Ed and I were absolutely honored to interview Dr. Thomas Sowell, certainly one of the world's greatest living economists, on The Soul of Enterprise: Business in the Knowledge Economy. Dr. Sowell is currently Senior Fellow at the Hoover Institution, Stanford University. Sowell was born in North Carolina, but grew up in Harlem, New York. He dropped out of high school and served in the United States Marine Corps during the Korean War. He received a Bachelor's degree, graduating magna cum laude from Harvard University in 1958 and a Master's degree from Columbia University in 1959. In 1968, he earned his Doctorate in Economics from the University of Chicago.

Dr. Sowell has served on the faculties of several universities, including Cornell University and University of California, Los Angeles. He has also worked for think tanks such as the Urban Institute. Since 1980, he has worked at the Hoover Institution at Stanford University. He writes from a conservative and classical liberal perspective, advocating free market economics and has written more than thirty books. He is a National Humanities Medal winner.

The new edition of his international best seller on economics, Basic Economics – 5th Edition (Basic Books, December 2015), was the focal point of our discussion.

Basic Economics is the best single volume primer on economics ever written. There are no graphs or equations, and the writing is clear, uncomplicated, eye-opening, and cogent. Ron has recommended this book to hundreds of people, most have thanked him profusely.

We discussed Dr. Sowell's early years as a Marxist, his definition of an economy and economics, early baseball tryout, the notion of a "fair" price, the illogic of the "trade deficit," his views on immigration, Thomas Pikkety's book and income inequality, and why there are only "non-economic values."

We also asked Dr. Sowell during the break what he thought of President Obama's recent policy on easing restrictions on Cuba. He was adamantly against it, and hopefully he will be writing on this topic for his syndicated column.

It's difficult to suggest one of Thomas Sowell's books over another. Be sure to read Basic Economics, 5th Edition, but if you want to venture beyond that (and you will), we've listed Dr. Sowell's books below, though not all of them. He's written two on late-talking children as well, which I hear are excellent.

Ron's favorites are: Knowledge and Decisions; A Conflict of Visions; and Intellectuals and Race.

Other Resources

Dr. Sowell's Wikipedia page.

Fred Barnes interview with Dr. Sowell.

Article by Jay Nordlinger, of National Review, on Thomas Sowell.

Follow Dr. Sowell's syndicated newspaper column on Twitter @sowellcolumn

Books by Thomas Sowell (partial list)

Say’s Law: An Historical Analysis, 1972

Classical Economics Reconsidered, 1974

Knowledge and Decisions, 1980

Markets and Minorities, 1981

Ethnic America: A History, 1981

The Economics and Politics of Race, 1983

Civil Rights: Rhetoric or Reality, 1984

Marxism: Philosophy and Economics, 1985

Education: Assumptions Versus History, 1986

A Conflict of Visions: Ideological Origins of Political Struggles, 1987

Compassion Versus Guilt and Other Essays, 1987

Preferential Policies: An International Perspective, 1990

Inside American Education: The Decline, the Deception, the Dogmas, 1993

Race and Culture: A World View (Part I of a trilogy), 1994

The Vision of the Anointed: Self-Congratulation as a Basis for Social Policy, 1995

Knowledge and Decisions, 1996 (1980 original)

Migrations and Cultures: A World View (Part II of a trilogy), 1996

Conquests and Cultures: An International History (Part III of a trilogy), 1998

The Quest for Cosmic Justice, 1999

A Personal Odyssey, 2000

Basic Economics: A Citizen’s Guide to the Economy, 2004

Applied Economics: Thinking Beyond Stage One, 2004

Black Rednecks and White Liberals, 2005

Every Wonder Why (collection of columns), 2006

A Conflict of Visions: Ideological Origins of Political Struggles, revised and expanded 2007

A Man of Letters, 2007

The Housing Boom and Bust, 2009

Intellectuals and Society, 2009

Applied Economics: Thinking Beyond Stage One, Revised and Enlarged Edition, 2009

Dismantling America (collection of columns), 2010

The Thomas Sowell Reader (collection of columns, essays, etc.), 2011

“Trickle Down” Theory and “Tax Cuts for the Rich,” (essay), 2012

Intellectuals and Race, 2013

Basic Economics: A Citizens Guide to the Economy, 5th Edition, 2015

♒ Read Full Transcript

On this show, Ron and Ed contrast and compare the labor theory of value and the subjective theory of value starting out with the “Diamond-Water Paradox.” Listen to the show at VoiceAmerica.com, here.

The Diamond-Water Paradox

Adam Smith was confounded. One of the greatest economic and social thinkers in the history of ideas struggled with the so-called “diamond-water paradox.”

None of us would be able to live beyond a couple of weeks without water, yet its price is relatively cheap compared to the frivolous diamond, which certainly no one needs to stay alive.

Most people resolve this paradox by replying the supply of diamonds is scarce compared to water. But this theory lacks explanatory power. If it did, those drawings by your kids on your refrigerator would be worth a few mortgage payments. Just because something is scarce does not make it valuable.

The Labor Theory of Value

Karl Marx had a theory, too. The labor theory of value still wields enormous influence over our present-day concept of value and price. Marx explained his theory in Value, Price and Profit, published in 1865:

"A commodity has a value, because it is a crystallisation ofsocial 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."

This sounds reasonable, but if Marx’s theory were correct, a rock found next to a diamond in a mine would be of equal value, since each took the same amount of labor hours to locate and extract.

If you have pizza for lunch today, under Marx’s theory, your tenth slice would be just as valuable as your first, since each took the same amount of labor hours to produce.

One glaring flaw in Marx’s theory was it did not take into account the law of diminishing marginal utility, which states the value to the customer declines with additional consumption of the good in question.

The Marginalist Revolution of 1871

Fortunately, three economists developed the theory of marginalism and created a revolution: William Stanley Jevons from Great Britain, Leon Walras from France, and Carl Menger from Austria.

There were forerunners to the marginal theory, but it was not until these three came together that the theory was accepted as valid in the economics profession. The idea that all value is subjective seems obvious is retrospect, given how consumer preferences and tastes can change on a whim.

So what made this new theory so revolutionary? As Menger explains in his book Principles of Economics, written in 1873:

"Value is…nothing inherent in goods, no property of them. Value is a judgment economizing men make about the importance of the goods at their disposal for the maintenance of their lives and well-being. Hence value does not exist outside the consciousness of men…[T]he value of goods…is entirely subjective in nature."

Value is like beauty—it is in the eye of the beholder. This theory has enormous explanatory. Philip Wicksteed, a British clergyman, wrote scientific critique of the Marxian labor theory of value in 1884, where he explained:

"A coat is not worth eight times as much as a hat to the community because it takes eight times as long to make it….The community is willing to devote eight times as long to the making of a coat because it will be worth eight times as much to it."

Still, cause and effect is confused constantly on this principle in businesses to this day. I remember taking a wine tour of Far Niente in Napa where the guide was explaining how one particular vintage had to be bottled by hand, which was why it was more expensive—due to the extra labor this entailed.

I could not help thinking: No, you are willing to invest in the labor necessary to bottle the wine by hand because some customers find it valuable (and delicious!) enough to cover the extra labor costs.

If one were to lay the two theories of value––labor and subjective––side by side, it would look like this:

Cost-Plus Pricing––Labor Theory of Value

Product » Cost » Price » Value » Customers

Pricing On Purpose––Subjective Theory of Value

Customers » Value » Price » Cost » Product

Notice how value pricing turns the order of cost-plus pricing inside-out, by starting with the ultimate arbiter of value––the customer. Goods and services do not magically become more valuable as they move through the factory and have costs allocated to them by cost accountants.

The costs do not determine the price, let alone the value. It is precisely the opposite; that is, the price determines the costs that can be profitably invested in to make a product desirable for the customer, at an acceptable profit for the seller.

Why Are Diamonds More Expensive Than Water?

The German economist Hermann Heinrich Gossen developed what is known as Gossen’s Law: The market price is always determined by what the last unit of a product is worth to people.

While the first several gallons of water may be vital for your survival, the water used to shower, flush the toilet, and wash the dishes is less valuable. Less valuable still is the water used to wash your dog, your car, and hose down your driveway.

On the other hand, the marginal satisfaction of one more diamond tends to be very high.

If water companies knew you were dehydrated in the desert they would be able to charge a higher price for those first vital gallons consumed, and then gradually adjust the price downwards to reflect the less valuable marginal gallons.

Since they do not possess this information—the cost of doing so would be prohibitive—the aggregate market price for water tends to be based upon its marginal value.

Old Fallacies Die Hard

Thomas Sowell explains in his book, Economic Facts and Fallacies: Second Edition, how the economics profession finally overcame the labor theory of value:

"By the late nineteenth century, however, economists had given up on the notion that it is primarily labor which determines the value of goods. This new understanding marked a revolution in the development of economics. It is also a sobering reminder of how long it can take for even highly intelligent people to get rid of a misconception whose fallacy then seems obvious in retrospect. It is not costs which create value; it is value which causes purchasers to be willing to repay the costs incurred in the production of what they want."

That all value is subjective is difficult for many business people to accept, but it does explain how we humans spend money.

Wrong Theory, Suboptimal Results

As John Maynard Keynes said, “The difficulty lies, not in the new ideas, but in escaping from the old ones, which ramify, for those brought up as most of us have been, into every corner of our minds,” to which philosopher Bertrand Russell added, “The resistance to a new idea increases as the square of its importance.”

Yet when people hear the subjective theory explained, they intuitively understand it, because it comports to human behavior. And isn’t this what learning is all about—understanding something you have known all along, but in a new way?

Despite this lesson, we return to our offices and fall back to pricing our products and services using a cost-base formula.

As John Kenneth Galbraith said, “There are many misfortunes that can befall an economist. The worst, by far, is to have a theory in which he devoutly believes, and which is wrong, put into practice.”

Additional Resources and Books Mentioned

LinkedIn Blog post: The First Law of Marketing: All Value is Subjective, which also explains the tale of two automobiles, and the problems with cost-plus pricing, which Ron and Ed discussed.

LinkedIn Blog post: Car Guys vs. Bean Counters. This is Ron’s book review of the book by Bob Lutz, a diagnostic book on the demise of General Motors: Car Guys vs. Bean Counters: The Battle for the Soul of American Business. Since we discussed the problems General Motors is currently having, this book provides more detail on why they are having these issues.