Question

Critical Thinking 1: The diamond-water paradox In “An Inquiry into the Nature and Causes of the Wealth of Nations” published in 1776, Adam Smith wrote: “Nothing is more useful than water: but it will purchase scarcely anything… A diamond, on the contrary, has scarcely any use-value; but a very great quantity of other goods may frequently be had in exchange for it”

Explain the diamond-water paradox and find out in the literature how economists have later solved this paradox.

Answer 1

Adam smith pondered over the question that diamond, so unessential for life, is so costly and water, so essential for life, is so cheap. But he could not solve this. In fact he and his contemporary economists believed on labor theory of value which states that the value of a good depends on the cost of labor emloyed in producing that good. However, this labor theory of value was not successful in resolving the paradox.

Later, Jevons, Menger, and Walras, seperately but simultaneously, resolved this paradox. According to them, it is the marginal utility and not the total utility that determines the price i.e. willingness to pay. Of course, total water present on the earth is absolutely more valuable than total diamond but marginal unit of diamond is more than that of water. Hence water is cheap and diamond is costly.

One other aspect is demand and supply. Water is so abundantly available that in some cases, it does not become an economic good. On the contrary, diamond is so scarcely available that for a given demand it is highly priced.