Paradox of value (diamond-water paradox)

The paradox of value is an economic paradox that concerns the apparent contradiction in the perceived valued of water to that of diamonds. Specifically, the paradox lies in the fact that water, which is of much greater importance as a means of survival, commands a lower price in the free market than diamonds, which are less useful. Because it is so often described in these terms, the paradox of value is also commonly referred to as the diamond-water paradox. Although the historic origins of the paradox can be traced back to the renowned Greek philosopher Plato, eighteenth-century economist Adam Smith is typically credited with its popularization. Plato, Smith, and others wrestled unsuccessfully with the paradox of value for centuries before modern economists finally concluded that it could be explained through the concepts of subjective valuation and marginal utility.

Background

No one person is more closely associated with the paradox of value than Scottish philosopher and economist Adam Smith. Widely regarded as the father of modern economics, Smith was one of the most influential figures in the history of economic theory. Among other things, he promoted the idea of laissez-faire economics and created the notion of gross domestic product (GDP).

At the time Smith first rose to prominence in the eighteenth century, a nation’s wealth was typically determined by how much gold and silver it possessed. In order to preserve this material wealth, most nations avoided importing goods from other countries because doing so required them to pay for the imports with their prized precious metals. On the other hand, exporting goods was seen as a worthwhile endeavor because it was means through which more precious metals could be acquired. With all of this in mind, many nations developed and used various methods of minimizing the loss of metal wealth. Some of these methods included taxing imports, providing subsidies for exporters, and ensuring the protection of domestic businesses. This economic approach became known as mercantilism. Smith was among the first economists to decry mercantilism. He instead supported an economic system of free exchange in which different parties openly engaged in trade. He believed that everyone stood to benefit from trading with one another and that imports were just as important to a vibrant national economy as exports. Smith also believed that nation’s wealth was determined by the sum total of its production and commerce, not just its supply of precious metals. Ideas like these rocked the foundations of traditional economic thought and marked the beginning of classical economics.

Smith outlined his economic philosophies in The Wealth of Nations, a landmark work that played a significant role in laying the groundwork for classical economics. In addition to arguing in favor of free markets, Smith also discussed key economic topics like productivity and the division of labor. One of the more unique topics he covered was the issue of valuation in human preferences—a matter he explored through the paradox of value.

Overview

The issue of valuation in human preference was one of the biggest unanswered questions among economists of Smith’s era. At the time, most economists adhered to the labor theory of value. This theory stated that the price of a good was a direct reflection of the amount of labor and resources need to bring that good to market. Smith famously used the labor theory of value to explain why the price of diamonds was higher than that of water, pointing out that diamonds were more expensive because it was more costly to bring them to market. Put simply, price is driven by costs. While this argument is fundamentally logical, it had some serious flaws. The biggest of these flaws was the fact that it could offer no explanation for the price of goods that required little or no labor to produce. As a result, the labor theory of value did not offer a definitive resolution to the issue of valuation in human preference.

Over time, economists gradually came to the conclusion that they were wrong about the relationship between costs and prices. Whereas the traditional view was that price was driven by cost, it eventually became clear that cost was actually driven by price. The reason for this is a concept called subjective value. For example, Wagyu beef from Japan is one of the world’s most expensive types of beef. This is not because it comes from valuable cattle or because the land where the cattle graze is inherently valuable, but simply because people like to eat food that tastes really good. In other words, consumers subjectively value Wagyu beef, which in turn makes the cattle it comes from and the land they graze on more valuable. This example demonstrates how costs are driven by subjective prices.

Going back to the classic diamonds and water problem, subjective value explains that diamonds are more expensive than water because consumers subjectively value diamonds more highly. It does not logically explain why consumers should value diamonds more than something as necessary for survival as water. Economists William Stanley Jevons, Carl Menger, and Leon Walras all figured out the answer to that problem. Through their own studies, each determined that consumers make economic decisions based on marginal benefit rather than total benefit. This phenomenon is based on what is known as the Marginal Theory of Value, which solves the paradox of value by stating that while water has greater total utility than diamonds, diamonds have greater marginal utility than water. In other words, water is more valuable if a consumer has to choose between water or diamonds, but diamonds are more valuable than water on the margin. Ultimately, an individual assigns value based on which good of a specified—or marginal—quantity will satisfy that individual’s most desired end. Another key factor in the paradox of value is the Law of Diminishing Marginal Utility, which states that the initial unit of consumption of a particular good or service offers greater utility than subsequent units. While this is certainly true of water, diamonds arguably do not suffer from diminishing utility as much, if at all. In other words, the fourth diamond in a set is just as valuable as the first. All of this explains the paradox of value and why diamonds are often considered to be more valuable than water.

Bibliography

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“The Diamond-Water Paradox.” NPR, 25 July 2018, www.npr.org/transcripts/632483606. Accessed 24 Nov. 2020.

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Vinay, Muddu. “Paradox of Value: Diamond vs. Water.” Education Post, 19 Aug. 2020, theeducationpost.in/paradox-of-value-diamond-vs-water. Accessed 24 Nov. 2020.