Class war, Adam Smith, and the Marginal Productivity Theory of Distribution

There is a pleasure almost cruel in seeing someone deploy irrefutable logic to destroy an opponent’s arguments. I felt it this week reading George Reisman’s Open letter to Warren Buffett where the well booted doctrines of Karl Marx got another kicking. By now Marx and his followers ought to be used to this sort of punishment at the hands of Austrians. Eugen von Böhm Bawerk produced his devastating destruction of Marx’s economics, Karl Marx and the Close of His System, back in 1896.

But Paul Samuelson was right when he said that “Karl Marx can be regarded as a minor post-Ricardian”. Marx simply took the aggregative, labour value theory based economics of David Ricardo and took them to their dismal and erroneous conclusions. And when Reisman writes “The doctrine of class warfare is a derivative of the exploitation theory, whose best-known proponent is Karl Marx” we ought to point out that it is found also in Ricardo’s predecessor Adam Smith.

Class War in The Wealth of Nations

Book One, Chapter VIII, of The Wealth of Nations is titled ‘Of the wages of labour’.  Smith charts the development from a situation of subsistence production where “the whole produce of labour belongs to the labourer” via the emergence of private property (which gives rise to rent) and stock (which gives rise to profit) to one where a payment for a good must be divided between the labourer (wages), the landlord (rent), and the stockholder (profit).

Smith goes on to say that “It seldom happens that the person who tills the ground has wherewithal to maintain himself till he reaps the harvest. His maintenance is generally advanced to him from the stock of a master, the farmer who employs him and who would have no interest to employ him, unless he was to share in the produce of his labour, or unless his stock was to be replaced to him with a profit” Smith says that “The produce of almost all other labour is liable to the like deduction of profit”.

Here we have the genesis of the Marxist theory of the workers alienation from the means of production, exploitation, and ‘class war’. Workers do not receive the full product of their labour as they did in the “early and rude state of society which precedes…the accumulation of stock and the appropriation of land”. Instead, this product goes to the stockholder as profit and the labourer receives wages.

With wages, Smith states, “The workmen desire to get as much, the masters to give as little as possible”. We have Marx’s “contending classes”. Smith goes on

It is not, however, difficult to foresee which of the two parties must, upon all ordinary occasions, have the advantage in the dispute, and force the other into a compliance with their terms. The masters, being fewer in number, can combine much more easily…In all such disputes the masters can hold out much longer. A landlord, a farmer, a master manufacturer, or merchant, though they did not employ a single workman, could generally live a year or two upon the stocks which they have already acquired. Many workmen could not subsist a week, few could subsist a month, and scarce any a year without employment. In the long-run the workman may be as necessary to his master as his master is to him, but the necessity is not so immediate.

Smith argued that wages would rise when an economy was growing but otherwise he posited a clear general tendency for wages to feel only downward pressures. From this flowed the idea of the ‘subsistence wage’ with which Malthus earned economics the tag of “the dismal science” and Lasalle’s Iron Law of Wages. Wages will stagnate, Smith argues, and profits will rise. Warren Buffett would not disagree.

But looking at the passage from Smith we can see much wrong with it, or at least, much that has no application today.

First, Smith says that stockholders are “fewer in number” than labourers and thus have a kind of oligopoly power. The error here, perhaps less when Smith was writing, is to regard labour as homogeneous. It isn’t. Skills, like capital, can be specific to a certain role and, thus non-transferable. Just as a “tractor is not a hammer”, Joleon Lescott is not Mariah Carey. You wouldn’t consider putting Mariah Carey on Darren Bent at corners and you probably wouldn’t want to hear Joleon Lescott sing Without You.

It follows that workers with different skills are not substitutes for one another; they are not, in other words, in competition. No brain surgeon ever accepted a lower wage from the fear that the hospital might hire a juggler instead.

Of course, where labour is unskilled it is homogeneous and we would expect to see the increased competition for jobs and resultant low wages which we do. At this skill level, also, capital can be substituted for labour providing a further downward pressure. The answer here is not to raise the banner of class warfare but to accumulate skills.

Second, Smith says that stockholders “can combine much more easily”. However, in practical experience, such cartels are always plagued with problems as we see with OPEC. If a cartel sets a minimum price there is always the temptation for one member to sell below that price and capture the market. Although here we are considering the case where a cartel is setting a maximum price for its labour inputs, the analysis is unchanged as we shall see.

Wages and the Marginal Productivity Theory of Distribution

Thirdly, Smith contends that “In all such disputes the masters can hold out much longer”. This might well be true but the question has to be asked; why would they? If, by hiring a worker at £30,000 per year a stockholder would increase his profit by £40,000 per year, why would that stockholder hold out, throwing away £10,000, in an attempt to drive the worker down to £20,000?

It could be said that the stockholder will lose out on £10,000 this year but will gain £20,000 in every subsequent year. But Smith said that stockholders were “fewer in number”, not that there was only one, so there are those cartel problems. Thus, if, in the initial period, stockholder A is willing to forgo £10,000 and hold out for a wage of £20,000 stockholder B will step in and offer the worker £30,000. He will make £10,000 profit while stockholder A makes nothing. There is a saying about stepping over a dollar to pick up a penny, in this case stockholder B picks up both.

Indeed, if the worker adds £40,000 to profits it makes sense for the stockholder to employ them at any wage up to that (tax wedges notwithstanding). We have arrived, as economists did after 1870, at the Marginal Productivity Theory of Distribution. This simply states that a factor (labour or capital) will be paid to the value of its marginal product.

So, if hiring a first barman generates £100 a week extra profit for a pub landlord that barman will be paid up to £100. If, however, hiring a second barman adds only £80 a week the marginal product of bar staff has fallen to £80 a week and so will the wage even of the first. If hiring a third barman adds just £50 a week and no one will take the job at that wage no one else will be hired and £80 a week will be the wage.

Of course, if there are two barmen earning £80 a week one could go on a cocktail course. His mojito’s might prove a draw, his marginal product will rise and so will his wage. By doing the course, ‘upskilling’, the first barman is differentiating his labour from that of barman two. Their labour is heterogeneous.

Smith himself saw a situation where in a growing economy, one in which the profits of stockholders were increasing, demand for labour would also increase. In this case “The scarcity of hands occasions a competition among masters, who bid against one another, in order to get workmen, and thus voluntarily break through the natural combination of masters not to raise wages”.

However, as we’ve seen, because of heterogeneity on both the labour (due to non-transferable skills) and stockholder (due to cartel issues) sides of the wage bargain it is this which is the general case and not the previously enunciated tendency for wages to fall and profits to rise. Because some ‘hands’ are skilled at some things and other ‘hands’ at other things there is at any given time a “scarcity of hands” in any profession requiring a modicum of skill. And because we have a number of potential “masters” we have at any given time “competition among” them.

Both profits and wages can rise together and the zero sum thinking of Marx and Buffett can be discounted. But Adam Smith’s role in this thinking should not be forgotten either.

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7 replies on “Class war, Adam Smith, and the Marginal Productivity Theory of Distribution”
  1. says: John Phelan

    In that case you can read that paragraph as

    “First, Smith says that stockholders are “fewer in number” than labourers and thus have a kind of oligopoly power. The error here, perhaps less when Smith was writing, is to regard labour as homogeneous. It isn’t. Skills, like capital, can be specific to a certain role and, thus non-transferable. Just as a “tractor is not a hammer”, Usain Bolt is not Mariah Carey. You wouldn’t consider putting Mariah Carey up for the 4 x 100 metere relay and you probably wouldn’t want to hear Usain Bolt sing Without You.”

  2. says: Craig Howard

    Sadly, the references to Joleon Lescott and Darren Bent are culture-specific and limit the article’s effectiveness.

    I’m a culturally-clueless, 59 year old American. I recognized one of the names, not the other, but the reference was perfectly comprehensible in the context. You are being too hard on the author.

    Very good article, indeed.

  3. says: Rob Thorpe

    This is an interesting article.

    The error here, perhaps less when Smith was writing, is to regard labour as homogeneous.

    Smith can’t excuse himself here. Even when he was writing division-of-labour was extremely significant (it was even in ancient greek times, Plato noted it). Smith emphasised it strongly elsewhere in Wealth of Nations.

    We have arrived, as economists did after 1870, at the Marginal Productivity Theory of Distribution. This simply states that a factor (labour or capital) will be paid to the value of its marginal product.

    This is part of the story that classical economists missed, the other is entrepreneurship. The owner of capital does not stand idly by and earn income. He or she must secure an income by investing in profitable ventures. Granted, it’s possible to earn interest with little effort using bonds or bank accounts, but the general interest rate has never been very high in real terms (and when it has been, it’s never been high for very long). At the very least the capitalist must be able to identify competent entrepreneurs to lend to or otherwise deal with.

    The assumption that the work of each worker must be productive because it converts capital from one form into another is wrong. It must be useful to consumers for that conversion to occur for work to be truly productive. Workers themselves don’t guide that process, entrepreneurs do. At least entrepreneurs in the broadest sense, they may be managers rather than company directors or owners in practice.

    So, even if the economy is in the situation where no business benefits by employing another worker, there remains a strong argument for private ownership.

  4. says: Paul Marks

    “The Adam Smith problem” is an interesting one.

    For example Adam Smith once understood that there is no such thing as the “paradox of value” (this is clear from his early lecture notes).

    One does not value (say) all “diamonds” sgainst all “water” – one values a specific amount of diamonds against a specific amount of water in a specific TIME AND PLACE.

    So there is no “paradox” about a diamond being more valuable than a cup of water – even though water is needed for life and diamonds are not. If a person was dying of thist in the desert most people (although not everyone) would give a diamond for a cup of water. But where there is water available (just by turning on a tap) most people would not give a diamond for a cup of water.

    This was once known to Adam Smith – but later he just seems to have forgotten it.

    As for the labour theory of value….

    A diamond one finds lying on the sand is no less valuable than a diamond one spends all day digging out of the rock.

    Labour does not determine value – it just does not. And talking of “socially necessary” labour (as Karl Marx does) does not save the theory. The theoryn(the labour theory of value theory) is nonsense.

    Adam Smith (late in life) had some weak thinking – and David Ricardo built a whole system (a fairy castle in the air of folly) upon this weak thinking. And James Mill and John Stuart Mill followed David Ricardo (in spite of the refutaions of the labour theory of value by Richard Whately, Samuel Bailey and many others) in this folly.

    1. says: Rob Thorpe

      Perhaps the economics of Adam Smith’s era was more political than we think of it as now. Adam Smith must have understood quite a lot about use-value because he discusses Richard Cantillon’s ideas. Perhaps he saw the labour-theory-of-value as a way of opposing the rich and the aristocracy.

      Ricardo singles out landowners for criticism for living of unearned income. Capitalists don’t come in for the same degree of criticism. I think that may have been because (at least in Ricardo’s eyes) landowners represented the upper-class and capitalist more the middle class. The irony is that Ricardo rediscovered marginalism as it applies to land values, and he applied it only to that. Later economists had to decide if they wanted to use two value systems, marginalism for land and LTV for everything else, or one. They decided (quite correctly) to generalize marginalism and use it for everything.

      On the other hand perhaps neither Smith nor Ricardo could think of a way to build marginalism into an overall economic theory. That task took a long time, from the early example of small scenarios through to end-to-end theories that included the interest rate took decades. Those who finally did it (Walras, Jevons & Menger) were able to draw on much earlier work by Whately, Senior, Gossen and Ricardo.

  5. says: Paul Marks

    David Richardo, and James and J.S. Mill, do go in for this (pathetic) “landed interest” bashing.

    But I do not associate that with Adam Smith (others will correct me if I am mistaken).

    One story I heard was that Adam Smith really hated a Jacabin economist by the name of James Stewart (spelling alert – there are many ways of spelling this family name).

    The political economy book was full of statist nonsense – praise for the interventionist system set up by Louis XIV (and tragically kept by Louis XV) – but that was not all that was in it.

    What was also in the book by J.S. was a big defence of the subjective theory of economic value.

    Adam Smith hated the book (for understandable reasons – see above) – but made the mistake of thinking that EVERYTHING in the book must, therefore, be nonsense.

    Of course the late M.N. Rothbard also had an explination for Adam Smith and the labour theory of value – – Adam Smith was a Calvinist and…….

    You know the rap.

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