One of the most disconcerting problems to Adam Smith, the father of modern economics, was 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. Let's take a step back and see how economists arrived at that explanation.
Applying 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 prices.
But the labor theory suffers from many problems. The most pressing is that it cannot explain the prices of items with little or no labor. Suppose that a perfectly clear diamond, naturally developed with an alluring cut, is discovered by a man on a hike. Does the diamond fetch a lower market price than an identical diamond arduously mined, cut, and cleaned by human hands? Clearly not. A buyer does not care about the process, but about the final product.
What economists discovered was that costs do not drive price; it is exactly the opposite. Prices drive costs. This can be seen with a bottle of expensive French wine. The reason the wine is valuable is not that 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.
Diamond Water Paradox: 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 on 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 as an essential resource as opposed to the luxury of owning a diamond. As demand increases as well, consumers must choose between one additional diamond versus one additional unit of water. This principle is known as marginal utility.
Another way to look at this paradox is to apply the simple principles of supply and demand. The universal availability of water at little or no marginal cost (although many would argue that this is changing) relative to demand means that the equilibrium price will be low or negligible for water. Diamonds, on the other hand, are high in demand and are expensive to produce (and current producers have cartelized the industry) so that the supply is limited and the intersection of the supply and demand curves occurs at a high price. Hence water is “cheap” and diamonds are “dear.”
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.