Paradox of value: In economics, a paradox is a scenario in which the variables reject the theory’s fundamental principles and assumptions and act in a different manner. The following are some of the Paradoxes in economics.
- Leontief’s Paradox
- Paradox of Thrift
- Giffen’s Paradox
What is paradox of value
The paradox of value is known as the water and diamond paradox. Although water is more beneficial in terms of survival than diamonds, diamonds have a greater monetary price.
According to the paradox of value, which was introduced by great economist Adam Smith, humans do not value what they are using the most, such as water, but prefer to pay a high price for items that have no actual value, such as diamonds. As a result, the value paradox is also known as the diamond–water paradox.
Smith and the classical economists were unable to solve the paradox after identifying it as a puzzle.
There was an unfilled space in value theory until William Stanley Jevons solved the puzzle in his “Theory of Political Economy” by using marginal utility analysis (1871).
Identify economic terms by paradox of value
Understanding the economic concepts of marginal utility and scarcity can help to clarify why the paradox occurs.
In many regions of the globe, water is not scarce, which indicates that we, as consumers, have a marginal utility for it. We would not be prepared to spend a lot for one more drink under normal conditions.
However, diamonds are in low supply. Because diamonds are so difficult to come by and obtain, their high utility is much more than when someone offers us another drink.
Example: Understanding the Economic Concepts
Imagine being in the desert. Every five minutes you’re provided with a new diamond or a fresh bottle of water. If you’re like most people, you’ll select as much water as you can carry first. After that, carry as many diamonds as you can. This is due to a concept known as marginal utility.
It shows that while deciding between diamonds and water, you compare the utility gained from each extra bottle of water against the utility gained from each more diamond. And you do that every time someone makes an offer. The first bottle of water is more valuable to you than any quantity of diamonds. But, you will soon have enough water. After a while, each new bottle becomes a burden.
Then you start to prefer diamonds over the water. It isn’t only about basic needs like water. In the case of many things, the more you get from them, the less useful or fun each extra bit becomes. This is the law of diminishing marginal utility.
- Scarcity can simply describe as the degree to which a good, talent, or service is easily available.
- Marginal utility is the additional satisfaction received from consuming or purchasing an additional unit of a particular good or service. People are willing to pay a greater price for items with a higher marginal utility.
Adam Smith and Paradox of Value
Adam Smith, the father of economics, was unable to examine the question of testing human preferences. In his book, Wealth of Nations, he compared the high value of a diamond, which is not essential to human life, to the low value of the water in which people die.
He determined that “value in use” was separated from “exchange value”. Smith’s diamond-water paradox remained unresolved until later economists identified it.
Adam Smith recognizes the value in use and value in exchange.
- Value in use: Goods are consumed because they have use or utility.
- Value in exchange: All useful goods cannot be exchanged for other goods. (Water is very useful, without which life cannot survive, but in general, water cannot be exchanged for other goods)
Diamond Water Paradox: Marginal Utility vs. Total Utility
Three economists – William Stanley Jevons, Carl Menger, and Leon Walras found the answer to why diamonds should be valued higher than essential commodities such as water. They explained that economic decisions are made based on marginal benefits rather than total benefits.
Consumers do not have to choose between all the diamonds in the world and all the water in the world. Water is more valuable as an essential resource than the luxury of owning a diamond. As demand increases, consumers have to choose between one extra diamond and one extra water unit. This is known as the marginal utility.
By distinguishing between total utility and marginal utility, we get an understanding and clarification of the diamond-water paradox.
This is the total satisfaction of the needs and wants obtaining by consuming a product. In other words, total utility is the total quantity or total worth of satisfaction generated by several units of a product.
This is the extra satisfaction of wants and needs gained by consuming one more unit of products. In other words, marginal utility is the additional satisfaction provided by a single unit of a product and its value.
Explanation: Paradox of value
Water gives a huge amount of total utility to humans. Water satisfies the wants and needs of the majority of people and because it is abundant, it provides a high level of total utility.
However, due to the abundance of water, the marginal utility of water is relatively low. An extra glass of water gives very little extra satisfaction.
Diamonds, on the other hand, have a rather low total utility. Many individuals spend their entire life unable to find satisfaction in diamonds. Diamonds have an extremely low total utility since they are not as common as water.
The paradox of value is based on the law of diminishing marginal utility. The marginal utility determines the value in use of an item and the value of the exchange.
There is more value in using water. On the other hand, diamonds have more value in exchange. There is no greater value in the exchange of water and no greater value in the use of diamonds.
This difference between the value of use and the exchange value is due to the difference in marginal utility and price of the two goods.
The key to the marginal utility difference between water and diamond is the law of diminishing marginal utility. Since water is abundant, the marginal utility is slightly lower. However, because diamonds are not much more abundant, the marginal utility is significantly greater.
The law of marginal utility reduction does not apply to diamonds to the same degree. Price is determined by marginal utility rather than total utility. Because the marginal utility is low, the price of water is low cost. Diamonds are higher priced so that the marginal utility is high.
Graphical Presentation of Diamond Water Paradox
TU of water > TU of Diamond
TU – high
Solution to Paradox of Value
The value paradox can be resolved by differentiating between marginal utility and total utility. If water is as scarce as diamonds, the marginal utility and the price will be significantly greater. If diamonds are as plentiful as water, the marginal utility and price will be slightly lower as well.
Furthermore, if the quantity of water and diamonds were equally limited, the price of water will be several times greater than the price of diamonds. If the supply of water and diamonds were equally plentiful, the price of diamonds would most likely be a bit cheaper than water.