The Fundamental Economic Assumption

In the InnovAction report referred to in my recent post, there is a roundtable discussion and the first question posed to the group was: "What fundamental economic assumptions about lawyer's services would have to change before billing methods could evolve in earnest?"

You can read the report to see how the participants answered, but I wanted to weigh in as well, since this is such an important economic assumption most of us never even take the time to think about it, let alone challenge it. The fundamental assumption that has to change is the Labor Theory of Value. The idea that there is a link between the time spent to produce a service and its value can be traced back to Aristotle. In fact, throughout history, humans have always correlated labor with value, inputs with outputs. In medieval English, the word acre meant the amount of land a team of eight oxen could plow in a morning.

Even Adam Smith and David Ricardo, two economists with IQs that would make our heads hurt, fell pray to this assumption. Smith equated value with labor, writing in his seminal work, An Inquiry into the Nature and Causes of the Wealth of Nations (1776):

Labour alone, therefore, never varying in its own value, is alone the ultimate and real standard by which the value of all commodities can at all times and places be estimated and compared. If it usually costs twice the labour to kill a beaver as it does to kill a deer one beaver should naturally exchange for or be worth two deer. The real price of everything, what every thing really costs...is the toil and trouble of acquiring it. Labour, therefore, is the real measure of the exchangeable value of commodities.

And David Ricardo wrote in his 1817 treatise Principles of Political Economy and Taxation:

The value of a commodity, or the quantity of any other commodity for which it will exchange, depends on the relative quantity of labour which is necessary for its production.

The best way to disprove a theory is to ask when it doesn't work. Ricardo understood the flaws in the labor theory of value, but didn't live long enough to figure out a better theory. As Mark Skousen writes in his luminous book The Making of Modern Economics:

About a month before his death he wrote a fellow economist: "I cannot get over the difficulty of the wine which is kept in a cellar for 3 or 4 years...which perhaps had not 2 [pence] expended on it in the way of labour, and yet comes to be worth 100 [pounds]."

Of course, the biggest proponent of the labor theory of value was Karl Marx. Here is how he explained his theory in Value, Price and Profit, published in 1865:

A commodity has a value, because it is a crysallisation of social labour. The greatness of its value, or its relative value, depends upon the greater or less amount of that social substance contained in it; that is to say, on the relative mass of labour necessary for its production.

Marx is far from dead. His flock might have perished, but his church lives on. His labor theory of value still wields enormous influence over professional service firm's present-day concept of value and price. But if Marx's theory was correct, a rock found next to a diamond in a mine would be of equal value, since each took the same amount of "billable hours" to locate and extract. If you have pizza today for lunch, under Marx's theory, your tenth slice would be just as valuable as your first, since each took the same amount of "billable hours" to produce.

The Marginalist Revolution

There are particular epochs that occur throughout history, when an assembly of people construct the events that cause a substantial advancement for human society. One such era was 1776, with the publication simultaneously of Smith's Wealth of Nations and the Declaration of Independence. Another was 1871-1874, when three economists ushered in the "neoclassical" marginalist revolution and solved the paradox that so beleaguered Ricardo on his death bed.

Three economists, from three different countries, developed the theory of marginalism and created a revolution: William Stanley Jevons [1835-1882], from Great Britain, Leon Walras [1834-1910] from France, and Carl Menger [1840-1921] from Austria. Here is how Menger defined the true source of value in an economy in his book Principles of Economics, published in 1873:

Value is...nothing inherent in goods, no property of them. Value is judgment economizing men make about the importance of the goods at their disposal for the mainteance of their lives and well-being. Hence value does not exist outside the consciousness of men...The value of goods...is subjective in nature.

The determining factor in the value of a good, then, is neither the quantity of labor or other goods necessary for its production nor the quantity necessary for its reproduction, but rather the magnitude of importance of those satisfactions with respect to which we are conscious of being dependent on command of the good. This principle of value determination is universally valid, and no exception to it can be found in human economy.

The significance of this shift in thinking cannot be over-emphasized, especially since it hasn't happened yet among most professionals. A coat is not worth eight times more than a hat because it takes eight times longer to make it. Its producer is willing to invest eight times more labor into producing a coat because it is worth eight times more to a customer. You'd be willing to pay almost anything for a gallon of water if you were dying of thirst in the desert, but much less if you're washing your car. Water would have a negative value to you if it flooded your basement, as you'd have to pay to have it removed. Value is dependent on time, place, context, and subjective judgments that cannot be precisely calculated.

No better example exists than the very InnovAction reported cited above. In an article by Sheldon Gordon, "Wragge & Co: Scientific Pricing," he explains how this firm has developed Project X, which helps them in pricing the firm's engagements. It mentions the costs of a transaction, number of hours needed, level of team members, etc., but not once in the article does it mention the word "value"—and this is an article about pricing! It is trapped in the quicksand of the labor theory of value, and doesn't even recognize it. At best, Project X should be labeled a cost accounting and project management system, it is nowhere near being a pricing strategy, let alone one that is scientific. The fact it led to the firm being named co-winner of the 2004 Innovaction Leadership Award just shows how far away most law firms are from understanding that it's not labor hours (or costs) that determine price, but rather value.

We are ruled by our theories, whether we admit it or not. The labor theory of value is endemic in the cultures of most professional service firms, and it is past time to replace it with the subjective theory of value. We owe an enormous debt of gratitude to the Marginalist economists—let's start to repay it by at least catching up with their thinking and teachings on the true source of value. Let's stop blabbering about billable hours being related to value. It's an idea from the day before yesterday. An idea whose time has passed.