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Basic Economic Terms from

Barbara Goodrich, Ph.D.


Adam Smith was responding to the older mercantilist economic theory. This mercantilist theory was monarchist: the players weren't individuals but monarchs.

The goal was the growth of the monarch's power, vis a vis other monarchs.

There were several other presuppositions in this mercantilist theory besides monarchic government.

One presupposition: that gold and silver had intrinsic value.  (That is, that gold and silver were more than just a means of exchange, a complicated measure of the relations between the values of things.) Incidentally, this is a beautiful example of the "fallacy of misplaced concreteness."

This presupposition led to another presupposition: that there was a set amount of wealth in the world -- after all, there was a set, finite amount of gold and silver in the world. Competition among the players, the monarchs, was thus a zero-sum game: e.g. England could prosper only at Spain's expense.

(You can imagine how rumors of lavish gold mines in the "New World" affected European courts!)

So: How was a monarch to get more power vis a vis his competitor-monarchs?

By concentrating as much gold and silver within his nation's boundaries as possible! (Then you can always tax as much as you need from your subjects.)

If nothing else, this gold and silver could purchase direct power in the form of mercenaries.

Next question: how to concentrate as much gold and silver within your nation's boundaries as possible?

First, get colonies with gold and silver mines, and other natural resources, by whatever means necessary.

Second, command the colonies to send the gold, silver, and raw natural resources back to one's own nation, without competing with one's own nation in producing final products from the raw natural resources.

Third, increase exports to one's competitor-monarchs. Get as many final goods and services from one's own nation out onto the international market as cheaply as possible, to compete successfully with other countries. (To keep them as cheap as possible, work your subjects, your domestic workers, as hard as you can, for example, 16 hours a day, for subsistence wages.)

Fourth, discourage your subjects from purchasing imports to your nation. (After all, if they bought foreign goods such as tea, sugar, cotton, snuff, then their money would have been exiled to the competing nations that were offering these commodities. We can't have that!) Fortunately, if your subjects are paid only subsistences wages, they won't be able to afford these imported goods anyway.

Adam Smith

Smith opposed this theory, and developed another theory, focused more on each individual human as a player in his or her own right.

He returned to the older, pre-mercantilist labor theory of value, that labor was the real source of value, not gold or silver. These were merely means of exchange.

He pointed out that economics is not a zero-sum game; it allows for win-win situations, too.

And he claimed that if each player, each individual human, were allowed to pursue his or her own enlightened self-interest, then everyone in the society would ultimately benefit, as if an "invisible hand" were ordering things. The market itself, by the mechanism of supply and demand, would regulate itself.

Here are some of his basic terms.



For John Locke, Adam Smith, David Ricardo, and Karl Marx, all value is determined by labor.

Bob has an idea on a visit to Lyons, Colorado.


"Gee, look at all that beautiful granite.
I could make a lot of money
if I could think of an efficient way
to cut it out of the mountains and move it."

(Later theorists have noted that labor isn't the whole source of value; natural resources -- like granite -- count for much, too, and advanced machinery produces value through its "labor" without any human labor being directly involved. Further, just because something is labor-intensive doesn't mean it has a value proportional to the labor. )



Use-value is the value something has in itself, in its various uses.
Contrast this to a thing's exchange-value, which is influenced by such factors as supply and demand.
The natural price of a commodity covers expenses (e.g. wages), and some profit.
Contrast this to its market price.

At Bob's Granite in Lyons, CO:

"Granite makes strong and beautiful buildings,
like Denver's concert hall.
I'd say its use-value was about $1000 per truckful."

"And that should cover not only expenses, including wages,
plus a decent profit for us (i.e. the natural price so far),
but a little over that.
This market price, which happens here to coincide with
the use-value, will allow us
to give our workers a nice holiday bonus!



Exchange-value, and market price, are influenced by supply and demand.

"I'll sell my granite to you for $1000 per truckload."



"Nope -- sorry about that -- make it $1500 per truckload!"

(The market price of the granite just got raised, and its exchange-value just diverged from its use-value.)



Real price is the price that takes into account spending power. Contrast this to nominal price.

"I'm visiting from Canda. My company wants to buy granite for a new cathedral.
Could my company pay you in Canadian dollars,
rather than in U.S. dollars?"

"Sure. And let's celebrate the deal!"

(If inflation forced Bob to raise the price he charges and the wages he pays, the real price of both would be the same, though the nominal price of both would have changed.

Bob is happy, and everyone has benefited from his enterprise. (Well, except for some displaced and disgruntled chipmunks.)




However, Smith, Ricardo, and their peers hadn't spelled out everything that their theory implied -- hadn't even recognized it all.

Their own terms lead inexorably to the conclusion that under free market capitalism, people who make a living by selling their labor as a "commodity" (rather than, say, by being self-employed, or worker-owners in a co-operative enterprise) will be paid less than they are worth. Economists managed to blind themselves to this until:

Karl Marx

Marx accepted Smith's labor theory of value, and much of Smith's account of supply and demand.

Marx pointed out that by Smith's own thinking, labor is a resource whose market-price (exchange-value e.g. wages) may differ from its use-value.

So, here's the big question (and one that surprisingly many economists never ask, and can't answer.)

Where does profit come from?



Mr. Capitalist wants to produce cotton yarn, in order to meet the demand for it, and thus make a profit (surplus value).

"Hello, Mr. Capitalist. How much do you charge for your finished cotton yarn (i.e. its exchange value?)? Say, how much would you charge for 10 pounds of it?"

"So glad you asked,dear fellow. Hm, let me see what the current costs are."



He figures out the expenses that he has put into making it:

"1) Ten pounds of raw cotton cost me 10 shillings (its exchange value).*
2) The wear on the spindle for spinning would be about one shilling,
based on the exchange-value of a replacement spindle.*
3) Space and other equipment and miscellaneous costs would be another shilling.
So far I've invested twelve shillings in the yarn for its means of production.
4) Now, for the labor that transforms the cotton into yarn,
that the finished yarns has 'embodied' in it:
How much did I pay those workers?"

(* For Marx, what makes the raw cotton worth ten shillings is the labor needed to grow and pick it;
likewise, what makes the spindle worth its replacement value is the total labor needed to manufacture it.)



"How much am I paying you, Mr. Spinner?"

"You agreed to pay me three shillings a day, Guv,
since that's the usual market-price (exchange-value) around here.
Remember, we looked at what I have to pay for rent, food, and clothes,
and it takes three shillings a day for me to survive, with the local cost of living.
None of us can live on anything lower, so none of us can work for less.
(That's why it's the exchange-value of a day's work around here.)" 

"Can you spin ten pounds of cotton into yarn in one day?"

"Sure, Mr. C. I can spin ten pounds in eight hours."

"So three shillings added for labor,
to the twelve shillings covering means of production,
equals fifteen shillings for ten pounds of cotton yarn.
That'll cover all the expenses."

"No, wait! What about my profit?"

"I know.
I'll charge eighteen shillings for ten pounds!"

"Forget me, Mr. Capitalist. That's above the usual market price.
I can buy ten pounds from your competitor for fifteen shillings."



"Oh, the Dickens. How does my competitor manage to make a profit?
He's just able to meet expenses, isn't he?"



"No, wait!

Hallo, Mr. Spinner!
You can live on three shillings a day, correct?
What I'm already paying you?
The local exchange-value for labor?"

"Yes, Mr. C.."

"And in eight hours of work you supply me with
labor equivalent to three shillings in use value,
since in eight hours you give that much more value
to the raw cotton by spinning it."

"Yes, Guv. Looks like the exchange value of my day's work,
what you pay me, happens to be exactly equal to
the use you get out of my eigth hours."




"Well, it won't be any longer!
I'm paying you for a full day's work,
since I'm paying you enough to support yourself for a full day.
And from now on, I define "a full day's work" as sixteen hours of work,
not a mere eight!"

"But Guv! That's not fair!
You'll be getting twice more use-value out of my labor
than I get in exchange-value i.e. wages, from you!"

That's the lovely thing about human labor:
It can produce far more value than it must consume,
far more than it must have to maintain itself!

Providence is very wise in ordaining such a world!"

"Poor Mr. Spinner. Hey mates! We have got to do something about this!"




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