Over the past 200 years or so, many of the world's conflicts have developed around a little-known debate in economic theory. The outcome of this argument has had an impact equal to that of a major war. As an educator, I find it one of the most important but difficult concepts to teach to students, but let me take a shot at explaining it to adults.
The issue is valuation, what something is worth. The debate started in 1776 with the publication of Adam Smith's landmark book The Wealth of Nations (it was a pivotal year on this side of the Atlantic as well!). In his text, Smith posed this question: Why are diamonds more valuable then water? His answer, synopsized, is that there is more labor involved in obtaining diamonds. In one of the most erroneous sentences ever written, Smith explained, "The real price of every thing, what every thing really costs to the man who wants to acquire it, is the toil and trouble of acquiring it."
This was not an accurate answer. It led directly to the Labor Theory of Value and the Exploitation Theory of Capitalism, which became the cornerstone of Marxism/Leninism. One could say that this one misstep in economic analysis led to the virtual imprisonment of over a billion people in the USSR and China and other nations, and brought the world close to nuclear destruction.
What made this mistake so tragic was that Smith originally had it right: the price of diamonds is higher than that of water because of the difference in supply and demand. Smith wrote in 1763: "It was only on the account of the plenty of water that it is so cheap as to be got for the lifting and on account of the scarcity of diamonds that they are so dear." (Quoted in Mark Skousen, The Making of Modern Economics, 2nd ed. (Armonk, NY: M. E. Sharpe, 2009), p. 175.)
Nobody knows why Smith forgot this true principle of marginal utility when he wrote his magnum opus, The Wealth of Nations, 13 years later.
The price of anything is determined by the intersection of the marginal supply and demand for it. From that idea comes the concept that prices are signals to both entrepreneurs and consumers about the relative value and availability of particular goods and services. Prices carry information that drives people's behavior at the margin -- guiding the "invisible hand" of the market to respond by increasing the amount supplied when there is an increase in price, and by a decrease in the amount demanded as prices rise. A price will be reached that balances the two forces, determined at the margin; this is "the market clearing price."
Example: Suppose a tornado hits a midwest city and disrupts the supply distribution of milk, creating a temporary shortage of milk -- the price of milk soars. The local government, unaware of basic economics, puts controls on milk prices. Supplies shrink even further, because there was no signal (price rise) to entrepreneurs saying: "Bring milk quick!" If officials lift the price freeze, suppliers will respond, flooding the area with milk so that prices will soon go down dramatically, until the normal balance of supply and demand is restored.
Understanding the role prices play in communicating value is based on an insight made by Carl Menger in 1871, that prices and values are determined on the margin; that is, the "last unit" of any product is the key building block of analysis. The contemporary economist Mark Skousen (whom I regard as the nation's top economist today) writes: "Menger demonstrated that prices and costs are determined at the margin -- by the marginal benefit-cost to buyers and sellers."
Much of the world took a dark road down the path of totalitarianism by the acceptance of Smith's earlier error.
The English economist David Ricardo had the brilliant insight of "comparative advantage," creating the argument for international free trade, but he compounded Smith's mistake and defended the Labor Theory of Value, arguing passionately that the value of something is determined by how much labor goes into making it. Ricardo had second thoughts about this, however, and repeatedly posed the question as to why bottles of wine increased in value over time.
So, what gives something value? It was not until almost a century later after the publication of The Wealth of Nations that, working independently, three economists made what is called "the subjective value breakthrough." Menger was the most clear: a product's value was determined by the demand for it by consumers in the marketplace and its marginal supply. Hence, value could change moment by moment and was ultimately determined by consumers responding to the current supply. Both Jevon and Walrus also argued in favor of the subjective value theory of value. Together Menger, Jevons, and Walrus created the Marginalist Revolution of the 1870s and transformed political economy (as it was called back then) to the science of economics.
This was a radical departure from the Labor Theory of Value, and it had important political implications. If value is subjective, then one person cannot tell another what the worth of something is. Ultimately, it gave an individual the right to voice opinions on what was of value, and these could change and no doubt would. People were free as consumers. This scenario became the basis for "voluntary trade."
When values are objective, on the other hand, it gives the government the right to tell its citizens what the monetary worth of goods and services are and, by extension, how the citizens should best spend their time and earn their livelihoods. This scenario became the basis for totalitarianism, both communism and fascism. Under communism, the Labor Theory of Value became a science of oppression. Until the collapse of the Soviet Union and its satellites, in 1989, most prices were determined by central authority, as they are now in North Korea. This fatal conceit -- that government bureaucrats in an office can determine how goods and services should be priced and allocated -- violates a basic human concept: every individual has unique knowledge of personal needs and wants and how those could best be satisfied. That was Nobel Prize economist Friedrich Hayek's brilliant insight. This knowledge leads to the voluntary decisions that, collectively, drive the prices of goods and services. Without this economic base of subjective value, a government will become totalitarian. At one time or another, over a billion people in about three dozen countries have lived under a political system which, at its heart, was driven by the Labor Theory of Value.
This concept of subjective value is often misunderstood at the pre-college level (and beyond!). Here is how I teach it to my junior- and high-school-level students. (Thanks to Les Charm for imparting this lesson at the SEE seminar at Babson college.) I hold up a picture (say, from a magazine) of something of value that would not be known to the students -- like a house -- and ask each to write down its worth. Typically, students list a wide range of estimates. This lesson brings home the fact that value is subjective, and that everyone has the right to an opinion. In addition, it is a great way to teach young people about ignoring fixed costs and focusing on the next marginal decision. This can have special implications for those children who are suffering from poor choices made in the past, and gives them a mental framework to begin again with a clean slate. Subjective value may be the hardest concept to teach to young people but is perhaps the most important, because of its implications for human freedom.