Question

In: Economics

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

 

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.  

Solutions

Expert Solution

So the diamond-water paradox is a classic example of how economists for years and years have struggled with the question of "value"; what defines a good's value, is it the utility it serves, is it the amount of labour imputed in its production, is it the quantity of other commodities that can ne exchanged for it, or is it the relative scarcity or abundance in its availability, or a combination of these reasons, or even something else.

At the paradox's core, lies a simple question - Why does something as useful as water have a lower price (which is how value of goods is expressed in a society or marketplace) than something so less useful like diamond? It is this paradox that generations of economists have tried to resolve.

We often think about the diamond-water paradox or the paradox of value, as arising out of Smithian literature, precisely the Wealth of Nations. But interestingly enough, there are mentions of the problem in Plato's Euthydemus, as well as writings of Nicolaus Copernicus, John Locke, and John Law.

According to Adam Smith, there exists a dichotomy; goods posses a value-in-use (which is their value in terms of how useful they are), and a value-in-exchange (which is their value in terms of how many goods can they be exchanged for). Water clearly has a higher value-in-use and diamonds have a greater value-in-exchange. Further Smith was an ardent advocate of the labour theory of value. He said that a good's value is determined by how much labour goes into it i.e. what is the level of human toil in producing it. Since water is abundantly available and diamonds scarely, and the extraction of diamonds taking excessive labour, this explains why diamonds are more valuable than water.

Later, the neo-classical marginalists also attempted to reconcile this disparity. They said that price of a good is not decided by its total utility, but in fact its marginal utility. Marginal utility is the addition to utility when one additional unit of the good is consumed. Looking at the two goods in concern, the marginal utility of diamonds in comparison to water, is huge. One more diamond ring / necklace will surely be greatly more valuable than one more glass or even gallon of water. This is why the dichotomy arises.


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