The paradox of value
which is also known as the 'Diamond - Water Paradox' is the apparent 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. Nicolaus Copernicus, John Locke, John Law and others
had previously tried to explain the disparity.
Labor theory of value
In a passage of Adam Smith's An Inquiry into the Nature and
Causes of the Wealth of Nations, he discusses the concepts of value in use and
value in exchange, and notices how they tend to differ:
Furthermore, he explained the value in exchange as being
determined by labor:
Hence, Smith denied a necessary relationship between price
and utility. Price on this view was related to a factor of production and not to the point of view of the consumer.
The best practical example of this is saffron - the most expensive spice - here
much of its value derives from both the low yield from growing it and the disproportionate
amount of labor required to extract it. Proponents of the labor theory of value
saw that as the resolution of the paradox.
The labor theory of value has lost popularity in mainstream
economics and has been replaced by the theory of marginal utility.
Marginalism
The theory of marginal utility, which is based on the
subjective theory of value, says that the price at which an object trades in
the market is determined neither by how much labor was exerted in its
production, as in the labor theory of value, nor on how useful it is on a whole
. Rather, its price is determined by its marginal utility. The marginal utility
of a good is derived from its most important use to a person. So, if someone
possesses a good, he will use it to satisfy some need or want. Which one? Naturally,
the one that takes highest-priority. Eugen von Böhm-Bawerk illustrated this
with the example of a farmer having five sacks of grain.
With the first, he will make bread to survive. With the
second, he will make more bread, in order to be strong enough to work. With the
next, he will feed his farm animals. The next is used to make whisky, and the
last one he feeds to the pigeons. If one of those bags is stolen, he will not
reduce each of those activities by one-fifth; instead he will stop feeding the
pigeons.
So the value of the fifth bag of grain is equal to the
satisfaction he gets from feeding the pigeons. If he sells that bag and
neglects the pigeons, his least productive use of the remaining grain is to
make whisky, so the value of a fourth bag of grain is the value of his whisky.
Only if he loses four bags of grain will he start eating less; that is the most
productive use of his grain. The last bag of grain is worth his life.
In explaining the diamond-water paradox, marginalists
explain that it is not the total usefulness of diamonds or water that matters,
but the usefulness of each unit of water or diamonds. It is true that the total
utility of water to people is tremendous, because they need it to survive.
However, since water is in such large supply in the world, the marginal utility
of water is low. In other words, each additional unit of water that becomes
available can be applied to less urgent uses as more urgent uses for water are
satisfied.
Therefore, any particular unit of water becomes worth less
to people as the supply of water increases. On the other hand, diamonds are in
much lower supply. They are of such low supply that the usefulness of one
diamond is greater than the usefulness of one glass of water, which is in
abundant supply. Thus, diamonds are worth more to people. Therefore, those who
want diamonds are willing to pay a higher price for one diamond than for one
glass of water, and sellers of diamonds ask a price for one diamond that is
higher than for one glass of water.
Efficiency model
The Chinese economist Tan Lidong addresses the question
through relative Economic efficiency. noting water is in such large supply in
the world, but in the desert water-taking efficiency is very low, so the value
of water is also high. If someone can invent high efficiency equipment to get
water in the desert, by then the water would be cheap. He avers that value is
determined by efficiency, as well as efficiency affected by tools, labor and
resources.
He suggests we can calculate the exact value of the water or
the diamond by using efficiency. He takes a historical approach to value, that
exchange ratios have been known for many products for a very long time, and
established by custom and practice. Technological change changes the efficiency
of production, thus changing the relative values.
Criticisms
George Stigler has argued that Smith's statement of the
paradox is flawed, since it consisted of a comparison between heterogeneous
goods, and such comparison would have required using the concept of marginal
utility of income. And since this concept was not known in Smith's time, then
the value in use and value in exchange judgement may be meaningless:
The paradox; that value in exchange may exceed or fall short
of value in use was, strictly speaking, a meaningless statement, for Smith had
no basis on which he could compare such
heterogeneous quantities. On any reasonable interpretation, moreover, Smith's
statement that value in use could be less than value in exchange was clearly a
moral judgment, not shared by the possessors of diamonds. To avoid not being able to compare money and utility, one may interpret Smith to mean that the
ratio of values of two commodities is not equal to the ratio of their total
utilities. Or, alternatively, that the ratio of the prices of two commodities
is not equal to the ratio of their total utilities; but this also requires an
illegitimate selection of units: The price of what quantity of diamonds is to
be compared with the price of one gallon of water?
