Labor theory of value
The labor theory of value (sometimes the cost theory of value) holds that a good derives its value from the quantity of labor required to produce it. It was held in various forms by classical economists including Adam Smith and David Ricardo, and was taken over by Karl Marx as the foundation of his theory of exploitation.[1]
Its rejection is one of the founding acts of the Austrian School. The marginalist account of value that replaced it is not a refinement of the labour theory but its reversal.
The problem it could not solve
The classical economists could not explain why water, which is indispensable, is nearly free, while diamonds, which are not, are dear. Nor could they explain why a good produced at great expense may fetch nothing if no one wants it. Both difficulties arise from the same source: the theory runs causation from cost to value, and so has nothing to say about goods whose cost and usefulness point in opposite directions.
The marginalist reversal
Carl Menger's answer was that value is not a property inhering in goods but an importance attributed to them by valuing people, and that people never value "water" or "diamonds" as such. They value particular units for particular purposes, at the margin, so the relevant question is what depends on the specific unit in question.[2]
This inverts the causal order. Value does not flow from cost; cost is itself a value phenomenon. The factors of production are valued because of the anticipated value of the consumer goods they can be used to make, so prices of inputs are imputed from expected prices of outputs rather than the reverse. Labour is one such input and is valued the same way, which is why a labourer's wage tends toward the discounted value of what his work is expected to add.
The theory's residual plausibility comes from a genuine but secondary fact: costs already incurred cannot determine value, but expected value does govern which costs people are willing to incur, so in a settled industry price and cost of production do tend to move together. That correlation is an effect, not the cause.
Böhm-Bawerk's critique of Marx
Eugen von Böhm-Bawerk gave the classic Austrian criticism in Karl Marx and the Close of His System. He argued that Marx's system is internally inconsistent: the first volume of Das Kapital has commodities exchanging in proportion to labour time, while the third concedes that they exchange at prices of production which diverge from labour values wherever the ratio of capital to labour differs between industries, as it generally does. The transformation offered to reconcile the two, Böhm-Bawerk held, does not reconcile them but abandons the original proposition while retaining its vocabulary.[3]
He also objected to the derivation itself. Marx arrives at labour as the common substance of exchangeable goods by abstracting away every other property they share, but the abstraction is not forced: scarcity and usefulness survive it too, and nothing in the argument selects labour except the conclusion it is wanted for.
Consequences for exploitation
Because the wage tends toward the discounted marginal value product of labour, interest on capital appears in the Austrian account as the discount arising from time preference rather than as a deduction from what workers produced. The employer who pays wages now for output realised later is advancing present goods against future goods, and the difference is the price of time rather than a share withheld. The Marxian charge of exploitation therefore does not survive the change of value theory, which is why the dispute over the labour theory was never a narrow technical matter.