Adam Smith Theory Of Value, Value Theory Definition

Certain questions regarding value, or price, that should be kept separate were sometimes confused by early

economists. (1) What determines the price of a good? In the language of modern economics, what determines

relative prices? (2) What determines the general level of prices? (3) What is the best measure of welfare? The

first and third questions are part of modern microeconomics; the second, although it defies the usually simple

micro-macro dichotomy, is generally included under the broad umbrella of macroeconomics. Smith did not

provide an unambiguous answer to any of these different questions. His treatment of them is, in places,

confusing in this regard because he intermingled his discussion of what determines relative prices with his

attempt to discover a measure of changes in welfare over time.

It is not surprising that historians of economic ideas have argued over Smith's true opinion. One group of

writers holds that Smith had three theories of relative prices (labor cost, labor command, and cost of

production) and a theory explaining the general level of prices. Another group maintains that he settled on a

cost of production theory of relative prices, a theory measuring changes in welfare over time, and a theory of

the general level of prices. The latter group denies that Smith had a labor theory of relative prices. We believe

that Smith experimented with all these theories: a theory of relative prices consisting of labor cost and labor

command for a primitive society and cost of production for an advanced economy; the formulation of an index

measuring changes in welfare over time; and a theory explaining the general level of prices. We first consider

his theory of relative prices.

Relative Prices: Although Adam Smith explained relative prices as determined by supply or costs of production

alone, he did not completely ignore the role of demand. He believed that market, or short-run, prices are

determined by both supply and demand. Natural, or long-run equilibrium, prices generally depend upon costs

of production, although Smith sometimes stated that natural price depends upon both demand and supply.

These inconsistencies provide ample opportunity for historians of economic theory to debate Smith's real

meaning.

Smith's analysis of the formation of relative prices in the economy of his time distinguishes two time periods,

the short run and the long run, and two broad sectors of the economy, agriculture and manufacturing. During

the short-run, or market, period, Smith found downward-sloping demand curves and upward-sloping supply

curves in both manufacturing and agriculture; therefore, market prices depend upon demand and supply.

Smith's analysis of the more complicated "natural price," which occurs in the long run, contains some

contradictions. For the agricultural sector, natural price depends upon supply and demand because the long-

run supply curve is upward-sloping, indicating increasing costs. But for the manufacturing sector, the long-run

supply curve is at times assumed to be perfectly elastic (horizontal), representing constant costs, and in other

parts of the analysis is downward-sloping, indicating decreasing costs. In manufacturing, when the long-run

supply curve is perfectly elastic, price depends entirely on cost of production; but when it is downward-sloping,

natural price depends upon both demand and supply.

There are a number of possible interpretations of Smith's statements with regard to the forces determining

natural prices for manufactured goods. One may assume that he was merely inconsistent—possibly because of

the long period of time it took him to write Wealth of Nations—or that he thought these issues were of minor
importance. Another approach is to select one of his statements on manufacturing costs as representative of

"the real Adam Smith." It makes little difference which approach is employed, because Smith consistently

noted the role of demand in the formation of natural prices and in the allocation of resources among the

various sectors of the economy. Nevertheless, regardless of the shape of the long-run supply curve in

manufacturing, the major emphasis in the determination of natural prices is on cost of production, an emphasis

that is characteristic of Smith and subsequent classical economists.

The scholastics became interested in the question of relative prices because they were concerned with the

ethical aspects of exchange, and the mercantilists considered it because they thought wealth was created in

the process of exchange. Even though Smith on occasion discussed prices in ethical terms, he had a more

important reason for being interested in the factors determining relative prices.

Once an economy practices specialization and division of labor, exchange becomes necessary. If exchange

takes place in a market such as the one existing at the time Smith wrote, certain obvious problems arise.

The Meaning of Value

Smith believed that the word value has two different meanings, and sometimes expresses the utility of some

particular object, and sometimes the power of purchasing other goods which the possession of that object

conveys. The one may be called "value in use"; the other, "value in exchange." The things which have the

greatest value in use have frequently little or no value in exchange; and on the contrary, those which have the

greatest value in exchange have frequently little or no value in use. Nothing is more useful than water: but it

will purchase scarce any thing; scarce any thing can be had in exchange for it. A diamond, on the contrary, has

scarce any value in use; but a very great quantity of other goods may frequently be had in exchange for it.

According to Smith, value in exchange is the power of a commodity to purchase other goods—its price. This is

an objective measure expressed in the market. His concept of value in use is ambiguous; it resulted in a good

part of his difficulties in explaining relative prices. On the one hand, it has ethical connotations and is therefore

a return to scholasticism. Smith's own puritanical standards are particularly noticeable in his statement that

diamonds have hardly any value in use. On the other hand, value in use is the want-satisfying power of a

commodity, the utility received by holding or consuming a good. Several kinds of utility are received when a

commodity is consumed: its total utility, its average utility, and its marginal utility. Smith's focus was on total

utility—the relationship between marginal utility and value was not understood by economists until one

hundred years after Smith wrote—and this obscured his understanding of how demand plays its role in price

determination. It is clear that the total utility of water is greater than that of diamonds; this is what Smith was

referring to when he pointed to the high use value of water as compared to the use value of diamonds.

However, because a commodity's marginal utility often decreases as more of it is consumed, it is quite possible

that another unit of water would give less marginal utility than another unit of diamonds. The price we are

willing to pay for a commodity—the value we place on acquiring another unit—depends not on its total utility

but on its marginal utility. Because Smith did not recognize this (nor did other economists until the 1870s), he

could neither find a satisfactory solution to the diamond-water paradox nor see the relationship between use

value and exchange value.

Smith on Relative Prices

separate theories relating to them. (1) a labor cost theory of value, (2) a labor command theory of value, and

(3) a cost of production theory of value. He postulated two distinct states of the economy: the early and rude

state, or primitive society, which is defined as an economy in which capital has not been accumulated and land

is not appropriated; and an advanced economy, in which capital and land are no longer free goods (they have

a price greater than zero).

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.

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.

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, TCb = Wb + Pb + Kb; likewise

for a deer, TCd = Wd + Pp + R-d- 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.

Meaning of Canons of Taxation:

By canons of taxation we simply mean the characteristics or qualities which a good tax system should possess. In fact, canons of

taxation are related to the administrative part of a tax. Adam Smith first devised the principles or canons of taxation in 1776.

Even in the 21st century, Smithian canons of taxation are applied by the modern governments while imposing and collecting

taxes.

Canons of Taxation:

A tax has no connection with the benefit received by the payer. Also, the charge is compulsory.

Hence in distributing the burden of taxation, a person’s share cannot be decided with reference to the benefit derived by him.

Adam Smith laid down four principles to guide the taxing authority.

Adam Smith’s Canons:

The principles or canons of taxation enunciated by Adam Smith were so important that they have become classic.

They are:

(1) Canon of Equality:

“The subjects of every State,” Smith asserted, “ought to contribute towards the support of the Government as nearly as possible

in proportion to their respective abilities, that is, in proportion to the revenue which they respectively enjoy under the

protection of the State. In the observance or neglect of this maxim consists what is called the equality or inequality of taxation.”

Equality here does not mean that all tax-payers should pay an equal amount. Equality here means equality or justice. It means

that the broadest shoulders must bear the heaviest burden.

This canon has given rise to two theories:

(i) Equality of Sacrifice Theory:

It means that the burden of taxation should involve an equal sacrifice for every individual. This equality, however, though good

in theory, is difficult to attain in practice. Sacrifice is subjective, something in the mind and feelings of a person. It is difficult to

measure. Besides, it has to take into consideration the number of dependents on the earning member in the family and their

standard of living.

(ii) The second principle indicating justice is the Ability or Faculty Theory:

Which hold that the rich should be made to pay something more than proportionate to their income? A man with an income of

Rs. 500 per month will not, other things being equal, feel the same pinch in parting with Rs. 50, as a man with an income of

only Rs. 50 feels in paying Rs. 5 (though the percentage is the same), because the former’s faculty to pay is greater. On this

principle is based progressive taxation, i.e., increasingly higher rates of taxation as incomes – increase. Proportional taxation

will not do justice.

(2) Canon of Certainty:

Adam Smith further said, “The tax which each individual has to pay ought to be certain and not arbitrary. The time of payment,

the amount to be paid ought all to be clear and plain to the contributor and to every other person.” The individual should know

exactly what, when and how he is to pay a tax otherwise it will cause unnecessary suffering. Similarly, the State should also

know how much it will receive from a tax.

Smith wrote, “Every tax ought to be levied at the time or in the manner which it is most likely to be convenient to pay it.”

Obviously, there is no sense in fixing a time and method of payment which are not suitable. Land revenue in India is realised

after the harvest has been collected. This is the time when cultivators can conveniently pay.

(4) Canon of Economy:

Lastly, Adam Smith held that “every tax ought to be so contrived as both to take out and keep out of the pockets of the people as

little as possible over and above what it brings into the public treasury of the State.” This means that the cost of collection

should be as small as possible. If the bulk of the tax is spent on its collection, it will take much out of the people’s pockets but

bring very little into the State’s pocket. It is not a wise tax.

Other Canons of Taxation:

Economic science has progressed much since the days of Adam Smith. Later writers have added to his canons.

The additions are:

(5) Canon of Productivity:

This canon emphasizes that a tax should bring in a substantial amount of money to the State. After all, the main object of the

taxing authority is to secure funds. Therefore, a tax which does not yield a fair income is not of much use. It is much better to

have a few taxes which yield good revenue instead of many taxes yielding a little.

(6) Canon of Elasticity:

This canon points out that a tax should automatically bring in more revenue as the country’s population or income increases.

There should be an automatic link between the needs of the State and resources of the people. If, in an emergency, an increase

in the rate of the tax brings in increased income, the tax is elastic.

(7) Canon of Simplicity:

It argues that the tax system should be simple; otherwise there would be confusion and, worse still, corruption. During the war

and after, certain taxes, e.g., on sale of cloth and lather essential supplies in India resulted in corruption mainly because they

lacked in simplicity.

(8) Canon of Variety:

It is also necessary that the tax system off a country should be diversified. Reliance on just a few taxes is risky. The revenue will

not be sufficient, nor will it be fair, because it will not touch a large number of people. In order to be just, a tax system must be

broad-based. In order to be adequate, it must be diversified, having a wide coverage over commodities and persons.

(9) Canon of Flexibility:

‘Flexibility’ in taxes is different from ‘elasticity’ mentioned earlier as a canon. Flexibility connotes the absence of rigidity in the

tax system. A flexible tax quickly adjusts to the new conditions; on the other hand, elasticity means that income can be

increased. Presence of flexibility is a pre-condition for elasticity. Lack of flexibility in a tax can cause financial troubles to a

State.

His canons of taxation are, indeed, ‘classic’. His four canons of taxation are:

(i) Canon of equality or equity

(ii) Canon of certainty

(iii) Canon of economy

(iv) Canon of convenience. Modern economists have added more in the list of canons of taxation.