The paradox of value (also known as the diamond–water paradox) is the 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, although it had already appeared as early as Plato's Euthydemus.[1]Nicolaus Copernicus,[2]John Locke, John Law[3] and others had previously tried to explain the disparity.
The subjective theory of value is an economic theory which proposes the idea that the value of any good is not determined by the utility value of the object, nor by the cumulative value of components or labour needed to produce or manufacture it, but instead is determined by the individuals or entities who are buying or selling the object in question.[1] This trend is often seen in collectable items such as cars, vinyl records, and comic books. The value of an object may have increased substantially since its creation or original purchase due to age, a personal affinity, or scarcity.
The modern version of this theory was created independently and nearly simultaneously by William Stanley Jevons, Léon Walras, and Carl Menger in the late 19th century.[2]
ECONOMY ECONOMICS
The Diamond-Water Paradox, Explained
By SEAN ROSS Updated August 23, 2021
Reviewed by ROBERT C. KELLY
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."
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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.
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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.
