The Diamond-Water Paradox
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The Paradox of Value, sometimes called the Diamond-Water Paradox, describes a contradiction in how we price, and even more fundamentally, value, different resources, depending on the circumstances in which we’re performing the valuation.
A common example of this paradox in action is right there in the nickname: despite water being fundamentally more necessary to survival than diamonds, diamonds often cost far more than water.
This tendency to ostensibly misvalue resources in this way, has been noted and explained in different ways, from the beginning of recorded, philosophical history.
Plato, Copernicus, and Locke, among others, were agog that what seemed to be the most important things in life were priced far lower than what would seem to be completely unnecessary luxuries; water near-worthless, priced cheap, while diamonds were, at times, worth killing over.
Adam Smith was one of the first modern thinkers to attempt to formally explain this paradox, coming to the conclusion that goods have two different types of value: use value and exchange value.
From Smith’s work, An Inquiry into the Nature and Causes of the Wealth of Nations:
“The things which have the greatest value in use have frequently little or no value in exchange; on the contrary, those which have the greatest value in exchange have frequently little or no value in use. Nothing is more useful than water: but it will purchase scarcely anything; scarcely anything can be had in exchange for it. A diamond, on the contrary, has scarcely any use-value; but a very great quantity of other goods may frequently be had in exchange for it.”
Later in that same piece, he came to the conclusion that the exchange value of a good is often associated with the labor required to acquire or create it.
Karl Marx later expounded upon these same concepts, saying that we often speak of an object’s worth based on how valuable it is in terms of utility, while the value of something is more closely related to how much can be had for it, in terms of money, on the market: diamonds are more valuable than water, but worth less than water, according to this framing.
That said, Marx didn’t think exchange value correlated perfectly to monetary value, but rather to a sense of comparable value between two things. So exchange value might tell us that people are willing to trade five barrels of fresh water for a sackful of diamonds, but not how much money either of these things would go for, nor how much they would be worth when compared to other goods.
Both the exchange value and the monetary value of a good, according to this theory, are also shaped by the temperature of the room in which two traders are standing, what these traders ate for breakfast that morning, the general sense of wellness or non-wellness they each feel due to personal issues, politics, and the weather, and countless other variables, some of which we can notice and measure, and some of which we, in most cases, cannot.
This overarching vibe, this instinctual mega-variable, is sometimes, within the world of Keynesian economics, referred to as animal spirits.
These animal spirits, according to Maynard Keynes, in his 1936 book, The General Theory of Employment, Interest and Money, are made up of the instincts, proclivities, and emotions that nudge, shape, and guide human behavior.
Modern economics often refer to animal spirits-derived concepts, like consumer confidence, to make inferences about where the stock market will go next, how swiftly or slowly a recession will pass, and other such difficult-to-measure things.
We also work such variables into our thinking when we’re assessing how much water we can get for our sackful of diamonds.
It may be, for instance, that we’re conducting a trade in the midst of a drought. It may also be that we know the person on the other end of the potential trade is worried about a future, theoretical drought, and thus, may be valuing their water differently than we are.
This duality of value, though, is perhaps most intuitively explained by an example presented by the Austrian economist, Eugen von Böhm-Bawerk, in his work, Principles of Economics.
Böhm-Bawerk explained that if a farmer had five sacks of grain—or corn, according to some tellings of this story—he would use the first bagful to make bread, to ensure his survival. With the second bagful, he’d make more bread, so that he was in good shape, nice and strong, to perform his work. The third sack he would use to feed his farm animals, the fourth he’d use to make whisky, and the fifth he would use to feed the birds.
Each sack of grain is exactly the same as all the others, and yet as we progress, each sack becomes less and less valuable, the value it represents to the farmer depleting as he acquires more of it. This is how the first bag could be vital to the farmer’s survival, while the fifth was so valueless that he was willing to throw it on the ground for the birds.
This story paints a picture of what’s often called marginal utility: a theory of value that says an object is as valuable as it is important to a particular person.
This concept is elegant, because it allows us to understand why water, at a fundamental level, might be incredibly valuable—more valuable than anything else on the planet, even—if you’re dehydrated in a desert, with no natural sources of water, anywhere. But that same water, if you have gallons and gallons of it, more than you could possibly drink or use, might be so valueless that you decide to pour it out on the ground so that you don’t have to carry it anymore.
The theory of marginal utility goes on to explain that we often value diamonds more highly than water because we’re pricing the marginal value of one diamond versus the marginal value of one unit of water, not the entirety of both things, added together.
Water is, by most measures, more valuable than diamonds, overall. And all of the water on the planet, added together, would be worth more than all of the diamonds on the planet.
Each individual diamond, though, will generally be worth far more than each unit of water. The water is more vital, but the diamond has more marginal value, in almost every context.
This same concept can be applied to services, as well as goods.
Folks who work at grocery stores, for instance, are generally paid far less than celebrity athletes. But that doesn’t mean the whole of the world’s grocery store employees are less valuable, or valued, than pro football players: it just means that the marginal value is different, with each pro athlete making more, individually, but the whole of the grocery store employee population being more valuable, as a totality.
Our perspective on such things can, too, just as our determination as to the value of water can change, based on circumstances.
As our animal spirits-related variables shift, so too does our assessment of the marginal value of each grocery store employee, and the ratio of how much we value them compared to pro athletes.
There are, of course, numerous other variables at play here, as well, from government regulations to cultural mores to the abundance or finitude of overall resources in a system, both perceived and actual.
But our valuation of various goods and services fluctuates based in part on marginal value-related distortions, and in part based on the context in which those distortions are taking place—which itself can influence, and be influenced by, those distortions.
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