286967998 Diamond Water Paradox PDF

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Principles of Economics

Shubham Gupta

IIT2013180

Diamond-Water Paradox The Diamond-Water Paradox, also known as the Paradox of Value, is a famous contradiction that has been argued for long by Economists. Coined by Adam Smith, the paradox points out a rather strange but usual anomaly that water, despite being life-essential, has a very low market value; whereas diamond, having little usefulness in our daily lives, is very costly.

Concepts of Utility To explain this paradox, Economists have taken the aid of concepts of Marginal Utility and Total Utility. It is suggested that neither the supply, nor the demand ‘alone’ determine the market value of a commodity. Not even the Labour Theory of Value, viz., ‘Commodities requiring high labour input for production cost more’, is capable of describing this price disparity. Instead, it is said that Marginal Utility is the chief deciding factor of a product’s price. So it was reasoned that Diamond, having a high Marginal Utility costs much more than water, that only has a high Total Utility. This can be seen from the following curve:

Explanation Eugen von Bohm-Bawerk tried to clarify this with the example of a peasant with five sacks of grain. Suppose a farmer has 5 sacks of grains, each one of which is used in the following manner: 1. First sack satisfies the basic nutritional requirement of the farmer 2. Second sack is also consumed by the farmer, but only out of surplus in order to gain additional nourishment to strengthen himself physically, so that he can do more laborious tasks

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Principles of Economics

Shubham Gupta

IIT2013180

3. The third sack is fed to cattle as fodder 4. The fourth sack is used for making whiskey 5. The farmer feeds pigeons with the last sack of grains Now if he loses possession of one sack, he would not distribute the ‘shortage’ of grains among all the above use-cases. Rather, he would simply discontinue feeding the pigeons, which is done only out of fondness and internal urge and not some essential need. Similarly, losing another sack would check his whiskey consumption. His diet wouldn’t be affected unless 4 bags are lost; where the last bag is critical for his survival.

Conclusion So while the Total Utility of grains, and similarly of Water is very high, since it is life-supporting commodity, its Marginal Utility is quite low. This is a direct consequence of the abundance of grains as well as Water. Contrary to this, the Total Utility of Diamonds is negligible but their Marginal Utility is very high. This is supported by the fact that Diamonds are a rarity and a lot of effort goes into extraction and polishing of a handful of them. Another perspective to view this is that relative price is not governed by the total usefulness of water or diamond but by the usefulness of each additional unit of these two. In this context, one can easily see that each additional litre of water adds lesser value to the life of people because it is already available in surplus so that its Marginal Utility remains low. Opposed to this, Diamonds are so scarce that owning an extra gem doesn’t impact its usefulness as a valuable possession.

Note The concept of Marginal Utility employed in above discussion also applies to special and unique scenarios. For instance, a thirst-gripped wanderer in a desert would happily trade-in a gemstone for glass of water because at that moment, the Marginal Utility of a glass of water for him would be greater than diamond. He might even exchange one or two more gems before switching back to diamond-centric ideology!

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