Classical economists struggled with the \"Water-Diamond Paradox\" which seeks an
ID: 1229782 • Letter: C
Question
Classical economists struggled with the "Water-Diamond Paradox" which seeks an explanation for why water (which is very useful) has a low price, whereas diamonds (which are not particularly important to life) have a high price. How would Smith explain the relative prices of water and diamonds? Would Ricardo's concept of diminishing returns pose some problem for this explanation? Can you resolve matters by using Marshall's model of supply and demand? If water is "very useful" to the demanders in Marshall's model, how would you know?Explanation / Answer
The paradox of value (also known as the diamond–water paradox) is the apparent contradiction that, although water is on the whole more useful, in terms of survival, than diamonds, diamonds command a higher price in the market. The philosopher Adam Smith is often considered to be the classic presenter of this paradox. Nicolaus Copernicus[1], John Locke, John Law[2] and others had previously tried to explain the disparity. In a passage of Adam Smith's An Inquiry into the Nature and Causes of the Wealth of Nations, he discusses the concepts of value in use and value in exchange, and notices how they tend to differ: What are the rules which men naturally observe in exchanging them [goods] for money or for one another, I shall now proceed to examine. These rules determine what may be called the relative or exchangeable value of goods. The word VALUE, it is to be observed, has two different meanings, and sometimes expresses the utility of some particular object, and sometimes the power of purchasing other goods which the possession of that object conveys. The one may be called "value in use;" the other, "value in exchange." The things which have the greatest value in use have frequently little or no value in exchange; on the contrary, those which have the greatest value in exchange have frequently little or no value in use. Nothing is more useful than water: but it will purchase scarce anything; scarce anything can be had in exchange for it. A diamond, on the contrary, has scarce any use-value; but a very great quantity of other goods may frequently be had in exchange for it.[3] Furthermore, he explained the value in exchange as being determined by labor: The real price of every thing, what every thing really costs to the man who wants to acquire it, is the toil and trouble of acquiring it.[4] Hence, Smith denied a necessary relationship between price and utility. Price on this view was related to a factor of production (namely, labor) and not to the point of view of the consumer.[5] Proponents of the labor theory of value saw that as the resolution of the paradox. The labor theory of value has lost popularity in mainstream economics and has been replaced by the theory of marginal utility.