Paradox of value
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The paradox of value (also known as the diamond-water paradox) is the apparent contradiction, or paradox, within classical economics that, although water is on the whole more useful than diamonds, diamonds command a higher price in the market. Although Adam Smith famously propounded on the paradox in The Wealth of Nations, he was not the first to note it. Nicolaus Copernicus[1], John Locke, John Law[2] and others had previously tried to explain the disparity in value between water and diamonds.
Smith outlined the paradox in The Wealth of Nations by noting that:
Nothing is more useful than water; but it will purchase scarce anything; scarce anything can be had in exchange for it. A diamond, on the contrary, has scarce any value in use; but a very great quantity of other goods may frequently be had in exchange for it
– Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations[3].
It is generally maintained that Smith was unable to solve the paradox in The Wealth of Nations[4]. Instead it was the theory of marginal utility which became the accepted solution to the paradox. Marginalism brought about the birth of neoclassical economics and argues that it is not the use-value of a good that determines its price but its marginal utility.
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[edit] Labor theory of value
Adam Smith explained the paradox by arguing that value had two different meanings:
- The one may be called 'value in use ;' the other, 'value in exchange.' The things which have the greatest value in use have frequently little or no value in exchange; and on the contrary, those which have the greatest value in exchange have frequently little or no value in use. [3]
Furthermore, he explained the value in use as being determined by labor:
- The real price of every thing, what every thing really costs to the man who wants to acquire it, is the toil and trouble of acquiring it.[5]
Hence, Smith denied a necessary relationship between price and utility. Price on this view was related to a factor of production (namely, labor) and not to the point of view of the consumer.[6] Proponents of the labor theory of value saw that as the resolution of the paradox.
The labor theory of value has lost popularity in mainstream economics and has been replaced by the theory of marginal utility.
[edit] Neoclassical solutions
[edit] Marginal utility
The theory of marginal utility, which is based on the subjective theory of value, says that the price at which an object trades in the market is determined neither by how much labor was exerted in its production, as in the labor theory of value, nor on how useful it is on a whole (total utility). Rather, its price is determined by its marginal utility. The marginal utility of a good is its least important use to a person. The reasoning goes like this. If someone possesses a good, he will use it to satisfy some need or want. Which one? Naturally, the one that takes highest-priority. Eugen von Böhm-Bawerk illustrated this with the example of a farmer having five sacks of grain.[7] With the first, he will make bread to survive. With the second, he will make more bread, in order to be strong enough to work. With the next, he will feed his farm animals. The next is used to make whisky, and the last one he feeds to the pigeons. If one of those bags is stolen, he will not reduce each of those activities by one-fifth; instead he will stop feeding the pigeons. So the value of one bag of grain is equal to the satisfaction he gets from feeding the pigeons. If he sells that bag and neglects the pigeons, his least productive use of the remaining grain is to make whisky, so the value of one more bag of grain is the value of his whisky. Only if he loses four bags of grain will he start eating less; that is the most productive use of his grain. The last bag of grain is worth his life.
In explaining the diamond-water pardox, marginalists explain that it is not the total usefulness of diamonds or water that matters, but the usefulness of each unit of water or diamonds. It is true that the total utility of water to people is tremendous, because they need it to survive. However, since water is in such large supply in the world, the marginal utility of water is low. In other words, each additional unit of water that becomes available can be applied to less urgent uses as more urgent uses for water are satisfied. Therefore, any particular unit of water becomes worth less to people as the supply of water increases. On the other hand, diamonds are in much lower supply. They are of such low supply that the usefulness of one diamond is greater than the usefulness of one glass of water which is in abundant supply. Thus, diamonds are worth more to people. Therefore, those who want diamonds are willing to pay a higher price for one diamond than for one glass of water, and sellers of diamonds ask a price for one diamond that is higher than than for one glass of water.
[edit] Marginal Utility and relations of distribution
As in a market economy the marginal utility of a commodity must be expressed in its price and in a market economy the only mechanism for expressing the utility of something is through effective demand, i.e. through consumers spending money on commodities. Consequently prices derived from marginal utility assume a pre-existing set of relations of distribution. An alternative distribution of income would produce a different set of prices, as different consumers with different needs and a different distribution of income would spend their money differently. As marginal utility theory cannot explain the existing distribution of income, it cannot explain how that distribution effects prices and cannot therefore explain prices.[citation needed]
[edit] Objectivist Opinion
One objection (raised by Objectivists, that is followers of philosopher Ayn Rand), is that the concept of marginal utility ignores the fact that items have some inherent properties that make them useful.[citation needed] The fact that the farmer has chosen to store grain in sacks and not pebbles, is because grain has the property of being edible, a property that pebbles lack.
[edit] See also
[edit] References
- ^ Gordon, Scott (1991). "Chapter 7: The Scottish Enlightenment of the eighteenth century", History and Philosophy of Social Science: An Introduction. Routledge, 141. ISBN 0-415-09670-7. “This 'paradox of value', as it was called, was frequently noted before Adam Smith (for example, by Copernicus who wrote a bit on economic questions)...”
- ^ Blaug, Mark (1962). "Chapter 2: Adam Smith", Economic Theory in Retrospect. Cambridge University Press, 39. ISBN 0-521-57701-2. “Moreover, long before Adam Smith, such writers as Locke, Law and Harris had contrasted the value of water with that of diamonds...”
- ^ a b Smith, Adam (1776). "Of the Origin and Use of Money", An Inquiry into the Nature and Causes of the Wealth of Nations. Retrieved on April 2006.
- ^ Murray N. Rothbard (February 2006). "Chapter 16", Austrian Perspective on the History of Economic Thought. Ludwig von Mises Institute. ISBN 0-945466-48-X. “Suddenly, only ten or a dozen years after the lectures, Smith finds himself unable to solve the value paradox.”
- ^ Smith, Adam (1776). "Book I, Chapter V Of the Real and Nominal Price of Commodities, or of their Price in Labour, and their Price in Money", An Inquiry into the Nature and Causes of the Wealth of Nations. Retrieved on July 2006.
- ^ Dhamee, Yousuf(1996?), Adam Smith and the division of labour accessed 09/08/06
- ^ Böhm-Bawerk, Eugen von (1891). "Book III, Chapter IV: The Marginal Utility", The Positive Theory of Capital. Retrieved on June 20, 2006. “A colonial farmer, whose log but stands by itself in the primeval forest, far away from the busy haunts of men, has just harvested five sacks of corn...”
