The labor theory of value is a theory in economics that the price of a commodity traded on a market tends toward the labor time required to produce that commodity. The labor theory of value is popularly associated with classical economics and Marxism. It is a theory of objective value, superseded in much of Western economics by the turn toward economic subjectivism associated with the development of neoclassical economics in the 1870s.
The labor needed to produce a commodity includes both labor directly expended on production of the commodity and labor expended on the production of capital goods used up in the production of the commodity. For example, if twenty workers are used for a year to produce capital goods used by twenty workers in the next year to produce a consumer good, the consumer good embodies the labor of forty workers.
This theory supports a highly political conclusion, that the role of owners and managers in production is exploitative, since it is only the workers that add value to the product. The price of the product is said to tend towards the sum of the value of the capital goods used up in production and the value added by direct labor. But profit, interest, rent, etc. is only possible, according to the theory, if the wages of these direct workers do not fully compensate them for the value they add to the capital goods to produce the product.
The classical economists and Marx quickly realized that the labor theory of value could not be exactly true. Suppose the proportion of unpaid to paid labor time is the same for all workers. Further suppose that workers are paid when the product is sold. Technology will result in the ratio of direct labor to the value of capital goods differing among industries. If products were traded based on labor values, prices would result in different industries earning different rates of profits on the capital invested. But competition among industries should be modeled as tending to remove differences in profitability. Thus, the labor theory of value cannot be true. David Ricardo presented a numerical example of this reductio ad absurdum:
Suppose I employ twenty men at an expense of 1000 pounds for a year in the production of a commodity, and at the end of the year I employ twenty men again for another year, at a further expense of 1000 pounds in finishing or perfecting the same commodity, and that I bring it to market at the end of two years, if profits be 10 per cent., my commodity must sell for 2,310 pounds.; for I have employed 1000 pounds capital for one year, and 2,100 pounds capital for one year more. Another man employs precisely the same quantity of labour, but he employs it all in the first year; he employs forty men at an expense of 2000 pounds, and at the end of the first year he sells it with 10 per cent. profit, or for 2,200 pounds. Here then are two commodities having precisely the same quantity of labour bestowed on them, one of which sells for 2,310 pounds--the other for 2,200 pounds.
There are other difficulties with the labor theory of value associated with varying skills among heterogeneous workers, land rent, and machinery. The above logical consequence of varying capital intensity has been the main focus of economic analysis of Marxist economics. Discussion of this aspect of the theory goes on under the rubric of the transformation problem, since it is about the "transformation" of labor values to prices.