Pricing Principles: Theories of Value and Their Importance
A Theory of Value is any idea that explains the price of any product.
The question that lies at the heart of all theories of value is how and why someone would buy or sell a product for any amount of money. Being a cross between philosophy and economics, theories of value propose different reasonings a person may have when setting the price of or buying a product. It is a complex subject to detail each person's internal values. From the workers who make the product and the tools they use, the business owner who may set a price to sell the product at, and the purchaser who determines if they want to buy the product, a theory of value must try to explain it all.
Intrinsic Theory of Value (ITV)
Starting easy, the Intrinsic Theory of Value is not commonly cited today as an explanation for value. Its basic premise is, things just have value based on themselves. Water is valuable because it is water, mudpies are not valuable because they are mudpies. Due to the value items have they can be objectively compared against each other to find the most valuable products. There's not much more to say here.
There are people who would debate the simplicity of this explanation but any attempt to further flesh out the theory only transforms it into theory altogether. It is best to view ITV as a springboard for other theories to explain the intrinsicness of products.
Labour Theory of Value (LTV)
While being a controversial theory of value, it is important to not automatically ignore this theory due to its association with Karl Marx. We must keep in mind that David Ricardo was the first to coin the term the “labour theory of value”, and such term was never used by Marx despite both Ricardo’s and his ideas being functionally the same. Adam Smith, the “Father of Capitalism”, as well had his own ideas on labour theory, so it's best to approach this subject with an open mind.
According to the theory, the value of a product reflects the average time it takes to produce the product. For example, the price of a $1 hamburger is due to the time needed to produce the product. If more time on average was needed to make the hamburger it could cost the consumer $1.5, $3 or even $1 million; if less labour time on average was needed then the price would decrease.
More importantly, the value of the product is only worth the average amount of time needed to make the product. If the average time it takes to make a hamburger is 5 minutes, then by spending an hour the value does not increase, and thus the price does not increase either; it stays tied to the average 5 minute labour time.
Exceptions do apply. Ricardo notes that “rare statues and pictures, scarce books and coins’’ are not covered by labour theory as their value is not determined by labour time but rather by scarcity.
Understanding the Labour Theory of Value is key in understanding the evolution of capitalism and socialism. In modern capitalism, the LTV has lost favour to other ideas, but socialism maintains its importance. To the capitalist Ricardo, LTV meant achieving a fair value for the consumer to buy at. Marx on the other hand would use LTV to prove how workers were being exploited by not being paid an hourly wage that equalled the price of products their employer sold (a whole article could be written on this idea alone). Either way, such an idea has been at the root of economics as a discipline and as such deserves a cursory analysis.
It is worth noting that some modern Marxists dip into another theory called Marginalism, an explanation for which follows.
Subjective Theory of Value (STV)
A relatively new and current widely accepted theory, Subjective Theory of Value contradicts the Labour Theory of Value. Rather than focusing on the production side of products as in the Labour Theory, STV focuses on the consumer's decisions. Consumers only buy things that are valuable to them, and in turn, each consumer may have different products they value.
For example, if one consumer has 100 apples, it is unlikely the consumer will buy another as they do not need to; but if a consumer has 0 apples then it is likely the consumer will buy an apple — assuming that the consumer likes apples, if not, then an apple will not be bought.
In this theory, every consumer’s value judgements are different (subjective), and they express themselves in what they buy in the market. The contradiction of the Labour Theory of Value is that if the consumer does not want a product, no matter the time put into the product, it would not be bought by the consumer.
Assuming the usage of the Labour Theory of Value, multiple authors can on average spend 10 million hours writing a 500,000-page book, but if nobody wants it, then all those averaged hours by all those authors are worthless.
This theory also answers the diamonds and water paradox. It asks why diamonds cost more than water, even though humans need water to survive but diamonds only affordable for the rich; the solution was accounting for supply, or also known as scarcity (keep in mind Ricardo accounted for this in his LTV). Since water is so abundant to the average person, people are unlikely to buy large amounts of it as the average person on earth is like the person with 100 apples: there is no need to buy more. Diamonds, on the other hand, are scarce and the average person has few diamonds, thus many people want more because their wants are not fully met.
In our modern time's diamonds are not scarce and have high costs due to restricted supply by diamond companies, alas another topic for another article.
Some Marxists are more commonly to be found referring to the STV as Marginalism. There is functionally no difference in the ideas between STV and Marginalism. Marginalism however is a term more usually reserved for looking at marginal utility differences in economics as a whole and is not exclusively used to refer to value theory. Subjective Theory of Value is the more accurate term used.
How Understanding the Value of Products Directs the Economy
Our modern conception of how prices are made and why people buy are at stake in value theory and it has its consequences on markets. When developing a new product, a company must figure out what people value, and market and sell the product they want.
In the modern age of the internet, online dictionaries are faster, more convenient, and most importantly free to the consumers — granted there may be advertisements. In other words, dictionaries are not scarce and thus are not valued as high as other products such as a flat-screen TV. So, knowing that consumers are less inclined in buying physical paper dictionaries, the production of them will slow to match people's values in the market. If a dictionary company kept producing the number of dictionaries that were needed in the 80s (pre-internet), then the company would be wastefully producing and losing money. As such, it is imperative that companies know what consumers value to drive profits and save resources.
