A:

One of the most disconcerting problems to Adam Smith, the father of modern economics, was that 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." Smith's "diamond/water paradox" went unsolved until later economists combined two theories: subjective valuation and marginal utility.

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.

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 price.

The labor theory suffers from many problems. The most pressing is that it cannot explain prices of items with little or no labor. Suppose a perfectly clear diamond naturally developed in a perfect shape. It is then discovered by a man on a hike. Does it fetch a lower market price than an identical diamond arduously mined, cut and cleaned by human hands? Clearly not. A buyer does not care.

Subjective Value

What economists discovered was that costs do not drive price; it is exactly the opposite. Prices drive cost. This can be seen with a bottle of expensive French wine. The reason the wine is valuable is not because 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.

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.

Three economists, William Stanley Jevons, Carl Menger and Leon Walras, discovered the answer almost simultaneously. They explained that economic decisions are made based on marginal benefit rather than total benefit.

In other words, consumers are not choosing between all of the diamonds in the world versus all of the water in the world. Clearly, water is more valuable. They are choosing between one additional diamond versus one additional unit of water. This principle is known as marginal utility.

A modern example of this dilemma is the pay gap between professional athletes and teachers. As a whole, all teachers are probably valued more highly than all athletes. Yet the marginal value of one extra NFL quarterback is much higher than the marginal value of one additional teacher.

RELATED FAQS
  1. What is "marginalism" in microeconomics and why is it important?

    Find out what economists mean by marginal utility or cost and why marginalism is such an important concept in microeconomic ... Read Answer >>
  2. What is the difference between marginal utility and marginal value?

    Find out what marginal utility and marginal value mean in economics and why these terms sometimes overlap to describe the ... Read Answer >>
  3. How do I identify a Diamond Top Formation?

    Learn how to identify a diamond top technical chart pattern, a rare formation that analysts look to as a possible sign of ... Read Answer >>
  4. What are common trading strategies when identifying a Diamond Top Formation Pattern?

    Learn how traders identify diamond top formations and what the pattern signifies. Then, develop a profitable trading strategy ... Read Answer >>
  5. Why is a Diamond Top Formation important for traders and analysts?

    Read about the rare diamond top formation, and learn how traders and technical analysts interpret this pattern when it shows ... Read Answer >>
  6. What does it mean to be "above water"?

    The term "above water" is used to describe any situation in which the ending or current value of a subject is higher than ... Read Answer >>
Related Articles
  1. Investing

    Top 3 ETFs With Exposure to Diamonds (PICK, SLX)

    Learn the benefits of investing in diamonds. Discover three ETFs that have exposure to companies that are major players in the world’s diamond industry.
  2. Personal Finance

    Credit Card Review: Citi Diamond Preferred

    Read about Citi's Diamond Preferred credit card, a low APR offering with excellent balance transfer benefits and a long-term low introductory rate.
  3. Investing

    Taking Measure: Gold, Diamonds and... Karats?

    We look at the difference between karats and carats, as well as investment opportunities in gold and diamonds.
  4. Investing

    Water: The Ultimate Commodity

    Opportunities to invest in this scarce resource are flowing freely - dive in!
  5. Investing

    Four Interesting Ways to Invest in Water (PHO, CGW)

    The U.S. and many other countries are widely expected to invest in water infrastructure and equipment on an unprecedented scale over the next several years – ostensibly to make up for decades ...
  6. Personal Finance

    4 Reasons Why You Should Consider Costco's Diamond Rings

    Costco's low prices on diamond rings is one thing, but finding the ring that you want is another story.
  7. Insights

    Adam Smith and "The Wealth Of Nations"

    Adam Smith's 1776 classic "Wealth of Nations" may have had the largest global impact on economic thought.
  8. Investing

    Millenials and Weather are Ruining Ca. Wine Sales

    After 20 years of growth in U.S. wine consumption, the California wine industry is set for a reversal. Here's a breakdown of why California wine sales will decline beginning in 2016.
  9. Insights

    Adam Smith: The Father of Economics

    Adam Smith is renowned as "The Father of Economics" for his work in pioneering ideas such as free trade and GDP.
  10. Investing

    Top 3 ETFs for Investing in Water in 2017

    It may be time to look at a scarce commodity that isn't getting the investor attention it deserves.
RELATED TERMS
  1. Marginal Utility

    The additional satisfaction a consumer gains from consuming one ...
  2. Diamonds

    1. An extremely hard gemstone used mainly for jewelry, tools ...
  3. Labor Theory Of Value

    An economic theory that stipulates that the value of a good or ...
  4. Above Water

    1. Refers to the condition of a company's asset when its actual ...
  5. Water ETF

    An exchange-traded fund that invests in companies operating in ...
  6. Produced Water

    Waste water generated during the production of oil and natural ...
Hot Definitions
  1. SEC Form 13F

    A filing with the Securities and Exchange Commission (SEC), also known as the Information Required of Institutional Investment ...
  2. Quantitative Easing

    An unconventional monetary policy in which a central bank purchases private sector financial assets in order to lower interest ...
  3. Risk Averse

    A description of an investor who, when faced with two investments with a similar expected return (but different risks), will ...
  4. Indirect Tax

    A tax that increases the price of a good so that consumers are actually paying the tax by paying more for the products. An ...
  5. Zero-Sum Game

    A situation in which one person’s gain is equivalent to another’s loss, so that the net change in wealth or benefit is zero. ...
  6. Beta

    Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. ...
Trading Center