The water-diamond paradox
The water-diamond paradox, also known as the paradox of value, was introduced by Adam Smith in his seminal work The Wealth of Nations (1776). It highlights the apparent contradiction between the value of a good in use versus its value in exchange.
The Paradox Explained:
- Water is essential for life, has immense utility, and is crucial for survival. However, it typically has a low price in exchange (or market value) because it is abundant and easily accessible in most places.
- Diamonds, on the other hand, have very little practical utility compared to water but command a very high price in exchange because they are scarce and highly desirable.
This contradiction puzzled economists of Smith’s time and raised questions about how value is determined.
Smith’s Explanation:
Adam Smith suggested that value comes from two sources:
- Value in use: The utility a good provides (water is incredibly useful).
- Value in exchange: The market price or what a good can be traded for (diamonds are highly priced).
Smith noted that market value (exchange value) is not solely determined by a good’s utility. Instead, scarcity and the effort or cost involved in obtaining the good play a significant role.
Modern Economic Resolution:
The water-diamond paradox was later resolved through the concept of marginal utility, developed by 19th-century economists such as Carl Menger, William Stanley Jevons, and Léon Walras. According to marginal utility theory:
- The value of a good is determined by its marginal utility—the additional satisfaction or benefit derived from consuming one more unit of the good.
- While water is essential, its abundance means the marginal utility of an additional unit of water is low. Diamonds, being rare, have a high marginal utility for the consumer.
This distinction clarified why goods like water can have low exchange value despite high utility, while goods like diamonds can have high exchange value despite low practical utility.