Adam Smith's Labor Theory of Value: Everyone's a Merchant

This article is an excerpt from the Shortform book guide to "The Wealth of Nations" by Adam Smith. Shortform has the world's best summaries and analyses of books you should be reading.

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Could you live your life without ever buying something that someone else produces? What do you produce that others buy?

In The Wealth of Nations, Adam Smith lays much of the groundwork for the field of economics. He makes the case for free markets, and he puts forward his theories on what markets exchange and how they’re able to facilitate this exchange. One of his theories is that labor is the basis of value.

Let’s take a look at Adam Smith’s labor theory of value.

Adam Smith’s Labor Theory of Value

In a capitalist society, everyone’s a merchant. Smith contends that you cannot meet your needs without purchasing goods produced by others. Therefore, everyone must exchange value for value, wealth for wealth. Workers sell their labor in exchange for wages just as merchants sell goods in exchange for profits. But, what are we really exchanging, and how do we do so?

What Do Markets Exchange?

Markets exchange the value of labor. Smith explains that the value of every good is derived from the work people put into producing it. For example, when you buy a block of cheese at a grocery store, you are paying for the work of the farmers who raised and milked the cows, the farmers who raised feed for the cows, the dairy processors who turned the milk into cheese, the truck drivers who shipped the cheese to your grocery store, the store clerks who keep the shop open, the workers in the energy sector providing electricity for every step of the process, and so on.

Therefore, when you trade your labor for wages and then spend those wages on goods, you’re really exchanging your labor for the labor of others. You gain wealth by contributing labor to society, and your wealth gives you the power to command labor from others.

Adam Smith and Labor Theory of Value

Smith maintained that labor was the foundation of all economic value and thus backed the “labor theory of value.” The labor theory of value states that the value of a commodity can be objectively measured by the amount of labor required to produce it. However, this idea has since become controversial and is no longer considered part of mainstream economic thought. Here we’ll review some of the criticisms of this theory as well as how Smith’s defenders respond.

Critics of the labor theory of value mainly assert that it can’t be used to accurately understand or predict pricing. They point out that a good that takes twice as much work doesn’t necessarily cost twice as much money, and it’s possible to expend a lot of work on making something nobody wants to buy. Since Smith’s time, a new theory called “subjectivism” has maintained that the real value of a good lies in its desirability, in consumers’ subjective evaluation of its worth.

However, the labor theory of value still has its supporters. Marxists have taken up the idea to contend that workers produce the “real value” in society, and therefore capitalists are exploiting them by taking value without contributing labor themselves.

Meanwhile, Smith’s defenders argue that the critiques of his labor theory of value misconstrue his position. They maintain that Smith doesn’t use labor as an objective measure for comparing prices, but that he views it more as an abstract claim about the nature of wealth itself. Smith states that labor is the “first price” by which goods are purchased from nature, and so he sees it as the “origin” of all wealth.

How Do Markets Exchange?

Smith asserts that markets can exchange labor only if there’s a shared medium of exchange. This is because there’s a problem with exchanging labor for labor. Not everyone’s work produces something everyone else wants. If you make nails, you can only buy a pair of socks if you can find someone selling socks who also wants nails.

However, if you have a shared medium of exchange, such as a currency, then you can sell your nails to anyone who wants to buy them. Then you can take the currency and use it to buy socks. The person selling socks can then take the money and use it to purchase whatever they want in exchange for their labor. This allows for a much smoother and more efficient functioning of markets.

(Shortform note: Economists have found that a shared medium of exchange (money) also allows for greater decentralization of markets. If traders needed to find a perfect match each time they traded (a “double coincidence of wants” in economic terms) this would force traders into large, centralized marketplaces where they could increase the odds of finding that rare match. This would also reduce the diversity of goods people could trade, as each trader would need to find the commodities others want most to increase the likelihood of finding that match. A shared medium of exchange allows for markets to spread out geographically and accommodate a greater diversity of niches.)

Adam Smith’s Labor Theory of Value: Everyone’s a Merchant