Diamondwater Paradox PDF

The Diamond-Water Paradox
One of the most disconcerting problems to Adam Smith, the father of

modern economics, was he could not resolve the issue of valuation in
human preferences. He described this problem in The Wealth of
Nations by comparing the high value of a diamond, which is unessential to
human life, to the low value of water, without which humans would die. He
determined "value in use" was irrationally separated from "value in
exchange."
Smith's diamond-water paradox went unsolved until later economists

combined two theories: subjective valuation and marginal utility. Let's take
a step back and see how economists arrived at that explanation.
Applying Labor Theory of Value

Like nearly all economists of his age, Smith followed the labor theory of
value. Labor theory stated that the price of a good reflected the amount of
labor and resources required to bring it to market. Smith believed
diamonds were more expensive than water because they were more
difficult to bring to market.
On the surface, this seems logical. Consider building a wooden chair. A

lumberjack uses a saw to cut down a tree. The chair pieces are crafted by
a carpenter. There is a cost for labor and tools. For this endeavor to be
profitable, the chair must sell for more than these production costs. In
other words, costs drive prices.
But the labor theory suffers from many problems. The most pressing is
that it cannot explain the prices of items with little or no labor. Suppose
that a perfectly clear diamond, naturally developed with an alluring cut, is
discovered by a man on a hike. Does the diamond fetch a lower market
price than an identical diamond arduously mined, cut, and cleaned by
human hands? Clearly not. A buyer does not care about the process, but
about the final product.
Subjective Value
What economists discovered was that costs do not drive price; it is exactly
the opposite. Prices drive costs. This can be seen with a bottle of
expensive French wine. The reason the wine is valuable is not that it
comes from a valuable piece of land, is picked by high-paid workers, or is
chilled by an expensive machine. It is valuable because people really
enjoy drinking good wine. People subjectively value the wine highly, which
in turn makes the land it comes from valuable and makes it worthwhile to
construct machines to chill the wine. Subjective prices drive costs.
Diamond Water Paradox: Marginal Utility vs. Total

Utility
Subjective value can show diamonds are more expensive than water
because people subjectively value them more highly. However, it still
cannot explain why diamonds should be valued more highly than an
essential good such as water.
Three economists—William Stanley Jevons, Carl Menger, and Leon

Walras—discovered the answer almost simultaneously. They explained
that economic decisions are made based on marginal benefit rather than
on total benefit.
In other words, consumers are not choosing between all of the diamonds
in the world versus all of the water in the world. Clearly, water is more
valuable as an essential resource as opposed to the luxury of owning a
diamond. As demand increases as well, consumers must choose between
one additional diamond versus one additional unit of water. This principle
is known as marginal utility.
Another way to look at this paradox is to apply the simple principles

of supply and demand. The universal availability of water at little or no
marginal cost (although many would argue that this is changing) relative to
demand means that the equilibrium price will be low or negligible for water.
Diamonds, on the other hand, are high in demand and are expensive to
produce (and current producers have cartelized the industry) so that the
supply is limited and the intersection of the supply and demand curves
occurs at a high price. Hence water is “cheap” and diamonds are “dear.”
A modern example of this dilemma is the pay gap between professional

athletes and teachers. As a whole, all teachers are probably valued more
highly than all athletes. Yet the marginal value of one extra NFL
quarterback is much higher than the marginal value of one additional
teacher.

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The Diamond-Water Paradox

One of the most disconcerting problems to Adam Smith, the father of

Smith's diamond-water paradox went unsolved until later economists

Applying Labor Theory of Value

On the surface, this seems logical. Consider building a wooden chair. A

Diamond Water Paradox: Marginal Utility vs. Total

Three economists—William Stanley Jevons, Carl Menger, and Leon

Another way to look at this paradox is to apply the simple principles

A modern example of this dilemma is the pay gap between professional

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