But the idea of the spontaneity of economic institutions finds its most interesting illustration in the theory of demand and supply, upon which we must dwell a little.
In a society based upon division of labour, where everyone produces for a market without any previous arrangement with his fellow producers and without any external direction, the great difficulty lies in adapting the amount of goods supplied to the amount demanded. How, as a matter of fact, are these producers to know at any particular moment what they ought to produce and in what quantities? Moreover, who is to direct and who can restrain them? It is true that Smith was careful to point out that they are not concerned with the satisfaction of all needs, of whatever kind they may be. Their duty lies towards what he calls the “effectual,” not the “absolute,” demand. By effectual demand we are to understand the demand of those who are capable of offering not merely something in exchange for the products which they desire, but of offering at least enough to cover the expenses of raising those products.[169] Society founded upon division of labour and exchange implies that nothing can be gratuitous and every loss involves a sacrifice on the part of some person or other.[170] But if production is carried on in this haphazard fashion how are we to avoid an occasional over-production or an accidental under-supply?
Before we can understand this we must acquaint ourselves with Adam Smith’s theory of prices.
In the preceding chapter we had occasion to note how Condillac in 1776 put forward a theory of value which was altogether superior to the Physiocrats’. Smith’s book, also published in 1776, betrays not the least sign of Condillac’s influence, and the new theory never comes up for discussion. The very success of the Wealth of Nations had eclipsed the fame of the French philosopher, and Smith’s theory, though quite inferior to Condillac’s, held the field for so many years simply because it won the allegiance of the English economists, whose influence was paramount throughout the first half of the nineteenth century. Its popularity only waned with the publication of the works of Walras, Jevons, and Menger. Its historic interest is further enhanced by the fact that it had the singular good fortune to win the approval both of the socialists and the Liberal economists. It is the fate of writers like Smith, remarkable for wealth of ideas rather than for logical presentation, to impel minds along different and sometimes even opposite paths. Unfortunately the theory of value is not the only one that presents a somewhat hazy outline. We cannot here enter into the details of the theory, but must content ourselves with a mere sketch of it. Even this, however, will immediately enable us to understand its insufficiency, and appreciate the twofold influence which it exercised upon subsequent doctrines.
Smith opens his treatment by emphasising the fundamental distinction which exists between “value in use” and “value in exchange.”[171] By value in use he means almost[172] exactly what we understand by utility, or what other writers call subjective value, desirability, or ophelimity.
Present-day economists when treating of prices—the exchange value of things—chiefly rely upon this conception of “value in use.” The explanation of the “ratio of exchange” of commodities is based upon a previous analysis of their utility for those who exchange them. Smith proceeds in a different fashion. “Value in use” is mentioned, but only for the purpose of contrasting it with value in exchange. It is then dismissed without further consideration. The two notions seem to have no point of contact. Value in exchange was the only one that was of any interest to Smith; hence there was all the more reason for denying its derivative character.[173]
Thus from the very first the only avenue that might have led to a satisfactory solution of this problem of prices was closed. One could easily have predicted that this was bound to land Smith in difficulty; as a matter of fact he is doubly involved.[174] Two different but equally erroneous solutions have been successively adopted by him, but he has never actually decided between them. The socialists and economists who are to follow will be engaged in the same task, and the cleavage between them will be marked by their adoption of one or other of these two theories.
Smith was led to the study of prices because he wished to know something of the constant oscillation which is such a feature of their history. The actual or market price is unstable because of the unstable connection between demand and supply,[175] or, as he puts it, “It is adjusted, however, not by any accurate measure, but by the higgling and bargaining of the market, according to that sort of rough equality which, though not exact, is sufficient for carrying on the business of common life.”[176] It seemed impossible that their perpetual fluctuation should represent the true value of the commodity. Its real value could not vary from this moment to the next or from one place to another. Underneath the constantly oscillating market price may be discerned another price, referred to by Smith as the real or sometimes as the natural price. The discovery of a more stable and a more constant element beneath the continual fluctuations of price movements still constitutes the great problem of pure economics.[177]
Smith’s first theory makes the true value of any commodity depend upon the amount of labour or effort it has taken to produce. “Labour, therefore, is the real measure of the exchangeable value of all commodities.” “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.”[178] Labour—that is, the effort expended upon the production of a commodity—is both the origin and the measure of its exchange value. The theory that labour or effort is the cause of value (if value can be said to have a cause) was first formulated by the father of political economy himself. It is curious to think that it was this same theory that was used with such good effect by Karl Marx in his attack upon capitalism.
This first attempt to find a firmer foundation for exchange value than that afforded by the shifting sands of demand and supply was scarcely made before Smith became aware of some difficulties in the path. For example, how was this work and the value dependent upon it to be measured? “There may be more labour in an hour’s hard work than in two hours’ easy business; or in an hour’s application to a trade which it cost ten years’ labour to learn, than in a month’s industry at an ordinary and obvious employment. But it is not easy to find any accurate measure either of hardship or ingenuity.”[179] A second objection arises when the theory is applied to civilized society. Work by itself cannot produce anything; something must be contributed by both land and capital. But neither of these is a free good, and they must cost something to those who employ them. Accordingly primitive societies[180] are the only ones where “the quantity of labour commonly employed in acquiring or producing any commodity is the only circumstance determining its value.” We must nowadays take some account of land and capital. So that labour is not the only source of value, nor is it its sole measure.
Another hypothesis becomes necessary forthwith. This time cost of production is hit upon as the likely regulator of value. Hitherto the “real” price has signified the price that is based upon labour. Now the “natural” price is defined as the price of goods valued at their cost of production. The change of name is not of any great significance. What Smith was in search of on both occasions was that true value which always kept in hiding behind the fluctuations of market prices. It is the same problem, but with a new solution. Just now we were informed that if a commodity sold at a price representing the labour which it cost to produce, that price would also represent its real cost. With no less assurance we are now told that a commodity sold at cost of production “is then sold precisely for what it is worth, or for what it really costs the person who brings it to market.”[181] The true value of goods corresponds to their cost of production. By this we are to understand a sum sufficient to pay at normal rates the wages of labour, the interest of capital, and the rent of land, all of which have collaborated in the production of the particular commodity.
Smith, having discarded labour, finds a new determinant of value in cost of production, and if socialists rallied to his first hypothesis the great majority of economists right up to Jevons have clung to his second. As for Smith himself, he never had the courage to choose between them. They remain juxtaposed in the Wealth of Nations because he never made up his mind which to adopt. As a result his work is full of contradictions which it would be futile to try to reconcile. For example, land and capital in one place are regarded as sources of new values,