23 May 2011

Problems With the Cost Theory of Value

Shameless Self-Promotion 14 Comments

I list some of them here. Now you can sleep at night.

14 Responses to “Problems With the Cost Theory of Value”

  1. Joseph Fetz says:

    Darn you, Murphy. Why did you have to bring me back to Smith and Marx? Why, oh why? I’ve been trying to get them out of my head for over 3 months now (and the rest of the classicals).

    You know, I am going to blame you if I end up spending weeks reading defunct theory just to quote a passage or two from some forgotten Nobleman of the 17th century, and you’re going to truly regret it. Seriously!!!

    By the way, wasn’t this all hashed out by St. Thomas? Cantillon? Turgot? The Scholastics?

  2. Joseph Fetz says:

    Oh yeah, don’t forget that Olivi was the originator of subjective value back in the 13th century…

  3. Avram says:

    I think it was Marshal (?) who said something like both costs of production and demand influence the price just that the difference is at what time scale you’re using (the quotation I am thinking of includes tides or waves or something)

    I think thats the right of it in terms of phenomenological explanation. Namely it explains why competition can lower prices, and I think just looking at things from a demand based perspective you can’t provide an explanation for that.

    If I’m wrong I’d love to know. I guess I’m really asking a question and the question is: “how does a purely demand based analysis explain things like prices falling due to compeition cutting costs of production”

  4. Joseph Fetz says:

    Marshall, a neoclassical, got much of his theory from Smith. Much of it is based upon the long-run equilibrium theory, and that of long-run costs. But, this is erroneous because all equilibrium prices are arrived at in short run spurts, in instantaneous progressions that never actually reach equilibrium. Equilibrium is merely a concept that the market tends toward based upon market exchanges, but since the real world is rife with continual change, equilibrium is never reached. Now, onto your question.

    No matter what the cost of production, the sales of the produce of such must necessarily depend upon the demand for those goods. If the price is high, then demand will be lower than if the price is low. Let’s say that there are 2 fork makers A and B, and each has equal production/labor costs and equal market share. Each sells forks for $1. Now what if the production costs of one of the fork makers A increased by twofold such that he had to sell his wares at $2 in order to reap the same profit? Would you expect him to still realize the same market share, or the same rate of profit? I wouldn’t. The same holds true for firms that innovate and increase efficiency and are able to lower the price of their wares, except that it is the entirely opposite direction.

    Obviously, it is much more complicated than that, and the supply and demand curves come into play, as well as the elasticity of demand, medium of exchange, time preference, subjective value, etc. However, the primary key to the entire ordeal is that it is the consumer’s choice of whether they purchase a good or not, or which good they will purchase. They can buy a fork from A or B, or they can decide that they would rather purchase a good from X, Y or Z. Ultimately, it is the consumer that determines the cost of production through their purchases of goods. If the costs become excessive and prices rise, then they can just buy from a producer that offers a lower price, or they can just purchase a substitute good. The price of the goods sold and their total revenue determine the cost of production, not the other way around.

    • Avram says:

      Ok, a simple example: in the tech sector if you look at dollar / gigabyte price of hard drives you’ll notice that every year its been falling. This isn’t because people have decided that they don’t like hard drives as much as the last year, but that is the only explanation a purely demand based theory of prices can offer.

      The real causal explanation of course is that the silicon manufacturing process becomes more efficient and lowers the costs of production, hence increasing supply and hence lowering prices.

      • Avram says:

        Uhh obviously silicon die size has nothing to do with hard drives (platter density does) I just had a mix up in my head, not that it matters for the point I was trying to make.

      • Roger Ritthaler says:

        Perhaps Robert Murphy’s point was that “cost” is not a sufficient condition for a thing’s “value”?

        • Avram says:

          I am pretty sure it was that costs have nothing to do with a thing’s value, and I agree with this. But I think costs may have something to do with market prices. I mean I get the whole “well its peoples valuation that is the ultimate determiner of the price” thing, but then you just have no explanation for why in the real world something like my hard drive example happens, and I really want to know the answer to this.

  5. RG says:

    I believe it was a Neanderthal named Noog in the heart of France that grunted the subjective theory of value first: “Me no care how long it take Grog to catch fish, fish a fish and Noog only give two spearhead for fish.”

    • Joseph Fetz says:

      Obviously, at the human level of consciousness we all have realized the subjective nature of value and utility (just watch a baby’s first instincts). Unfortunately, it took many centuries to put into a conceptual nature and theory. Unfortunately, that truth of human reason was lost, found, lost, found, lost again, then found again… Even today people parrot the labor theory of value, or its ugly cousin the cost theory of value, even though the proof of subjective value is everywhere around us.

  6. Dave B says:

    What is funny is that on Saturday, I looked through your Academic work and saw “The Labor Theory of Value: A Critique of Carson’s Studies in Mutualist Political Economy.” I clicked it and started reading it. My baby woke up from a nap so I held him while I finished reading it. Very well done by the way. You picked his weak argument apart. Anyways, Monday I find you did a mises daily on that topic and you linked the paper I read of yours.

    It was done in 2006 and I found it to be an interesting coincidence that I read the full work while you did an article on it the following Monday. Maybe that is a sign or something? I have just been digging into the theories of value recently and I take it that I continue on this journey. You do great work as always.


  7. Major_Freedom says:

    Dr. Murphy,

    Maybe I am way off base, but the marginalist revolution was not “universalizable” was it? What I mean is, subjectivist pricing does not apply to ALL goods and services at ALL times, that it only applies to certain situations.

    Bohm-Bawerk for example expressed strong reservations about marginal utility always being the direct determinant of prices. He argued that the law of marginal utility can show us that costs of production are often the main determinant of prices for goods that have relatively high marginal utility and are produced by factors of production that are plentiful enough so that they are used in the production of goods with relatively lower marginal utility. Here, the marginal of utility of the factors of production for a good are not determined by the direct marginal utility of the good in question, but by the marginal utility of goods with the lowest relative marginal utility that also utilize the plentiful factors in their production. For the goods with higher marginal utility, their prices will tend to gravitate to costs of production plus a competitive rate of profit.

    I thought the marginalist revolution was just a refutation of the mistaken classical idea that costs of production are an ALTERNATIVE to utility considerations, not that it itself represented a universal explanation for the prices of all things at all times.

    Suppose I can produce 3 bushels of wheat over a given time period, and one loaf of bread made from the flour made from one bushel of wheat, for a total of 4 goods, that is, 3 bushels of wheat and 1 loaf of bread. Suppose the bread is all that I ate for food, and thus represented sustenance for my life itself. The three bushels of wheat I devote to less important goods, like birdseed, and decorating my cottage. The “absolutist” marginal revolution position would argue that the value I should attach to this loaf of bread would be as high as the value I attach to my life, for that is the direct utility the loaf of bread serves. But what happens if this loaf of bread becomes mouldy and inedible? Well, I will just take one of my 3 other bushels of wheat, and make flour and then make a loaf of bread again. My life is not threatened. Therefore, the value I will attach to the loaf of bread is not the direct marginal utility of the bread, which is my life, but by the lesser marginal utility of feeding the birds, which is very low on my marginal value scale.

    • bobmurphy says:

      MF I have to get my ducks in a row before my trip to Mordor. If I forget to come back to this, pls remind me.