Of wages and money: cost as a proxy measure of value

The subjective theory of value, used by the Salamanca school in Renaissance Spain and most recently in neoclassical and Austrian economics, is undoubtedly the correct one, despite the fact that figures ranging from Smith to Ricardo to Marx used labor as a fundamental measure of value. This labor theory of value is profoundly wrong. If I spend hours digging a hole in your back yard, that doesn't provide you any value unless you wanted a hole in your back yard.

Nevertheless, as we shall see, using labor, or more generally cost, as a measure of value is a common strategy of our institutions and in itself often quite valuable thing to do. How does this come about? The key to the puzzle is Yoram Barzel's idea of a proxy measure, which I have described as follows:

The process of determining the value of a product from observations is necessarily incomplete and costly. For example, a shopper can see that an apple is shiny red. This has some correlation to its tastiness (the quality a typical shopper actually wants from an apple), but it's hardly perfect. The apple's appearance is not a complete indicator -- an apple sometimes has a rotten spot down inside even if the surface is perfectly shiny and red. We call an indirect measure of value -- for example the shininess, redness, or weight of the apple -- a proxy measure. In fact, all measures of value, besides prices in an ideal market, are proxy measures -- real value is subjective and largely tacit.

Such observations also come at a cost. It may take some time to sort through apples to find the shiniest and reddest ones, and meanwhile the shopper bruises the other apples. It costs the vendor to put on a fake shiny gloss of wax, and it costs the shopper because he may be fooled by the wax, and because he has to eat wax with his apple. Sometimes these measurement costs comes about just from the imperfection of honest communication. In other cases, such as waxing the apple, the cost occurs because rationally self-interested parties play games with the observable...

Cost can usually be measured far more objectively than value. As a result, the most common proxy measures are various kinds of costs. Examples include:

(a) paying for employment in terms of time worked, rather than by quantity produced (piece rates) or other possible measures. Time measures sacrifice, i.e. the cost of opportunities foregone by the employee.

(b) most numbers recorded and reported by accountants for assets are costs rather than market prices expected to be recovered by the sale of assets.

(c) non-fiat money and collectibles obtain their value primarily from their scarcity, i.e. their cost of replacement.

(From "Measuring Value").

The proxy measure that dominates most of our lives is the time wage:

To create anything of value requires some sacrifice. To successfully contract we must measure value. Since we can’t, absent a perfect exchange market, directly measure the economic value of something, we may be able to estimate it indirectly by measuring something else. This something else anchors the performance – it gives the performer an incentive to optimize the measured value. Which measures are the most appropriate anchors of performance? Starting in Europe by the 13th century, that measure was increasingly a measure of the sacrifice needed to create the desired economic value.

This is hardly automatic – labor is not value. A bad artist can spend years doodling, or a worker can dig a hole where nobody wants a hole. Arbitrary amounts of time could be spent on activities that do not have value for anybody except, perhaps, the worker himself. To improve the productivity of the time rate contract required two breakthroughs: the first, creating the conditions under which sacrifice is a better estimate of value than piece rate or other measurement alternatives, and second, the ability to measure, with accuracy and integrity, the sacrifice.

Piece rates measure directly some attribute of a good or service that is important to its value – its quantity, weight, volume, or the like -- and then fix a price for it. Guild regulations which fixed prices often amounted to creating piece rates. Piece rates seem the ideal alternative for liberating workers, but they suffer for two reasons. First, the outputs of labor depend not only on effort, skills, etc. (things under control of the employee), but things out of control of the employee. The employee wants something like insurance against these vagaries of the work environment. The employer, who has more wealth and knowledge of market conditions, takes on these risks in exchange for profit.

In an unregulated commodity market, buyers can reject or negotiate downwards the price of poor quality goods. Sellers can negotiate upwards or decline to sell. With piece rate contracts, on the other hand, there is a fixed payment for a unit of output. Thus second main drawback to piece rates is that they motivate the worker to put out more quantity at the expense of quality. This can be devastating. The tendency of communist countries to pay piece rates, rather than hourly rates, is one reason that, while the Soviet bloc’s quantity (and thus the most straightforward measurements of economic growth) was able to keep up with the West, quality did not (thus the contrast, for example, between the notoriously ugly and unreliable Trabant of East Germany and the BMWs, Mercedes, Audi and Volkswagens of West Germany).

Thus with the time-rate wage the employee is insured against vagaries of production beyond his control, including selling price fluctuations (in the case of a market exchange), or variation in the price or availability of factors of production (in the case of both market exchange or piece rates). The employer takes on these risks, while at the same time through promotion, raises, demotions, wage cuts or firing retaining incentives for quality employee output.

Besides lacking implicit insurance for the employee, another limit to market purchase of each worker’s output is that it can be made prohibitively costly by relationship-specific investments. These investments occur when workers engage in interdependent production -- as the workers learn the equipment or adapt to each other. Relationship-specific investments can also occur between firms, for example building a cannon foundry next to an iron mine. These investments, when combine with the inability to write long-term contracts that account for all eventualities, motivate firms to integrate. Dealing with unspecified eventualities then becomes the right of the single owner. This incentive to integrate is opposed by the diseconomies of scale in a bureaucracy, caused by the distribution of knowledge, which market exchange handles much better. These economic tradeoffs produce observed distributions of firm sizes in a market, i.e. the number of workers involved in an employment relationship instead of selling their wares directly on a market.

The main alternative to market exchange of output, piece rate, or coerced labor (serfdom or slavery) consists of the employers paying by sacrifice -- by some measure of the desirable things the employee forgoes to pursue the employer’s objectives. An hour spent at work is an hour not spent partying, playing with the children, etc. For labor, this “opportunity cost” is most easily denominated in time – a day spent working for the employer is a day not spent doing things the employee would, if not for the pay, desire to do.

Time doesn’t specify costs such as effort and danger. These have to be taken into account by an employee or his union when evaluating a job offer. Worker choice, through the ability to switch jobs at much lower costs than with serfdom, allows this crucial quality control to occur.

It’s usually hard to specify customer preferences, or quality, in a production contract. It’s easy to specify sacrifice, if we can measure it. Time is immediately observed; quality is eventually observed. With employment via a time-wage, the costly giving up of other opportunities, measured in time, can be directly motivated (via daily or hourly wages), while quality is motivated in a delayed, discontinuous manner (by firing if employers and/or peers judge that quality of the work is too often bad). Third parties, say the guy who owned the shop across the street, could observe the workers arriving and leaving, and tell when they did so by the time. Common synchronization greatly reduced the opportunities for fraud involving that most basic contractual promise, the promise of time.

Once pay for time is in place, the basic incentives are in place – the employee is, verifiably, on the job for a specific portion of the day – so he might as well work. He might as well do the work, both quantity and quality, that the employer requires. With incentives more closely aligned by the calendar and the city bells measuring the opportunity costs of employment, to be compensated by the employer, the employer can focus observations on verifying the specific quantity and qualities desired, and the employee (to gain raises and avoid getting fired) focuses on satisfying them. So with the time-wage contract, perfected by northern and western Europeans in the late Middle Ages, we have two levels of the protocol in this relationship: (1) the employee trades away other opportunities to commit his time to the employer – this time is measured and compensated, (2) the employee is motivated, by (positively) opportunities for promotions and wage rate hikes and (negatively) by the threat of firing, to use that time, otherwise worthless to both employer and employee, to achieve the quantity and/or quality goals desired by the employer.

(from From "A Measure of Sacrifice")

Proxy measures also explain how money can depend on standards of nature instead of a singular trusted third party:

Although anatomically modern humans surely had conscious thought, language, and some ability to plan, it would have required little conscious thought or language, and very little planning, to generate trades. It was not necessary that tribe members reasoned out the benefits of anything but a single trade. To create this institution it would have sufficed that people follow their instincts to make obtain collectibles with the characteristics outlined below. (as indicated by proxy observations that make approximate estimations for these characteristics).

Utilitarian jewelry: silver shekels from Sumeria. The recipient of a payment would weigh the segment of coil used as payment and could cut it at an arbitrary spot to test its purity. A wide variety of other cultures, from the Hebrews and the famously commercial Phoenicians to the ancient Celtic and Germanic tribes, used such forms of precious metal money long before coinage.

At first, the production of a commodity simply because it is costly seems quite wasteful. However, the unforgeably costly commodity repeatedly adds value by enabling beneficial wealth transfers. More of the cost is recouped every time a transaction is made possible or made less expensive. The cost, initially a complete waste, is amortized over many transactions. The monetary value of precious metals is based on this principle. It also applies to collectibles, which are more prized the rarer they are and the less forgeable this rarity is. It also applies where provably skilled or unique human labor is added to the product, as with art.

(from "Shelling Out: The Origins of Money")

The rational price of such a monetary commodity will be, ignoring more minor effects (e.g. the destruction of monetary units) the lesser of:

(1) the value a monetary unit is expected to add to future transactions, i.e. what it will save in transaction costs

(2) the cost of creating a new monetary unit

Since (1) cannot be objectively measured, but at best can only be intuitively estimated, as long as one is confident that (1)>(2) the cost of creating a monetary unit becomes a good proxy measure of the value of the monetary unit. If monetary units are not fungible, but their costs are comparable, their relative value can be well approximated by their relative costs even if (2)>=(1). If the expected value of a monetary unit drops below the replacement cost, gold miners (for example) stop creating new monetary units (in the case of gold miners, if their production costs exceed this expected value they stop mining gold), holding the money supply steady which minimizes inflation. If it goes above replacement costs more gold mines can be affordably worked, increasing the money supply as the economy grows without inflation. This all depends on having a secure floor to replacement costs, which is well approximated by gold and silver but violated by fiat currencies (as can be seen by for example comparing the rampant inflations of many 20th century fiat currencies against the quite mild, by comparison, inflations that followed discoveries such as Potosi silver in the 16th century and California gold in the 19th).

Sumerian shell money.

We often adapt institutions from prior similar institutions, and often by accident. So, for example, money can evolve from utilitarian commodities that have the best characteristics of money (securely storable, etc.) in a particular environment (e.g. cigarettes in a prison). But humans also have foresight and can reason by analogy, and so can design an exchange to trade new kinds of securities, a new kind of insurance service, or a new kind of currency.

Naturally such designs are still subject to a large degree of trial and error, of the creative destruction of the market. And they are subject to network externalities: to, roughly speaking, Metcalfe's law, which states the value of a network is proportional to the square of the number of its members, and that a network of one is useless. A telephone is useless unless somebody else you want to talk to also has a telephone. Likewise, currency is useless unless one has somebody to buy from or sell to who will take or give that currency. Indeed, with money the situation is even worse than most networks, because unless that person wants to do a corresponding sell or buy back to you at a later date, the money will get "stuck." It will have zero velocity. One needs either specific cycles to keep money circulating (as with the ancient kula ring), or a second currency with such cycles that can be exchanged for the first. Thus, the marketing problem of starting a new currency is formidable. Although Paypal was implementing just a payment system in dollars, not a new currency, it hit on a great strategy of general applicability: target specific communities of people that trade with each other (in Paypal's case, the popular eBay auction site).

But insisting that gold, silver, shells, online payment systems or currencies, etc. must be useful for some other purpose, such as decoration, before they can be used as money, is a terrible confusion, akin to insisting that an insurance service must start out as useful for something else, perhaps for stabling horses, before one can write the insurance contracts. Indeed many of us value precious metals and shells for decoration more for a reverse reason, which I explain in the above-linked essay on the origins of money.

Conclusion

The labor theory of value is wrong. Value is fundamentally a matter of subjective preferences. Nevertheless. Yoram Barzel's crucial idea of proxy measures allows us to understand why measures of labor and more generally measures of cost are so often and so usefully applied as measures of value in institutions, including wage contracts and non-fiat money.

Agricultural consequences of the Black Death

The Black Death, caused (as DNA testing of victims has recently confirmed) by the bubonic plague, Yersina pestis, swept through Europe primarily in the years 1347-1351, with some recurring outbreaks thereafter. This plague not only brought great demographic changes to Europe, killing off probably about half of the population, but substantial changes to the economy and especially to the dominant sector of the economy then, agriculture. The Black Death provides a great empirical test of Malthusian theories of agricultural economies and it is very informative to look at what happened.

Under a naive reading of Malthusian theory, yield (the amount of food or fodder produced per unit area) should have improved after the Black Death: a lower population abandoned marginally productive lands and kept the better yielding ones. Furthermore, the increased ratio of livestock to arable acres should have improved fertilization of the fields, as more nutrients and especially nitrogen moved from wastes (wild lands) and pastures to the arable.

But while marginal lands were indeed abandoned (or at least converted from arable to pasture), and the livestock/arable ratio indeed increased, it's not the case that yield improved after the Black Death. In fact, the overall (average) yield of all arable probably declined slightly, and the yields of particular plots of land that were retained as arable usually declined quite substantially. Yields declined and for the most part stayed low for several centuries thereafter. Other factors must have been work, factors stronger than the abandonment of marginally productive lands and the influence of more livestock on nutrient movement.
Per capita agricultural output (vertical axis) vs. population density (horizontal axis) in England before, during, and after the Black Death and through the agricultural revolutions of the succeeding centuries.

The main such factor is that increasing yield without great technological improvement requires more intensive labor: extra weeding, extra transport of manures and soil conditioners, etc. Contrariwise, a less intensive use of land readily leads to falling yield. After the Black Death, labor was more expensive relative to land, so it made sense to engage in a far less intensive agriculture. The increase of pasture and livestock at the expense of the arable was a part of this. But letting the yield decline was another. What increased quite dramatically in the century after the Black Death was labor productivity and per capita standard of living (see first three points on the diagram, each covering an 80-year period from 1260 to 1499).

Indeed, the whole focus in the literature on improvements in "productivity" as yield in the agricultural revolution has been very misleading. The crucial part of the revolution, and the direct cause of the release of labor from the agricultural to the industrial and transport sectors, was an increase in farm labor productivity: more food grown with less labor. Over short timescales, that is without dramatic technological or institutional progress, farm labor productivity was inversely correlated with yield for the reasons stated. Higher labor productivity, certainly not higher yield, is what distinguished most of Europe for example from East and Southeast Asia, where under intensive rice cultivation, and abundant rain during warm summers, yield had long been far higher than in Europe. Per Malthus, however, population growth in these regions had kept pace with yield, resulting in a highly labor-intensive, low labor productivity style of agriculture, including much less use of draft animals for farm work and transport.

The bubonic plague was spread by rodents, who in turn fed primarily on grain stores. This also had a significant impact on agriculture, because grain-growing farmers and grain-eating populations were disproportionately killed and people fled areas that grew or stored grain for regions specializing in other kinds of agriculture. In coastal regions like Portugal there was a large move from grain farming to fishing. In Northern Europe there was a great move to pasture and livestock, and in particular a relative expansion of the unique stationary pastoralism that had started to develop there in the previous centuries, both due to the relative protection of pastoralists from the plague and the less labor-intensive nature of pastoralism after land had become cheaper relative to labor.

A final interesting effect is that the long trend from about the 11th to the 19th century in England of conversion of draft animals from oxen to horses halted temporarily in the century after the Black Death. The main reason for this was undoubtedly the reversion of arable to pasture or waste (wild lands). Oxen are, to use horse culture terminology, very "easy keepers". As ruminants they can convert cellulose to glucose for energy and horses can't. Oxen, therefore, became relatively cheaper than horses in an era with more wastes and less (or at least much less intensive use of) arable for growing fodder. This kind of effect occurred again much later on the American frontiers where there was a temporary, partial reversion from horses to oxen as draft animals given the abundance of wild lands relative to groomed pasture and arable for growing fodder. For example the famous wagon trains to California and Oregon were pulled primarily by oxen, which could be fed much better than horses in the wild grasslands and arid wastes encountered. However in England itself, the trend towards horses replacing oxen, fueled by the increasing growth of fodder crops, had resumed by 1500 and indeed accelerated in the 16th century, playing a central role in the transportation revolutions of the 15th through 19th centuries.

Trotting ahead of Malthus

Progress in the Malthusian isocline in England from the 13th through 19th centuries, as, among many other factors, horses slowly replaced oxen for farm work and transport, the ratio of draft animals to people increased, and more arable land was devoted to fodder relative to food.(click to enlarge)

I have previously discussed Great Britain's unprecedented escape from the Malthusian trap. Such escapes require virtuous cycles, i.e. positive feedback loops that allow productive capital to accumulate faster than it is destroyed. There are a number of these in Britain in the era of escape from the Black Plague to the 19th century, but two of the biggest involved transportation.

One of these that I've identified was the fodder/horse/coal/lime cycle. More and better fodder led to more and stronger horses, which hauled (among other things) coal from the mines, initially little more than quarries, that had started opening up in northeastern England by the 13th century. Coal, like wood, was very costly to transport by land, but relatively cheap to ship by sea or navigable river. As fodder improved, horses came to replace oxen in the expensive step transporting goods, including coal, from mine, farm, or workshop to port and from port to site of consumption. Many other regions (e.g. in Belgium and China) had readily accessible coal, but none developed this virtuous cycle so extensively and early.

Among the early uses of coal was for heating, fuel for certain industrial processes that required heat (e.g. in brewing beer), and, most interestingly, for burning lime. Burned lime, slaked with water, could unlike the limestone it came from be easily ground into a fine powder. This great increase in the surface area of this chemical base, which let it de-acidify the soils on which it was applied. The soils of Britain tend to be rather acidic, which allows poisonous minerals, such as aluminum, to absorb into plants and blocks the absorption of needed nutrients (especially NPK -- nitrogen, phosphorous, and potassium). The application of lime thus increased the productivity of fields for growing both food and fodder, completing the virtuous cycle. This cycle operated most strongly during the period of the consistent progress in the English Malthusian isocline from the 15th through 19th centuries.

Another, related, but even more important cycle was the horse/transport and institutions/markets/specialization cycle. More and better horses improved the transport of goods generally, including agricultural goods. John Langdon [1] estimates that a team of horses could transport a wagon of goods twice as fast as a team of oxen, which suggests a factor of four increase in market area. Add to this the Western European innovations in sailing during the 15th century (especially the trading vessels and colliers that added lateen sails(s) to the traditional square sails, allowing them to sail closer into the wind), and market regions in much of Western Europe and especially Great Britain were greatly expanded in the 15th and 16th centuries.

Expanded markets in turn allowed a great elaboration of the division of labor. Adam Smith famously described how division of labor and specialization greatly improved the productivity of industry, but to some extent this also operated in British agriculture. Eric Kerridge [2] eloquently described the agricultural regions of Britain, each specializing in different crops and breeds of livestock. Some were even named after their most famous specializations: "Butter Country", "Cheese Country", "Cheshire Cheese Country", "Saltings Country", etc. These undoubtedly emerged during the 15th through 19th centuries, as prior to that time European agriculture had been dominated by largely self-sufficient manors. And closing the cycle, there emerged several localities that specialized in breeding a variety of horses. Most spectacularly different British regions during this period bred no less than three kinds of large draft horses: the Shire Horse, the Suffolk Punch (in that eastern English county) and the Clydesdale (in that Scottish county).

Institutions such as advertising and commercial law emerged or evolved to allow lower transaction cost dealings between strangers. This was probably by far the most non-obvious and difficult aspect of the problem of expanding markets. Greatly aiding in this evolution was the growth of literacy due to spread in Europe of the inexpensive books produced by printing especially in the 16th and later centuries. Where in the Middle Ages literacy had been the privilege of a religious elite, with very few on a manor literate beyond the steward, after the 15th century an ever increasing population could read advertisements, order goods remotely, read and even draft contracts.

Another effect of longer-distance transportation was to open up more remote lands, which had been too marginal to support self-sufficient agricultural, to reclamation for use in specialized, trade-dependent agriculture. The ability to lime soils that were otherwise too acidic also often contributed to reclamation.

There were many other improvements to English agriculture and transportation during these crucial centuries, but the above cycles were probably the most important up to the 19th century. Here I'll mention three important transportation improvements later in this period that in many ways show the culmination of the underlying trend: the development of the turnpike (private toll) roads in the 18th century and the associated development of scheduled transportation services, (2) a great expansion in the use of horse-drawn rail cars in coal and other mines, and (3) the development of river navigations largely in the 17th and 18th centuries, and canals largely in the 18th and early 19th centuries, again almost entirely through private investment and ownership.

As coal mines were dug deeper, they were increasingly flooded with water. Long before the steam engine, these mines were pumped by horse-powered gins. Here horses on a gin power an axle (bent through a Hooke universal joint) and belt, in this case powering an 18th century farmyard innovation, the threshing machine. The horses know to not step on the rapidly spinning axle. I'm going to guess that the horse gin was the inspiration for the merry-go-round:

Horse-drawn wagons on rails took coal from mines to docks on navigable rivers and (no small matter) pulled the empty wagons back uphill. Coal and other ores were hauled by horses over these wagonways over distances of a few kilometers. They were almost exclusively used for mines, quarries, clay pits, and the like, running from mine mouth to navigable water. Here's a horse pulling coal on a wagonway:

More horses pulling coal on rails:

Now the only thing left of horse-drawn rail are tourist relics:

Even in 1903 the London streets were still powered by horses (see if you can spot the two still-rare horseless carriages):

And now for a taste of the British river navigations and canals:

The Trent and Mersey canal, built in the late 18th century, could take you from one side of England to the other:

Where Romans had used aqueducts to move water, the British used them in their canal system to move goods where their canals needed to span valleys. A large number of aqueducts were built from stone in Britain during its canal boom in the 18th century. This was the original Barton Aqueduct on the Bridgewater Canal (1760s):

In the late 18th century the smelting of iron using coal instead of wood was perfected. Soon thereafter iron became cheap enough to use for constructing bridges and aqueducts. One result was the spectacular Pontcysyllte Aqueduct in Wales. What in the early 19th century was a towpath for horses is now a sidewalk for tourists. Careful, it's a long way down!

References

Eric Kerridge, The Farmers of Old England

John Langdon, Horses, Oxen, and Technological Innovation