Why are diamonds more valuable than water, when water is vital to surviving, and diamonds are little more than glorified rocks? This question surmises what is now understood as the Paradox of Value, or the Diamond-Water Paradox.
This so-called “paradox” was predominantly presented by the Father of Economics, Adam Smith. Smith couldn’t understand why something that had relatively little practical value, was worth so much. In Smith’s An Inquiry into the Nature and Causes of the Wealth of Nations, he mentions the dilemma: “The real price of every thing, what every thing really cost to the man who wants to acquire it, is the toil and trouble of acquiring.”
This passage shows that Smith saw the dilemma from the laborer’s eyes and disregarded a key factor of price and utility from the consumer’s eyes. If he were to look from the consumer’s eyes, he would’ve seen that what’s valued more to the consumer isn’t so much the amount it takes to create or acquire it, but its exchange value.
When something has practical value, it tends to be widely used, thanks to its abundance and ease of acquisition. The abundance of the resource will inevitably result in multiple applications of the resource. Although multiple applications make increase its practical value, it won’t increase its exchange value, because it’s still an abundant resource.
A fascinating aspect of this is if you look at it from a universal perspective. Water is vital for all forms of life. The reason it’s vital to all life is that life was shaped around the fact that there was an abundance of water. This is the same process that creates many products today based on resources.
This idea ties into a core segment of the economic theory of marginalism. What marginalism attempts to do is explain the value of goods based on the various marginal utilities. One resource can have many utilities and have less overall value, but as certain utilities are taken away, the value decreases based on the value of the core utility. A great example of this is shown through a farmer and his whiskey.
A pioneer farmer had five sacks of grain, with no way of selling them or buying more. He had five possible uses: as basic feed for himself, food to build strength, food for his chickens for dietary variation, an ingredient for making whisky and feed for his parrots to amuse him. Then the farmer lost one sack of grain. Instead of reducing every activity by a fifth, the farmer simply starved the parrots as they were of less utility than the other four uses; in other words they were on the margin. And it is on the margin, and not with a view to the big picture, that we make economic decisions.
To tie marginalism back into the Paradox of Value. We have many uses for water, but as water becomes less abundant, its available utilities decrease and its value increases. Once It gets to the point where your life depends on acquiring some water, diamonds will become less valuable.