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Yes, The World Is Round

in Economics by
   

Economic premises do not claim or suggest any judgments about what is right and wrong, or good and bad. So, for instance, economics does not tell you that unemployment is “bad”; it just points out the inevitable consequences of, say, a minimum wage law.  Thus, economics can and does say that if your goal is to help more poor people, you probably don’t want minimum wage as the final and ongoing solution. Every now and again you will come across an individual who will invoke an “ought” or a “should” when it comes to economics, or shrug off economics because their favorite “solutions” don’t actually produce their desired results. This is one reason I have a constant suspicion when talking to the Left;  when they seem to be talking about economics, even if they actually are talking about it, they’re not so much doing analysis as justifying their personal ideology.

Henry Hazlitt eloquently stated that economics is haunted by more fallacies than any other study known to man. Similarly, when discussing economics with those who consider it a dismal science, propositions that stem from a refuted theory will be argued, such as those which favor of a higher minimum wage or condemn hierarchies. You may have heard them. Usually these arguments sound something like, “Workers ought to be paid their worth!” or, “CEOs just sit on their butt all day while we break our backs!

Enter marginal economics.

The most pervasive objective theory of value is the Labor Theory of Value (LTV), which (depending on who you’re talking to and which or whose version they mean) basically says goods take on value according to the amount of labor expended in their production. The Subjective Theory of Value (STV) is a principle of value that promotes the concept that the value of a good is not based on any inherent property of the good, nor by the amount of labor required to produce the good, but rather that value is based on the importance an acting individual places on a good for the achievement of their desired ends — its utility.

Carl Menger, Leon Walras, and William Stanley Jevons, were independent co-discoverers of the Subjective Theory of Value (each had a slightly different interpretation, but the general idea was the same; Menger took it the furthest though), and it’s not like they had to shoot down the Labor Theory of Value — its problems were well-known at the time, but nobody had anything better. There is no reason, a priori or empirical, to accept the LTV (which is akin to believing the world is not round) except that holding to it helps to justify certain ideologies– pretty much all of them leftist — such as ones which give preferential treatment to labor over other factors of production.

The LTV’s biggest flaw is that its very premise is just plain wrong: value isn’t intrinsic to any good or service. Value lives in the mind of the evaluator and it can’t be transmuted into a physical form. But that’s easy to say now, having gone through the marginalist revolution, so it is hard to blame those who came before because it does often seem as though labor has something to do with value or how much you “ought” to be paid since there’s usually a correlation between the difficulty of producing a good and its price. LTV had some rather glaring, well-known problems, all of which were resolved by STV without introducing any new ones. It explains prices (and distinguishes them from value) and doesn’t have any problems with mud pies, or why diamonds cost so much more than water.

This is especially unique to the LTV, which, since the marginalist revolution, has few disciples in economics. But every once in awhile it will be invoked, even unintentionally, or by those who have never studied economics. For example, you will often hear complaints from people (particularly politicians or proponents of the minimum wage) about how “unfair” it is that low-skilled workers such as janitors or cashiers earn much less money than CEOs. After all, in most circumstances, janitors engage in much more physical labor than do CEOs, executives, and managers, and even the average “white collar” worker (which is the LTV rearing its ugly head).  Are the working class laborers being systematically “exploited” by managers and white collar workers? Is it the case that white collar workers are making money at the expense of blue collar workers, or is there a better explanation?

Value Does Not Come From Labor

For starters, more labor does not equal more productivity (think mud pies). Contemplate the radical increases in productivity that involve the application of less labor and more capital. Why is it better to build a swimming pool with a backhoe than with spoons? Another example is Walmart vs. Costco; when was the last time you saw a Walmart employee stack shelves with a fork-lift? Costco employees are far more productive. Walmart has more SKUs than Costco and this is why Walmart shelves are stocked by armies of stockers and Costco shelves are stocked by an employee with a forklift. Costco’s model substitutes greater capital investment for laborers. As a result, they need fewer employees and the productivity of any one laborer is greater, commanding a higher wage.

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Consider also the classic example of Henry Ford who paid more than his competition because his employees were far more productive thanks to his manufacturing innovations. Wages are based upon productivity; not how much labor you put into something. If labor created value, then society (and all of its members) could get rich by having everyone use their bare hands to dig large holes in the desert and then fill them back up. After all, this would be extremely hard work of a very physical nature. However, this would create no wealth for society—in fact, it would represent a destruction of wealth (imagine what the laborers could have actually produced if they were not hired to complete this task). While most examples are not quite this obvious, government programs entail similarly destructive effects.

The value of a product does not come solely from the labor of the workers. The value of a product is measured subjectively; a product is essentially worth what people are willing to pay for it.

A laborer in turn receives payment for his services based on the value that his work adds to the product or service, discounted for time. A janitor in a shoe factory adds relatively little value to the shoes that are being created. There is more value being added by the designer who designs the shoes, by the worker who sews the shoes together, and by the person who manages the distribution network which allows for the shoes to be sold in thousands of stores around the world. These workers add more value to the product, despite the fact that the janitor undoubtedly exerts more physical effort to do his own job. The idea is not that labor is useless and capital is all that is needed, it’s that capital makes labor more productive.

Scarcity

While value added by workers is an important reason for the existence of disparities in income, scarcity tells much more of the story. As Thomas Sowell puts it, economics is the study of the allocation of scarce resources which have alternative uses. All resources, insofar as they are economic goods, and thus subject to the laws of economics, are scarce. Similarly, all resources have alternative uses; e.g., should this rubber be used to make tires, or shoes?; should this glass be used to make a window, or a beer bottle?; should my time be spent watching a movie, or cleaning the house?

Scarcity doesn’t mean that there isn’t a large quantity of a certain good. It denotes that the supply of any particular good is not enough to satisfy all the particular ends that good could fulfill. If this were not the case, the good in question would cease to become an economic good, as it would be as abundant as the air we breathe.

Diamonds and Water

Think of diamonds and water. Which of the two resources is absolutely essential to life, and which could we live without? Water is infinitely important: without water we will all die very quickly. Diamonds are nice and sparkly and women love them, but they are hardly essential to our lives. However, water is very cheap and diamonds are very expensive. This phenomenon is known as the “diamond/water” paradox. The reason for the differences in the costs of these goods is scarcity; water is abundant, while diamonds are scarce.

The key to understanding this paradox which so stumped the classical economists is the use of marginal analysis. Marginal analysis, or the process of looking at the value of the successive unit of a given stock of goods, shows that individuals differ in their decisions when choosing between concrete units of goods, as opposed to choosing between entire categories of goods. In an analysis of the diamond/water paradox, it becomes clear that if mankind were to choose between all water in the world and all diamonds in the world, water would clearly be preferred. However, when given the choice between one additional unit of water, say the 100th gallon of water, or the 100th diamond, most individuals would take the diamond, as the value of the additional diamond will almost always dwarf the value of an additional gallon of water.

The same principles of marginal utility which determine the prices of water and diamonds also dictate the compensation received by laborers. Please keep in mind that my intent is not to belittle the work that low-skilled workers do. I know that this type of work is physically demanding and dirty. However, there is little skill involved or required. The fact of the matter is that nearly every able-bodied person above the age of 13 or so is probably qualified to be a janitor. In contrast, there are a very limited number of people who have the intelligence, experience, and ability necessary to be a successful CEO of a business. Low-skilled workers are replaceable and easily trained. High-level executives are not. In other words, the pool of available janitors is relatively abundant when compared to the pool of available qualified CEOs of Fortune 100 companies.

One common criticism by opponents of capitalism worth noting is the notion that how much someone makes doesn’t necessarily reflect their essential worth, but laborers should be paid more; but this is inconsistent. As Robert Murphy explains,

The very same people who remind us over and over that a person’s income is no measure of his or her intrinsic worth, are the ones who complain the loudest over this country’s “priorities” when it comes to salaries. But if we are already agreed that a person’s salary has no relation to moral worth or social importance, then why is the teacher (or nurse, fire fighter, etc.) entitled to more money than the professional athlete?

The same people saying that salary should have nothing to do with social importance are upset that salaries don’t match their idea of which professions are important. The idea is: progressives and socialists usually claim that a person’s social worth doesn’t hinge on what they make. And yet, they go right back around and imply that if somebody is making a lower salary than a person in a different profession, they are not paid sufficient wages given their worth. If you claim a person’s worth isn’t relevant to their wage and then try to claim that janitors, cashiers, etc., deserve more because their services are so valuable, you’re in a contradiction.

Everything that companies and entrepreneurs have only came to them because many people thought something they did was worth paying for. The people already control business because no business could survive without earning the support of others, namely consumers demanding products. If businesses try anything shady, the market punishes them, right down to eliminating those that hold no favor in the eyes of the public, simply by enough people saying “no“.

In a free society, you don’t depend on anyone for a job; go make a bucket out of weeds and transfer water from one end of a lake to the other. There’s a job. The high-risk but potentially high-reward function of entrepreneurs (what some package into an arbitrary little class they call “the capitalists”) is to find ways to make labor valuable to as many people as possible because they want to be rewarded. In the same way, workers are essentially capitalists because they look for the best chance to sell their labor to insightful entrepreneurs, because they too want to be rewarded. If you have a body and a brain and plan to use them to make your life better in some fashion, you are a profit-seeking “capitalist.”

Disparities in income are not necessarily the result of “exploitation” by the white collar class against blue collar workers or the working poor. Much of the wealth that corporations have obtained, deemed unfair by the Left, is the result of state interventions like subsidies, eminent domain, copyright laws, and so on. But this is an argument against state intervention and the barriers to entry the state erects. I’m all for abolishing these things. I think it’s likely there’d be less inequality under conditions of freedom. The poor will be richer, and the rich will also be rich absent these state privileges (though there may be a lot of shifting and interchange between income brackets). Compensation results from several factors, including the value added by the worker, as well as the relative scarcity of the pool of workers available to fill that position.

There is no federally mandated wage scale requiring certain salaries for certain types of workers. Decisions on how to pay employees—be they janitors, CEOs, or something in between—are generally made on a company-by-company basis. Those in the position to hire janitors will pay them according to the value that they believe will be added to the firm. They will likely tend to pay the janitor at levels similar to that of other janitors in related fields. This is because a janitor is likely to add similar levels of value at whatever company he happens to work for. The range of compensation for CEOs is very large, with CEOs of smaller companies earning drastically less than do CEOs at large multinational firms. This is because of the differences in the amount of value that can be added by different CEOs in different fields at different companies. The CEO of Walmart is responsible for running a worldwide distribution network, ensuring that over a million employees get paid, and in a broader sense—ensuring that society is fed and clothed. In contrast, the CEO of a small but delicious pizza chain has responsibilities which are much greater than his employees, but which do not even closely compare to that of the CEO of Walmart.

This article does not deal with things like corporate welfare or other special privileges which are often received by corporations from the State. While special privileges will likely skew the distribution of income away from the bottom quintile and towards the top, the essential principles at-hand do not change. In a truly free society with no governmental grants of limited liability, no business licensing requirements, corporate welfare, and private control of the currency, income is likely to be more evenly distributed among the productive members of society.

However, as long as there is any level of freedom of choice, there will always be some disparities in income. Income disparities are not always bad–in fact, they are very important. Differences in income give us something to strive for. If we all earned the same wages, no matter how hard we worked, no matter how much value we added to society, and no matter what type of work we did, no matter our ages, or no matter how much experience we had, there would be little reason for people to put much effort into their jobs. There would be little incentive for anyone to be productive beyond the subsistence level–after all, any additional effort would not result in a greater increase in income, despite an increase in the disutility from labor. If we were all exactly the same, there would be no reason for trade, or even for society to exist. It is our differences which encourage people to interact and trade with each other. No society larger than a small tribe could survive for long if wages were distributed equally.

As long as there are people with different skills, levels of intelligence, backgrounds, lifestyles, and so on, there will be differences in income. People are different from each other, and as such, will seek out different goods and services. They will also find themselves qualified for different types of employment than their friends and neighbors. Typically, those who are employed in positions that create a lot of value and are relatively scarce will earn higher incomes than those who are employed in positions that create little value and are relatively common. Even if you could make everybody economically equal without killing half of us and impoverishing the rest, we’d be unequal again by the end of the day, and by the end of the next day there would be poorer and richer people again, and there is no reason to object to that by itself.

The surest way to fallacious confusion and misunderstanding of the market is to start with your own preconceived ideals and flesh out your view of how things work from there. But you don’t start with a goal and try to build economic models to produce the desired results, resisting any understanding that fails to conform to your ideological preferences. No. Our sole pursuit is an understanding of the market, and our political advocacy comes from the results of this analysis, not the other way around.

Jeff Peterson II is a anarcho-capitalist and a student of the Austrian School of Economics via Mises Academy. When he is not studying economics, philosophy, or critiquing the Left, he is either working for Intercontinental Hotels Group as a site specialist or helping run a family business.