Understanding the paradox of value: Why Diamond (which is non-essential) is costly and Water (which is essential and life saving) is cheap (GS 3, Economics, The Hindu, Indian Express)
There is a paradox of value in economics when we witness very high prices for non essential goods and very low prices for essential items. also known as the diamond-water Paradox. In a market economy many goods and services which are essential for our lives, like food, water, shelter, have a much lower price in comparison to goods and services that are not so essential, like gold and diamond. For human existence water is essential but the diamond is not. But water sells at a price that is just a fraction of the price of diamonds.
The similar Paradox of value we witness in the wages of essential workers such as farmers and nurses and that of the others such as managers and CEOs of companies which are considered by many as non-essential workers. Many critics of the market economy have cited this paradox of value to argue that it is an unfair economic system that leads to inequality among different populations.
Many economists have tried to explain this paradox of value. Economists like Adam Smith believed that there is difference in the amount of labour to produce different goods or services which is why there is difference in their value.
The marginal revolution in economics took place in the latter half of the 19th century, which is attributed to the contributions made by economists like Leon walras, Carl Menger, William stanley Jevons. These economists adhered to the theory of marginalism. (Marginalism is an economic theory which states that buyers make decisions on the purchase of an additional unit of any item based on the additional utility they will get from it). They argued that the exchange value of the price of goods and services is not determined by the simple use value. It is actually their marginal use value (or utility) to the buyer which determines their value. This resolution for the paradox of value is the most widely accepted among economists.
Austrian economist Eugen von Bohm-Bawerk in his 1891 book “The Positive Theory of Capital”, explained very beautifully the theory of marginal utility. He took the example of a farmer who had five sacks of corn to use until next season. The farmer put values against all these five sacks. The first two sacks of corn he kept for his food to stay alive until the next season and that’s why he valued these two sacks the most. He was then supposed to use the remaining three sacks of corn for other purposes in descending order of importance, namely the third one to feed his poultry, the fourth one to make alcohol and the final corn sack to feed the parrots that amuse him. The farmer would be ready to pay the price for the last sack of grain depending upon the fact that how much he values feeding his parrots, which is like the least urgent of his desires.
It is to note here that it would not depend on the value for the first two corn sacks that the farmer places on his life which is most urgent desire. In case of severe shortage because of famine or other crises, the farmer would be willing to pay a higher price for the corn sacks.
Hence in the context of prices of water and diamond, it is the abundant supply of water which makes them cheap and it is the limited supply of diamond which makes it costly.
But it is not only the limited supply of diamond which makes it costly. Otherwise there are many things in the world which are very rare and scarce, but they are not as costly as diamonds.
It is to understand that for items like Gold and Diamond, people have developed trust which took a very long period of time, say since human civilization. Every civilization of the world has given cultural and traditional value to gold, most likely due to its metallic character like brightness, malleability, durability, indestructibility etc. The history of gold is unequaled by that of any other metal because of its perceived value from earliest times.
Thus there has been development of universal trust especially in gold and diamond (more in gold) regarding its acceptability as a wealth. Thus gold has traditional and cultural as well as historical significance across the world.