Adam Smith's Value Theory

 Value Theory

Economists of the past had different questions about values. There are,

 (1) What determines the price of a good? (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, and the second, although it defies the usually simple micro-macro dichotomy. Adam Smith has not been able to give a definite answer to these questions.

Relative Prices

Adam Smith explained that relative price is determined by supply or cost of production. In here he did not ignore the role of demand. He mentioned that both supply and demand are considered in determining the short-term price. Long-run or natural prices generally depend on the cost of production. But in some places, he said, demand and supply influence long-term price determination. These inconsistencies provide an opportunity for historians of economic theory to debate Smith's real meaning.

	Short run (market price)	Long run (Natural price)
Agriculture	Downward-sloping demand curve Upward-sloping supply curve
Manufacturing	Downward-sloping demand curve   Upward-sloping supply curve	When the supply curve is perfectly elastic, the price depends entirely on the cost of production; When it is downward-sloping, natural price depends upon both demand and supply

 Meaning of Value

Smith believed that the word value has two different meanings.

1. Utility of some particular object referred to as value in use
2. The power of purchasing other goods which the possession of the object conveys referred to as value in exchange   

 

Adam Smith used examples to present the meaning of value. In his works, Smith asked why diamonds are more valuable than water if water is essential to life but diamonds are not.  He saw a clear disparity in value: people valued diamonds more than water, even though one could not live without water and diamonds were essentially rocks. Smith suggested that this disparity in value arose because diamonds were rarer than water and harder to obtain and sell.  This determination has been defined as the diamond-water paradox. Value in use is the utility derived from keeping or consuming a good.  There are several types of utility when a good is consumed:

• Total Utility
• Average Utility
• Marginal Utility. 

Smith's focus was on total utility. Pointing out the high utility value of water relative to the utility value of diamonds, Smith noted that since the marginal utility of a commodity often decreases as it is consumed, another unit of water may provide a lower marginal utility than another unit of diamonds.  But the price we are willing to pay for a good depends not on its total utility but on its marginal utility. Because Smith did not recognize this, he was unable to find a definitive solution to the diamond-water paradox.

So, let's summarize the value theory with a song...

Written by : P.K. Wasana Sathsarani

Lyrics by : Dinushi Madushika & Chathurika Samanmali

References: Harry Landreth, D. C. (2002). History of Economic Thought (4th ed.). Boston, Toronto: Houghton Mifflin Company.