Problems with the Cost Theory of Value
One of the most important developments in the history of economic thought was the so-called Marginal Revolution of the early 1870s, in which the older cost (and more specifically, labor) theory of value was overturned by subjective value theory. This was an unambiguous advance in the science of economics, analogous to the superiority of Einsteinian relativity over Newtonian mechanics. The revolution is of special importance for Austrian economists, since Carl Menger — founder of the Austrian School — is credited as one of the three pioneers of the new approach.
In the present article, I'll explain a generic cost theory approach and point out some of its major shortcomings. In a future article, I'll show how the modern, subjectivist approach has more explanatory power and avoids all of these pitfalls.
A Generic Cost Theory of Value
In a short online essay, I don't want to get bogged down with quotations from specific economists from the past. Instead, I will try to present a generic version of the cost theory of value in order to summarize the viewpoint. The classical economists — including such giants as Adam Smith, David Ricardo, and Frederic Bastiat — had nuanced treatments of the subject in their writings, but all generally adhered to some form of the cost theory (and more specifically, a labor theory of value, which Karl Marx adopted from the other classical economists). Those who want a more academic treatment, dealing with arguments from proponents of the cost theory, should consult this article.
The Purpose of Economic Value Theory
The purpose of economic value theory — whether a cost, labor, or subjective approach — is to explain the prices of various goods and services in a market economy, i.e., to explain their "market value." For example, why is it that gold bars and automobiles are so valuable, while tinfoil and tube socks are not?
Explaining the formation and magnitudes of various market prices is not the sole task of economic theory, but it is a crucial component of it. The cost theory of value is a legitimate approach, and it did shed some light on the subject. But in light of the flaws we will discuss, the cost theory was ultimately displaced by a more satisfactory explanation.
The Cost Theory of Value
As its name suggests, the cost theory of value explains the final price of a good (or service) by how much it costs to produce it. Suppose a particular car has a retail price of $10,000. The cost theory would explain this market value by pointing out that the producer had to spend (say) $5,000 on the engine, $2,500 on the metal and plastic for the frame, $1,000 on the glass for the windshield and windows, $500 for the tires, and $500 for the labor and depreciation of the machinery needed to assemble the vehicle.
The direct cost of production of $9,500, coupled with a retail price of $10,000, allows for a healthy return on the invested capital. The cost theory of value would argue that if the final price were lower than $10,000 — say, $9,300 — then producers would have no incentive to stay in automobile production. Some of them would leave the industry and invest their financial capital elsewhere. The exodus would reduce the supply of automobiles, pushing up their price until it once again made sense for producers to make automobiles.
On the other hand, if the price of an automobile were significantly higher than $10,000 — say, $13,000 — then the "rate of profit" in this industry would be much higher than in other enterprises of comparable risk. Investors would flock into automobile production, increasing the supply and pushing down prices.
In summary, the cost theory of value provided a coherent explanation for a genuine empirical regularity in a market economy. It really is the case that retail prices bear a strong correlation to the costs of production for various goods and services. The cost theory of value gave a plausible mechanism to explain this phenomenon. The development of the cost theory of value was a definite advance in economic science.
To relate the cost theory to modern times, notice that it is a very natural approach, and shows a sophisticated understanding of markets. For example, tourists to New York City might initially be shocked at how much a deli sandwich costs in the Big Apple. But a thoughtful member of the group might observe, quite correctly, that the owner of the deli pays astronomical rent every month because of his location across the street from Broadway shows. Once he points out that the sandwiches "have to cost that much" in order for the deli to stay in business, the other tourists in his group might be less outraged at the owner.
Problems with the Cost Theory of Value
Although it was better than nothing, the cost theory of value nonetheless suffered from several important flaws. Fundamentally, the cost theory is deficient because it doesn't actually explain the determinants of market prices. Rather, the cost theory merely explains relationships among market prices.
"Costs" are prices too. To "explain" the price of a $10,000 car by reference to the prices of the engine, tires, glass, and so on, doesn't really explain market prices per se. At best, it pushes back the explanation one step: Why does the engine have a price of $5,000, etc.?
Even on its own terms, the cost theory of value (at least as I have summarized it above) acknowledges that the present day "spot" price of a good is determined by something other than the costs of its production. The theory explicitly deals with the cases where the actual market price is either higher or lower than the long-run "anchor" price set by the cost theory, and tries to explain the forces that would move those "aberrational" prices back toward the long-run "natural" price.
The classical economists weren't dummies. They understood that a sudden urge among the public to buy more of a certain good would lead to an immediate increase in its price. But the cost theory could only comment on this situation by saying that the market would tend toward a restoration of the same rate of profit in the industry through an increase in production to match the increased demand.
In other words, the cost theory of value could explain the long-run target toward which the day-to-day spot prices would tend. The cost theory could not explain what actually formed those spot prices on any given day.
Because the cost theory couldn't explain how actual market prices were formed "from scratch," it was useless when it came to nonreproducible goods. Obviously the price of the Mona Lisa, or of an original Shakespeare manuscript, would have nothing to do with the cost of producing these masterpieces.
Cost Theory Has Things Backward
Here we see the methodological problem of the cost theory: By explaining final retail prices through the cost of making the goods, the cost theory implies that economic value is an objective property of physical items that flows from resources into the goods that they produce. In contrast, the subjective value theory of Menger and others starts with the valuation of consumer goods and works its way back through the prices of labor and other inputs accordingly.
When a consumer is deciding on a purchase, the cost of producing the item is usually irrelevant. For example, going along with our hypothetical example above, if a new company decided to use twice as many resources to make an equivalent car, it couldn't charge $20,000 simply because "that's how much it cost."
For a different example, if a farmer discovers a meteorite chock full of gold on his property, he will charge whatever the market will bear for it. He won't sell it for less than other gold producers on account of his virtually zero cost of production.
Although the cost theory of value provided a coherent explanation of the long-run relationship between prices and costs for reproducible goods, it was not an adequate theory of market price determination. The marginal, subjectivist approach pioneered by Carl Menger and others is far superior, as I will show in a future essay.
 The labor theory of value avoids this particular snare by explaining the ultimate price of a good by the total amount of labor going into its production, including the labor required in the past to produce the components of the final good. However, the labor theory of value carries other problems beyond those of a generic cost theory, as I explain in "The Labor Theory of Value: A Critique of Carson's Studies in Mutualist Political Economy," Journal of Libertarian Studies, vol. 20 (Winter 2006), pp. 17–33.