per hour, what is the quantity of labor necessary to produce a deer? Ricardo solved this problem by using the wages paid to laborers to measure their relative productivities. Thus, the wage of the laborer producing two deer per hour would be twice that of the less productive laborer. Superficially it would appear that Ricardo had involved himself in the same circular reasoning as Smith, for relative wages, which are prices, are used to explain relative prices. However, Ricardo's reasoning is not circular, because he was not attempting to explain relative prices at a point in time but was devising a theory to explain changes in relative prices over time.

He responded to the objection that this was circular reasoning by pointing out that if differences in the wages paid to laborers because of differing skills remain constant over time, changes in the prices of final products will not be a result of the wages paid to labor. Thus, if a skilled laborer receives twice the wage of an unskilled laborer today and this ratio remains the same at some future date, any changes in the relative prices of the products produced by these two laborers must be explained by factors other than the wages paid to labor. Ricardo's assumption that wages paid to laborers with differing skills remain constant over time is open to question; but, granted this assumption, his solution of measuring labor in terms of clock hours is not circular reasoning, given the problem he was trying to solve.

Capital goods. The production of almost all commodities requires the utiliza­tion of both labor and capital. What is the influence of capital on the prices of final goods under a labor cost theory? Ricardo solved this problem by identifying capital as merely stored-up labor, labor that has been applied in a previous period. The quantity of labor in a commodity produced by both labor and capital is measured by the quantity of labor immediately applied plus the quantity of labor stored in the capital good that is used to produce the final product. If a capital good requires 100 hours of labor for its production and wears out, or depreciates, at the rate of one-hundredth of its cost for each unit it produces, then the total labor required to produce a final good, using this capital good, is the number of hours of labor immediately applied plus 1 hour of labor used up from the capital good.

In modern terminology, when a commodity is produced with both labor and capital, the capital depreciates during the production process. If the accountant's depreciation is an accurate measure of the capital destroyed in the production process, it is equivalent to the portion of the labor originally required to produce the capital that becomes embodied in final goods. Ricardo would therefore handle the capital goods problem by summing the labor immediately or directly applied plus the time equivalent of the depreciation of capital goods during the manufacturing process.

Ricardo's solution to the capital goods problem is not completely satisfactory. If labor has been applied in some past period to produce a capital good, the price of a final good produced by using up this capital good must include the amounts necessary to pay the labor directly applied, the indirect labor used to produce the capital good, and the interest on the funds paid to the indirect labor from the time of payment until the final good is sold. To put this in its simplest form, an hour of labor applied to produce a capital good two years ago would have a different influence on the price of a final good produced today than would an hour of labor applied one year ago. A more accurate solution would be to sum both labor and interest costs from the past, but this would be inconsistent with a theory of value based exclusively on labor.

Land rent. A labor theory of value must also deal with the question of land rent. Adam Smith was unable to develop a labor theory of value once land had become an economic good, which is one reason for his turning to a cost of production theory. Suppose that there are two laborers of equal skill working on two plots of land of different fertility. In one year the laborer on the more fertile land will produce more than the laborer on the less fertile land. What, then, is the quantity of labor necessary to produce a bushel of wheat? Ricardo solved this problem through his theory of land rent. For him, the price of a bushel of wheat depends upon the marginal cost of the bushel of wheat produced least efficiently. Price is determined at the margin, and at the margin there is no rent. Rent, as we have seen, is price-determined and not price-determining. The differing rents received by lands of differing fertilities will not, therefore, influence changes in relative prices over time.

Profits. Another difficulty inherent in any labor theory of value is determining the role of profits. If profits are a different percentage of final price for various commodities, then relative prices or changes in relative prices cannot be correctly measured by labor alone. Casual empiricism indicates that profit is not a constant percentage of the final price of commodities. The amount of profit (defined, according to the Smith-Ricardo tradition, to include what modern economists would call profits and interest) in the final sales price may vary for a number of reasons. The amount of capital per unit of final output can be expected to vary from one industry to another. Profit will be a larger element of final prices in industries that are capital-intensive than in industries that are labor-intensive. The rate of turnover of capital will also vary by industry, depending on the proportion between fixed and circulating capital. Industries with a faster rate of capital turnover will produce goods whose ratio of profit to final price is lower than that of goods produced in industries with a slower rate of capital turnover. After thoroughly examining the problems the existence of profits raises for a labor theory of value, Ricardo concluded that they do not alter his fundamental proposition that changes in relative prices over time depend upon changes in the relative quantities of labor embodied in commodities. His conclusion is that the influence of the rate of profits is not quantitatively important.

Did Ricardo Hold a Labor Theory of Value?

Two aspects of this question have troubled historians of economic ideas: (1) Did Ricardo hold a labor theory of value? (2) Did Ricardo change his mind about the merits of a labor theory of value? Ricardo did not hold a theoretical labor theory of value, because he admitted that changes in the quantity of labor required to produce goods are not the only forces causing changes in relative prices. "Mr. Malthus shows that in fact the exchangeable value of commodities is not exactly proportional to the labour which has been employed on them, which I not only admit now, but have never denied."8 He did, however, feel that changes in the amount of labor necessary to produce goods were quantitatively by far the most crucial element in explaining changes in relative prices.

George Stigler has labeled Ricardo's theory a 93 percent labor theory of value. On the basis of Ricardo's own illustrative figures, 93 percent of variations in relative prices can be explained by changes in the quantity of labor required to produce commodities. Ricardo's view is that even though changes in either the rate of profit or wage rates theoretically will cause changes in relative prices over time, these various changes in prices are quantitatively insignificant. He therefore concluded, "I shall consider all the great variations which take place in the relative value of commodities to be produced by the greater or lesser quantity of labour which may be required from time to time to produce them."

Prior to the Sraffa edition of Ricardo's Works, historians of economic thought generally believed that Ricardo himself was backing away from a labor cost theory of value and moving toward a cost of production theory, with costs including profits as well as labor costs. They concluded this largely on the basis of a passage from a letter Ricardo wrote to his friend J. R. McCulloch in 1820, following publication of the second edition of his Principles but before the third:

I sometimes think that if I were to write the chapter on value again which is in my book, I should acknowledge that the relative value of commodities was regulated by two causes instead of by one, namely, by the relative quantity of labour necessary to produce the commodities in question, and by the rate of profit for the time that the capital remained dormant, and until the commodities were brought to market.

On the basis of all the correspondence now published in Ricardo's Works and the content of the third edition of his Principles, the editors of Ricardo's Works conclude that this one letter to McCulloch represented "no more than a passing mood" and that Ricardo maintained to the end that labor was quantitatively the most important element explaining variations in prices. The validity of a labor cost theory of value is certainly subject to question, but it does seem to be beyond dispute that Ricardo thought it was valid.