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. 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 >>
  6. How do economists and psychologists calculate diminishing marginal utility differently?

    Find out why disagreements about the validity of the law of diminishing marginal utility usually boil down to arguments about ... Read Answer >>
Related Articles
  1. Investing

    Diamonds: The Missing Commodity Derivative

    While they may be "a girl's best friend", diamonds haven't made it to the futures market - yet.
  2. 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.
  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. Insights

    Wine Country: America's Love For Wine

    As the largest market for wine, Americans spent nearly $60 billion on vino in 2016.
  5. 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.
  6. 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.
  7. 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.
  8. Investing

    Black Diamond: The New North Face?

    Black Diamond went public in a reverse merger with Gregory Mountain Products. I'll look at why now is a good time to buy.
  9. Investing

    Water-Related Investments Are Making A Splash

    There’s no doubt about it. The world is facing a water crisis. However, for forward thinking investors, that could mean a huge opportunity.
  10. Investing

    Risks to Consider When Investing in Water

    Investing in water should be a lock. But water is volatile and could see as many risks as potential rewards.
RELATED TERMS
  1. Four Cs

    The four characteristics used to determine the value of a diamond. ...
  2. Diamonds

    1. An extremely hard gemstone used mainly for jewelry, tools ...
  3. Porter Diamond

    A model that attempts to explain the competitive advantage some ...
  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. Subjective Theory Of Value

    The idea that an object's value is not inherent, and is instead ...
Hot Definitions
  1. Call Option

    An agreement that gives an investor the right (but not the obligation) to buy a stock, bond, commodity, or other instrument ...
  2. Pro-Rata

    Used to describe a proportionate allocation. A method of assigning an amount to a fraction, according to its share of the ...
  3. Private Placement

    The sale of securities to a relatively small number of select investors as a way of raising capital.
  4. AAA

    The highest possible rating assigned to the bonds of an issuer by credit rating agencies. An issuer that is rated AAA has ...
  5. Backward Integration

    A form of vertical integration that involves the purchase of suppliers. Companies will pursue backward integration when it ...
  6. Pari-passu

    A Latin phrase meaning "equal footing" that describes situations where two or more assets, securities, creditors or obligations ...
Trading Center