Is the Labor Theory of Value useful at all?

Can we salvage anything from this muddled concept?

"North Korea - Ryugyong hotel" by Roman Harak, CC BY-SA 2.0

People occasionally ask me to write a post about the Labor Theory of Value. This is an interesting concept, if also a poorly defined one. It doesn’t help us think much about how things actually get valued in the real world, and it’s not concrete or coherent enough to give us much guidance about how things should be valued, either. But it does point us to some interesting clues about our own ideas of fairness.

As far as I can tell, there are actually two Labor Theories of Value. The first, which comes from Adam Smith, is that the price of something is equal to the amount of labor you can buy with it. This is very similar to the basic Econ 101 idea of a relative price — the idea that the price of something is just the amount of other stuff we’re willing to give up to get it.

But that’s not the Labor Theory of Value that we’re really interested in. We’re interested in the Marxist version. This is the idea that the value of something is equal to the amount of labor it took to produce it.

That idea is commonly associated with Marxism, but in fact it’s not clear whether Karl Marx himself actually believed it; his writings on the topic are fairly vague. Really, the idea comes from an earlier economist, David Ricardo (the same guy who came up with the idea of comparative advantage in international trade!).

Basically, at one point, Ricardo considered the idea that the price of things might equal the total amount of work that went into making them. That’s obviously wrong, as the picture at the top of this post demonstrates. It’s a giant empty unusable hotel in the middle of Pyongyang, North Korea. A hell of a lot of labor went into the making of that hotel, but because it was never finished, it was never occupied; it doesn’t have any economic value, except as a pretty thing to put in pictures at the top of blogs.

You can apply this same principle to pretty much any real-world example. For example, suppose that Jiro is better at making swords than Saburo. Saburo makes a mediocre sword in 150 hours, while Jiro makes an excellent sword in 100 hours. Saburo’s sword took more labor hours to make, but Jiro’s sword is probably going to have more economic value.

So the idea that value is equal to labor-hours is just obviously wrong, because labor hours have different levels of productivity. Playing around in an attempt to square this circle, Marx came up with the idea of “socially necessary labor time”, which he thought of as basically the amount of time something takes to make at the average level of productivity.

That takes care of the Jiro/Saburo problem, but it still doesn’t really work. No matter how much stuff you can make in an hour, it still doesn’t have much economic value if you don’t make things that people want. If Jiro and Saburo spend their time making goofy wavy swords that no one can actually use to fight (and which look ugly as wall decorations), neither one has any economic value. They’re basically the sword equivalent of the Ryugyong Hotel — a lot of wasted work.

So to patch that up, you could define productivity based on demand; if nobody is willing to pay for the wavy silly swords, then you didn’t really produce anything, so you didn’t exert any socially necessary labor. But at this point the definition becomes circular; you’ve defined economic value as economic value, and simply defined “socially necessary labor time” by dividing value by hours of input (in fact, you’ve just reinvented the standard econ concept of labor productivity). But you haven’t really said anything interesting about where economic value comes from.

In fact, the amount of labor that goes into making things is only one part of what determines the cost, and the cost is only one part of what determines the price. The Labor Theory of Value, as a theory of where prices actually come from, is pretty useless.

But there’s another way we could think about the Labor Theory of Value — as a moral theory of where income ought to go.

The phrase “He who does not work shall not eat” appears in both the Bible and the Soviet Constitution. That’s a pretty strong indication that humans have a deep-seated belief that consumption should be based on effort — that what we get out of the economy should in some way be proportional to the effort we put in. If I had to guess, I’d guess that this idea comes from the way that resources are divided up within a family or other household. Instead of paying people based on productivity, we try to divide resources equally and insist that everyone puts in equal work. This is also probably similar to the way people try to divide resources in natural disasters and wars.

That bears little resemblance to how people get paid in a market economy. In a market economy you can get paid a huge amount by owning stocks or cryptocurrencies or houses that luckily go up in price. You can own a business and get income passively, without lifting a finger. You can be a CEO and get paid a hundred times what the average worker in your company makes, even if you put in comparable hours. To many, this seems unfair. You’re getting paid a huge amount without doing any work. That seems like scarfing all the food at the table and sitting back while your poor mother does the dishes!

But here’s the thing — just because you didn’t exert much effort doesn’t mean you didn’t produce anything. Suppose you’re a business owner. Maybe if you hadn’t started that business, the workers you employ would only have been able to find much less valuable things to do. Thus, by creating that business, maybe you’ve created a ton of value, even if you don’t always put in a ton of effort. But that just means that the small amount of labor you put in, to get the business up and running, was insanely productive.

In fact, there’s sort of some evidence that this happens. In a 2019 paper called “Capitalists in the 21st Century” (LOL), economists Matthew Smith, Danny Yagan, Owen Zidar and Eric Zwick found that when business owners die, their businesses become much less profitable:

A primary source of top income is private “pass-through” business profit, which can include entrepreneurial labor income for tax reasons. This paper asks whether top pass-through profit mostly reflects human capital, defined as all inalienable factors embodied in business owners, rather than financial capital. Tax data linking 11 million firms to their owners show that top pass-through profit accrues to working-age owners of closely-held, mid-market firms in skill-intensive industries. Pass-through profit falls by three-quarters after owner retirement or premature death. Classifying three-quarters of pass-through profit as human capital income, we find that the typical top earner derives most of her income from human capital, not financial capital. 

So these business owners might be getting some lucky windfalls, but really a lot of what they’re doing is making good business decisions and/or helping their business run well. What looks like passive unearned capital income is really just incredibly productive labor income. Now, you might think that’s still an unfairly large amount of income, but it’s not quite unfair in the “sit on your butt and get something for nothing” sort of way.

Similarly, some CEOs that look overpaid might actually be earning their keep, at least in terms of the economic value they produce. Suppose a company has to decide whether to focus on manufacturing chips or designing chips. Suppose one of these is a really bad decision and will lead to the company dying, while the other is a really good decision and will lead to lots of profits and new hiring and everyone getting a raise. At that point, a good CEO, who can recognize which path is the path of doom and which is the path to success, would be invaluable — well worth a high salary, for saving the company from utter ruin! All they have to do is make that one decision on which everything hinges, and they’ve created a huge amount of value. Again, this hypothetical instance is an example of really really productive labor — labor that’s so productive it looks like passive unearned income.

In fact, even financiers can do this. If a financier decides to fund a company that otherwise would have struggled to get funding, and the company survives and and creates a lot of economic value, then just that small act of deciding which company to write a check to has produced a ton of value. Really, that’s just incredibly productive labor, even if we don’t count it as such in the official statistics (which satisfies the financiers just fine, since then they get to pay a lower tax rate).

So there are plenty of examples where what looks like passive income isn’t actually passive. Of course, that doesn’t mean that this income is deserved. There are lots of moral principles for how to divide up a society’s consumption that have nothing to do with the value of the deliberate actions people take. There’s utilitarianism, or Rawlsian justice, or all kinds of other ideas. Nowhere is it written stone that people should be paid the marginal product of their actions.

But there certainly are lots of sources of income that are truly passive. If you buy a house in Palo Alto and then the price goes through the roof, you really didn’t produce anything — you just squatted on a piece of land and got lucky. Same with any financial asset, really — if you speculate and get lucky, you can make a lot of money without your decision actually creating any economic value at all. Similarly, when safe interest rates are above zero, you can make money for free, just by starting out with money — you’re what Keynes called a “rentier”. And of course, CEOs can get paid based on connections.

Now, nowhere is it written in stone that passive income should go unrewarded, either. Many economists would argue that investors deserve money in exchange for taking risk and accepting illiquidity (i.e. holding their money in the market for a long time), even if that income doesn’t come from anything that could be remotely construed as productive labor. (I’m not sure I’ve seen anyone argue that CEOs getting paid based on having the right friends is justifiable, but maybe someone does argue this!) But regardless of where you come down on the morality, it’s at least possible, in principle, to draw a distinction between people getting paid for things they do and people getting paid for things they own.

So here’s where we might be able to see a use for the Labor Theory of Value. As a good Humean, I believe that all moral principles ultimately come from people’s moral intuitions — in other words, if people care about whether income is awarded based on actions, then it’s a thing society needs to take into account. And it might have practical usefulness as well — you can pretty easily create a social wealth fund to replace the risk-taking and liquidity-providing functions of investors, but that fund probably won’t be able to replace skilled entrepreneurs or discerning stock pickers.

Thus, even though it doesn’t describe how prices come about, the Labor Theory of Value seems to have some usefulness in thinking about the difference between active and passive income. But determining which income is active is not as easy as just looking at how hard people work. The real economy is infinitely more complex than doing the dishes.

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