The Diamond-Water Paradox

Why are diamonds valued more than water? Water, not diamonds, is necessary for life. So shouldn't it be more valuable? Classical economists puzzled over this question and named it the value paradox.

Scarcity of goods is what causes humans to attribute value. If we were surrounded by an unending abundance of both water and diamonds, we probably wouldn't value either very much.

In order to qualify as an economic good a thing must meet three criteria:

1. There must be a human need or want.
2. There must be an opinion that the thing in question will satisfy that need.
3. There must be command or control over the ability to satisfy this need or want.

The final point is significant. I may like a sunshine and know that a sunny day would improve my mood. However, I have no control over the weather. Thus, weather is not classified as an economic good.

How do we value an economic good? We value an economic good if there is an insufficient quantity to satisfy all human wants for that thing. Under normal instances we do not value air for instance.

Scarcity implies that we will rank our wants and this process results in economic activity. Consumers will use whatever resources they have at their disposal to satisfy their most important wants. Our value system is determined by our ranking of wants.

Take the following example. Assume you are a farmer with three horses and two cattle. Each of the horses is interchangeable with one another, as are the two cattle. You rank the importance of the animals as follows;

1. Horse: For tilling the fields.
2. Horse: For pulling the wagon to town.
3. Cow: For milk.
4. Cow: For cheese and butter.
5. Horse: For recreational riding.

What is the more valuable animal? The answer is the cow.

This answer may come as a surprise. It is the trap that the classical economists fell into when puzzling over why diamonds are valued more than water.

The important concept is that of marginal utility. We put a value on economic goods according to their marginal utility. In the above example, the marginal utility of the cow is greater than that of the horse.

The horse is valued lower than the cow, provided that the farmer has three of them. If the farmer was to lose one horse than the horse would clearly become more valuable than the cow.

In the same way, the marginal utility of diamonds is greater than that of water.

Published on Dollardaze.org - May 21, 2006.

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