Value and Price in Smith
Smith’s invisible hand is a metaphor for how prices organize a complex social division of labour. Within the factory, the division of labour is completely planned, and its purpose is to increase labour productivity.
For Smith this occurred for three reasons. Specialization of tasks increased dexterity and reduced the time otherwise needed to move between tasks; these two reasons are more or less specific to handicraft production. Thirdly, and historically overwhelmingly the most important, the division of labour was extended and productivity increased through the use of specialized machinery. However, outside the factory it is a different story. Rather than planned and hierarchically organized, the division of labour is (in principle) completely unplanned and spontaneous, emerging as the outcome of profit-seeking producers responding to price fluctuations, and limited only by the extent of the market. Thus Adam Smith famously wrote,[M]an has almost constant occasion for the help of his brethren, and it is in vain for him to expect it from their benevolence only. He will be more likely to prevail if he can interest their self-love in his favour, and show them that it is for their advantage to do for him what he requires of them. Whoever offers to another a bargain of any kind, proposes to do this. Give me that which I want, and you shall have this which you want, is the meaning of every such offer; and it is in this manner that we obtain from one another the far greater part of those good offices which we stand in need of. It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity, but to their self-love, and never talk to them of our own necessities, but of their advantages. (Smith 1776, hereafter WN, I.ii.2)
As well as depending upon what Smith called “a certain propensity in human nature...
to truck, barter and exchange one thing for another” (WN, I.ii.1), this market determination depended upon mobility of inputs. Since the accumulation of wealth depended upon the labour productivity increases brought about by the division of labour (restricted only by the overall size of the market), it seemed obvious then to relate the price of a product to the labour performed in its production. Certainly if a production process required labour alone, such as hunting deer and beaver on common land with no produced implements, then deer and beaver would exchange in a ratio measuring the relative times spent in hunting each. For if they did not, labour would reallocate itself to the more profitable activity in terms of labour time expended. So labour mobility is an important presupposition of a theory of value.Although the Industrial Revolution was in its early stages during Adam Smith’s lifetime, in most major sectors of production labour had come to be organized along capitalist lines, in which direct producers did not own the means of production, but sold their capacity to labour (in Marx’s terms, “labour-power”) to a capitalist, who did own means of production, in exchange for a wage. The capitalist’s profit per time period, for example, a year, is ∏ = R - C - W, where R is the sales revenue per year, C is the cost of other purchased inputs per year, and W is the wage payment per year, all in money units. If the capitalist in pursuit of profit on average ties up money, or “capital” worth K, the profit rate is r = K, a pure number per unit of time like an interest rate. Using “capital” to refer to the total money sum invested by the capitalist, irrespective of what inputs it is used to purchase, Smith and the other classical political economists argued that because the motivation of capitalist producers was the expansion of their wealth, they would tend to seek out sectors of production with the highest profit rate, withdrawing capital (and with it labour) from sectors with lower than average profit rates and moving capital (and labour) to sectors with higher than average profit rates.
Smith thus argued that a crucial feature of capitalist society was the mobility of capital. For he supposed that the long run level of price was determined through competition among capitalists by whatever level would generally equalize the rate of profit across all activities. This he called the “natural price”, contrasting it with the day-to- day fluctuations of the “market price” caused by all sorts of ephemeral and contingent factors. For Smith, the problem of the theory of value was to explain what determined the natural prices of commodities. In his “early and rude state of society which precedes both the accumulation of stock and the appropriation of land” (WN, I.vi.1), natural prices were determined primarily by labour hours required for the production of each commodity.
However, when means of production are appropriated (through the accumulation of “stock”, which is Smith’s technical term for the non-labour means of production) the determination of natural prices must also be influenced by the mobility of capital in search of higher profit rates. More generally, once the organization of the hunting process took a capitalist form, with the capitalist hiring hunters and supplying them with hunting implements, Smith’s simple labour theory of value became problematic. This is because the revenues from production have to cover more than wages: the capitalist requires a return on his or her capital, which has been invested in both labour and non-labour inputs, in the form of profit, and the landlord requires a return on his or her ownership of land in the form of rent. Faced with the need to include rent, wages, and profit in his account, Smith abandoned his labour-embodied theory for an adding-up theory of value based on the idea of explaining the natural price of commodities by adding up labour costs, land costs, and capital costs at natural wage, rent, and profit levels. This then required an independent determination of natural wage, rent and profit levels.
Smith did have some idea of a subsistence wage, and that wage determination was affected by employers (“masters”) being fewer in number than the workers they hired, more able to hold out longer in disputes, and more favoured by institutions and politics. He also had some idea that profits and rents were deductions from the product of labour, although he had no systematic theoretical account of any inverse relationships between distributive variables. Indeed Smith did not have any systematic account of the independent determination of natural levels of rent, wages and profit, and, without these, his adding-up theory remained enmeshed in circularity.
While he did not manage to work out a natural price interpretation of rent, wages and profit, Smith was very clear that differences between market price and natural price called forth quantity adjustments in an arbitrage process, and that this process was endless. Smith thus had an account of market price fluctuations around levels determined by natural prices, for the invisible hand process was one of continual adjustment (towards an equalized rate of profit) combined with continual displacement (as technology and demand evolved). Natural price was in effect the value substance underpinning market price, but once Smith had abandoned his embodied labour theory of value, he had no satisfactory theory of natural price levels.
Smith is therefore the father of modern economics in at least two ways. First, while he did not invent it but built on his predecessors, he had a clear vision of a decentralized market economy as an organic self-organized system that produced a roughly orderly and comprehensible result rather than chaotic anarchy. When an individual pursues private profit, “he is... led by an invisible hand to promote an end which was no part of his intention.... By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it” (WN, IV.ii.9).
Second, his two theories of price were the ancestral foundations of all subsequent theories of price. Contemporary neoclassical economics traces its genealogy back to Smith’s adding-up theory, while Smith’s immediate successors focused on developing his embodied labour theory of value, with both theories holding to the presumptions of labour and capital mobility.