Which do you think is more valuable: water, which is needed to sustain life, or diamonds, which we use to adorn ourselves? Let’s think about it this way: If a one-liter bottle of mineral water and a ring with a diamond weighing only one gram were placed on the table and you could take only one, which would you take? Did you know that this problem has been a puzzle for a very long time? Adam Smith, the father of modern economics, struggled to produce a fully acceptable theory of value, and he was particularly concerned with the apparent paradox of the high value placed on unnecessary goods like diamonds, compared to the low value of essential goods like water. Smith did indeed argue that there was a separation between “value in use” (the usefulness of a good for satisfying human needs or desires) and “value in exchange” (the price that a good can command in the market). He recognized that this distinction could create difficulties in understanding the nature of value and how it was determined in a market economy. Smith’s diamond-water paradox went unsolved until later economists combined the two theories of subjective valuation and marginal utility. Let’s see how economists arrived at that explanation.
Applying the Labor Theory of Value
Like nearly all economists of his era, 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 be sold at a higher price. In other words, costs drive prices.
Unfortunately, the labor theory suffers from many problems. The most pressing is that it cannot explain the prices of items requiring 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 bring in a lower market price than an identical diamond laboriously 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 prices; it is exactly the opposite. Prices drive costs. This can be seen with a bottle of expensive French wine. We put a high value on wine not to acknowledge the worth of the land it comes from or the use of expensive machines to make it but to reflect that people enjoy drinking good wine. People subjectively value the wine highly, which in turn makes the land it comes from valuable and makes it profitable to construct machines to chill the wine. Subjective prices drive costs.
Diamond-Water Paradox: Marginal Utility vs. Total Utility
Subjective value can show that 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, the marginal utility of a good is derived from its most important use to a person. So, if someone possesses a good, they will use it to satisfy some need or want, starting with the one that takes highest priority.
Eugen von Böhm-Bawerk illustrated this with the example of a farmer having five sacks of grain. With the first, he will make bread to survive. With the second, he will make more bread, in order to be strong enough to work. With the next, he will feed his farm animals. The next is used to make whiskey, and the last one he feeds to the pigeons. If one of those bags is stolen, he will not reduce each of those activities by one-fifth; instead, he will stop feeding the pigeons. So, the value of the fifth bag of grain is equal to the satisfaction he gets from feeding the pigeons. If he sells that bag and neglects the pigeons, his least productive use of the remaining grain is to make whiskey, so the value of a fourth bag of grain is the value of his whiskey. Only if he loses four bags of grain will he start eating less; that is the most productive use of his grain. The last bag of grain is worth his life.
In explaining the diamond-water paradox, marginalists explain that it is not the total usefulness of diamonds or water that determines price, but the usefulness of each unit of water or diamonds. It is true that the total utility of water to people is tremendous, because they need it to survive. However, since water is in such large supply in the world, the marginal utility of water is low. Each additional unit of water that becomes available can be applied to less urgent uses as more urgent uses for water are satisfied. For example, it may be used not to drink but to wash the streets. Therefore, any particular unit of water is worth less to people as the supply of water increases.
On the other hand, diamonds are of such low supply that the usefulness of one additional diamond is greater than the usefulness of one additional glass of water. Thus, diamonds are worth more to people. Therefore, those who want diamonds are willing to pay a higher price for one diamond than for one glass of water, and sellers of diamonds ask high prices.
Conversely, a man dying of thirst in a desert would have greater marginal use for water than for diamonds, so he would pay far more for water.