Essentially, this is the Marxist approach to valuing labor. Employers (capitalists) compensate employees (workers) for time and sweat. When they sell the widget to a third party for more than they paid for the labor, they capitalize on the surplus value created by the workers, and that is their profit. Notice that this profit is not scaled to the time of sweat expended by the capitalists. Also notice that there is no straightforward measurement scale for "effort" or what an hour of work is "really" worth. This uncertainty makes the valuation of labor elastic and open to strategic manipulation. Employees are naturally interested in keeping labor costs down. Marx (and I am sure many others) recognized that a powerful way of doing this is to create competition among those who only have labor to sell. The creation of a "reserve army" of workers puts the capitalist in a strong bargaining position. "If you don't want to make a widget for $X, I have five guys lined up who will do it for $.3X. These "guys" may be illegal immigrants, women, young people, old people, people without a degree or certificate. The possibilities are many.

The worker's defense against the reserve army tactic is to make better and more specialized widgets. This leads to alternative view on labor valuation. Adam Smith (and I am sure many others) also suggested that the price of a widget should be scaled according to the time and sweat needed for making it; but, instead of using the worker's (or seller's) time and sweat, what matters is the buyer's time and sweat. In a transaction where labor is sold and bought, the crucial question is what the widget is worth to the buyer. In a narrow sense, the question the buyer needs to ask is "How long and how hard would I have to work to make this thing myself?" In our example, the seller has gained experience in making widgets and is now prepared to make a better one (in less time). To make a widget of the same quality, the buyer would have to work even longer and harder because he the buyer has not improved his skills while the seller was working. By this logic, the second widget is worth more than the first. The seller should be entitled to ask for (much) more and the buyer should be willing to pay (a little) more. To settle the difference between "much" and "a little" should be the topic of negotiation.

The distinction between the Marxist and the Smithian perspective on value is unfortunately not as neat as my rough example might suggest. The seller and the buyer are not the only parties to reckon with. There are other sellers (the reserve army) and there are - one would hope - other buyers. The outcome of the power game very much depends on who manages to line up more alternatives on the other side. Buyers who can recruit many other workers can offer less, and sellers who can recruit many sellers can demand more. Both sides are naturally interested in presenting themselves as unique and irreplaceable to the other party. Clever posturing, threatening, or insinuating can go a long way to bamboozle the other side.

Although all this may sound fairly commonsensical, it is not. Notice that in the course of the narrative, the situation has become increasingly complex. We started with a two-party exchange and ended up with a dynamical multi-party scenario involving communication, both truthful and mendacious. And it gets better (or is it worse?). Once there are multiple buyers and sellers on the scene, each individual buyer and seller finds himself in a social dilemma. The buyer is interested in forming a coalition with other buyers to fix prices at a low level. At the same time, each buyer is tempted to pay a little more to get the better worker and the better product. Likewise, the seller is interested in forming a coalition with other sellers (e.g., unions) to keep prices high. At the same time, each seller is tempted to defect to get the job. Earning a little less is better than earning nothing. As if social dilemmas weren't hard enough to navigate, what we have here is two social dilemmas (one on the buyers' side and one on the sellers' side) intersecting with the conflict of interest between buyers and sellers. The master of this sort of situation is he (or she) who manages to convince the opponent that only he (or she) is willing to defect from the cooperative consensus on his (or her) side. The widget maker needs to convince the widget buyer that most widget makers will ask for a lot more, and the widget buyer needs to convince the widget maker that most widget makers will offer a lot less. Trivial? Obvious? Perhaps. Now try it in real life.  

This post was inspired, in part, by Carl Beuke's excellent post on the multifarious nature on salary-setting.  

Another inspiration came from a forthcoming paper in the Journal of Consumer Research, in which Yale psychologist Shane Frederick shows that most buyers overestimate what other buyers will pay for a good. That is a glimmer of hope for the seller of widgets. Telling the buyer that others will pay more will tap into a pre-existing belief and ought to make it easier to nudge the price upward.