DR.

RAM MANOHAR LOHIYA NATIONAL LAW

UNIVERSITY,

SUBJECT: - ECONOMICS

FINAL DRAFT ON:

“DIAMOND WATER PARADOX” OR “PARADOX OF VALUES”

Submitted for the project undertaken in partial fulfilment of B.A. LL.B.

(Hons.)

SEMESTER I

SUBMITTED TO: SUBMITTED BY :

ASSISTANT PROFESSOR (ECONOMICS) SECTION ‘B’

RMLNLU(U.P.) ROLL NO.

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 ACKNOWLEDGEMENT

My sincere gratitude and profound regards to Assistant Professor SS for his exemplary guidance
and constant encouragement throughout the course of this project. The help, blessing and
guidance given by him from time to time helped us to arrive at a better understanding of the
project topic.

I feel pleased to have been asked to make our project on Diamond Water Paradox. In this
project I will cover brief introduction Paradox of Value and various theories give to solve the
paradox including Labor Theory of Value and Subjective Theory of Value.

With this project, I aim to provide you with the most comprehensive information covering the
broad fields within Diamond Water Paradox.

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TABLE OF CONTENTS

 Acknowledgement………………………………………………………..ii
 Introduction………………………………………………………………iv
 Background……………………………………………………….v
 Research Questions……………………………………………..v
 Objective…………………………………………………………vi
 Research Methodology………………………………………..vi
 Analysis & Interpretation…………………………………….vi
 Conclusion……………………………………………………..vii
 Chapterisation…………………………………………………vii
 Labour theory of value…………………………………………….viii
 Criticism…………………………………………………….ix
 Subjective theory of value……………………………………….x
 Criticism…………………………………………………..xi
 How Can Marginal Utility Explains The Diamond Water Pradox…xi
 Marginal Utility And Total Utility………………………………xi
 The law of diminishing marginal utility…...............................xii
 Enter demand price……………………………………….xii
 Going to a graph………………………………………….xiii
 Conclusion……………………………………………………….xiv
 References………………………………………………………xv

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INTRODUCTION

“The Paradox that many necessities of life have a low ‘market’ value while many luxuries with
‘little’ use value has a high market price is called the Paradox of Value.” In 1776, Adam Smith
presented the diamond – water paradox in his book An Inquiry into the Nature and Causes of
the Wealth of Nations, wherein he said 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.”

Here, he tries to say that, water is important to support life. Diamonds and jewels are
insignificant ornamentation. Yet getting enough water to support life ordinarily has a low value,
while a bit of diamond ornament has a high cost. Why does an economy put a lower esteem on
what is important to manage life than on a frivolity? This is Diamond Water paradox.

To resolve this paradox, various theories have been given including Labor Theory of Value by
Adam Smith and Subjective Theory of Value by Carl Menger and Eugen von Boehm-Bawerk.
Here, while the Labor Theory focuses on value in exchange and value in use and how they
differ, on the other hand, Subjective Theory focuses on marginal utility or ability of a good to
satisfy consumer demand.

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BACKGROUND

The first Diamond Water Paradox or we can also say that paradox of values was first given by
ADAM SMITH in 1700s.

In his work SMITH points out that practical things that we use every day often have little or no
values in exchange, Things like cups, utensils, socks and water are a few examples. On the other
hand ,things that often have a greatest values in the market have little or no practical use. An
example may be an old piece of art or 1920 baseball card. Other than looking on it ,there isn’t
much else we can do with the art or with baseball card. So, why are things valued this way.

RESEARCH QUESTIONS

1. Why goods we could do without fetch high prices, but some goods with high value in use sell
for much less than they are worth “ explains this in context of Diamond water paradox”.

2. Explain labour theory of values given by ADAM SMITH and does it hold any significance in
today’s world.

3. Differentiate between use in values an use in exchange in context to, labour theory of value
being given by ADAM SMIITH also, cover the criticism to this labour theory of values.

4. How can marginal utility explains the diamond water paradox.

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OBJECTIVE

1. To know why does a economy puts a lower value on what is necessary to sustain life.

2. To analyze different theories given by different scientiests.

RESEARCH METHODOLOGY

DOCTRINAL RESEARCH: In this project we will go through the literature available on the
subject matter & thereon propound conclusion based on the study conducted.

ANALYSIS & INTERPRETATION

After completion of the project it is analyzed that the thigs that we purchased on high prices
valued less and the things that are available on less price were more sustainable to life.

The Diamond – water paradox poses the perplexing observations: Even though water is
obviously important to human activity ( life cannot exists without water ) , the price of water is
relatively low . Alternatively diamond are clearly much less important to human existence, but
the price of diamond is substantially higher. In other words , the utility obtained from water is
obviously very great, while the utility obtained from diamonds is substantially less .

The key question that arises is: why are diamonds so much more expensive than water?

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CONLUSION

The apparent contraction between price and utility is cleared up by distinguishing between
marginal utility and total utility, and with the understanding that marginal utility, not total utility,
is the key to determining price.

Moreover, this paradox can be turned on its head by considering what might happen should the
relative abundance of water and diamonds change.

 If water were as limited as diamonds, then the marginal utility and thus price would also
be quite high. In fact, if water and diamonds were equally limited in supply, the price of
water would likely be several times the price of diamonds.

If diamonds were as plentiful as water, then the marginal utility and price would also be quite
low. If water and diamonds were equally abundant in supply, then the price of diamonds would
likely be only a fraction of the price of water.

CHAPTERISATION

1. Labour theory of value.

2. Criticism

3. Subjective theory of values.

4. Criticism.

5. How can marginal utility explains the diamond water paradox.

6. Marginal utility v total utility.

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LABOUR THEORY OF VALUE

The labor theory of value says that the value of a finished good correlates solely with the number
of labor hours required to produce it.” Adam Smith used the co-relation between water and
diamond to show chasm between ‘value in use’ and ‘value in exchange’ which are key term to
his theory. According to Adam Smith,

“The word Value, it is to be observed, has two different meanings, and sometimes expresses the
utility of some particular object, and sometimes the power of purchasing other goods which the
possession of that object conveys. 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. 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.”

He further relates Value in Exchange to labor as follows:

“The value of any commodity ….... to the person who possesses it, and who means not to use or
consume it himself, but to exchange it for other commodities, is equal to the quantity of labour
which it enables him to purchase or command. Labour, therefore, is the real measure of the
exchangeable value of all commodities”

Thus, “he develops two seemingly different descriptions of value: labor embodied value and
labor commanded value.” Here, he tries to bring out that that, The genuine cost of everything,
what everything truly expenses to the man who needs to obtain it, is the drudge and
inconvenience of gaining it. Thus, Smith denied essential relationship between utility and price,
wherein Price was related to the factors of production, namely labor, and not to the consumers

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CRITICISM

Albeit spearheading, Smith's work did not pass without slagging. It is considered as an
fragmented hypothesis, which neglected to give a positive depiction of the nature of value.
Slagging comes both from non-labor value scholar, for example, the neoclassicals, and also labor
value scholars, for example, Marx.

Karl Marx, and also David Ricardo, had noticed the disarray of Smith in terms of the
qualification of labor command value and labor embodied value. This confusion arises from the
incapacity of Smith to contrive what Marx later called “labour force and its difference from
abstract labour."

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SUBJECTIVE THEORY OF VALUE

The theory of subjective value states that, “a good doesn’t have any objective or given value but
its value is determined by people’s personal judgement. Thus different people will value the
same good differently. The theory suggests that value isn’t a common property, like weight or
volume, but is something decided by individuals. People will put a value on a good

based on the benefit they think it will bring them. Therefore value is determined by people’s
situations and personal preferences”. In simple words, we can say that “the subjective theory of
value states that the price of a commodity is determined by its marginal utility to the consumer.
This is the
point, on an individual's scale of satisfaction, at which the desire of a good is satisfied.”

The utility for any item is never the same for any two individuals and on the later stage the utility
even changes for a particular individual too. Eg., a person will have a higher value for a chalk
when he has nothing to write but subsequently the value for the chalk will fall as soon as good
quality pens and pencils are available. It doesn’t matter to the individual that how much efforts
have been made in the production of that chalk, instead what will matter will be the stage where
his desire is achieved. Thus it can be inferred from the above example that “the subjective theory
of value is a theory of value which advances the idea that the value of a good is not determined
by any inherent property of the good, nor by the amount of labor required to produce the good,
but instead value is determined by the importance an acting individual places on a good for the
achievement of their desired ends”.

Menger used his “subjective theory of value” to arrive at one of the most powerful insights in
economics: both sides gain from exchange. People will exchange something they value less for
something they value more. Taking this assumption of Menger into account, we can relate the
Diamond-water paradox with subjective theory of value. According to diamond water paradox,
water which is available in abundance and is important for life existence has a very high value
for human being whereas diamonds, which have no essential element of being required for life
existence has a very high value. Thus, considering the insight of Menger, we can easily
understand the theory of diamond water paradox with subjective theory of value.

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CRITICISM

Though the subjective theory of value has explained diamond water paradox in a justified way,
there have been certain flaws in the subjective theory which have been highlighted by Paul
Mattick. “With the emergence of the subjective theory of value, which ultimately ended in a
hypostatization of prices, the bourgeois theory of value cut itself loose from all its former ties
with classical monetary theory. Clearly the theory of marginal utility is inapplicable to the
exchange value of money, since it cannot be determined by the subjective needs of consumers, as
can the exchange value of other commodities, but is in fact juxtaposed to these needs as an
already given objective value.” This is one of the prime drawback of subjective theory of value
as though it has a very wide and clear applicability, it cannot be used everywhere or in every
aspect of exchange. As mentioned above, it cannot be used in exchange value of money
subjective need cannot be determined for each distinct individual

HOW CAN MARGINAL UTILITY EXPLAINS THE DIAMOND WATER

PARADOX

One of the most disconcerting problems to Adam Smith, the father of modern economics, was
that he could not resolve the issue of valuation in human preferences. He described this problem
in "The Wealth of Nations" by comparing the high value of a diamond, which is unessential to
human life, to the low value of water, without which humans would die. He determined "value in
use" was irrationally separated from "value in exchange." Smith's "diamond/water paradox" went
unsolved until later economists combined two theories: subjective valuation and marginal utility

MARGINAL UTILITY AND TOTAL UTILITY

Insight into, and clarification of, the diamond-water paradox results by differentiating between
total utility and marginal utility.

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  Total utility: This is the over satisfactionof wants and needs obtained from consuming a
good. That is, total utility is the accumulated amount of satisfaction, or the total value,
generated by several units of a good.

 Marginal utility: This is the extra satisfaction of wants and needs obtained from
consuming one additional unit of good. That is, marginal utility is the incremental
satisfaction generated by, and the value of, a single unit of a good.

Water provides humans with an enormous amount of total utility. Water satisfies A LOT of
wants and needs for A LOT of people. Water provides a high level of total utility because it is
plentiful--water, water everywhere! However, because it is so plentiful, the marginal utility of
water is relatively low. An extra ounce of water provides very little additional satisfaction.

In contrast, the total utility generated by diamonds is relatively limited. Diamonds do not provide
much overall satisfaction of wants and needs, compared to water. Many humans spend their
entire lives without achieving any satisfaction from diamonds.

Diamonds have very little total utility because they are not nearly as plentiful as water. Most
houses do not have hot and cold running diamonds. Most people do not drink eight glasses of
diamonds a day, take showers in diamonds, or fill their Olympic-sized swimming pools with
hundreds of gallons of diamonds. However, because they are less plentiful, the marginal utility
of diamonds is relatively high. An extra ounce of diamonds provides a great deal of extra
satisfaction

THE LAW OF DIMINISHING MARGINAL UTILITY

The key to the marginal utility difference between water and diamonds law of diminishing
marginal utility. Because water is plentiful, marginal utility is quite low. The law of diminishing
marginal utility works its magic on water, driving marginal utility down... to a very low
level... to near zero.

However, because diamonds are substantially less plentiful, marginal utility is much higher.
The law of diminishing marginal utility is not active to the same degree for diamonds.

ENTER DEMAND PRICE

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Marginal utility, not total utility, is the critical determinant of price. The price of water is
relatively low because the marginal utility is relatively low. The price of diamonds is relatively
high because the marginal utility is relatively high.

In general, people are willing to pay a relatively less demand price for a good that generates
relatively more satisfaction. However, because goods are sold on an incremental basis--one unit
at a time--the additional satisfaction generated by each unit--that is, marginal utility--is the prime
determinant ofemand price.

GOING TO A GRAPH

Additional light can be shed on the diamond-water paradox using the generic marginal
utility curvedisplayed to the right. Like any marginal utility curve, this one has a negative
slope. As the quantity increases, the marginal utility decreases due to the law of diminishing
marginal utility. Total utility is indicated by the area beneath the marginal utility curve.

Most importantly, marginal utility determines the demand price that buyers are willing and
able to pay for the good. As marginal utility declines, so too does demand price.

Consider how the availability of diamonds and water might be reflected with this marginal
utility curve.

 Diamonds: Because diamonds are limited in supply, people are likely to operate
relatively high on the marginal utility curve, near the vertical curve. That is, the
quantity consumed is relatively small. Click the [Diamonds] button to highlight this
option.

Because the quantity is low, the marginal utility is high. The high marginal utility
corresponds with a relatively high demand price. The total utility of diamonds,
however, is indicated by the yellow area beneath the marginal utility curve. Because
the quantity is limited, the total utility area is relatively small.

 Water: Because water is abundant in supply, people are likely to operate relatively
low on the marginal utility curve, near thehorizontal exis.That is, the quantity
consumed is relatively large. Click the [Water] button to highlight this option.

Because the quantity is high, the marginal utility is low. The low marginal utility
corresponds with a relatively low demand price. The total utility of water, however, is
indicated by the yellow area beneath the marginal utility curve. Because the quantity
is abundant, the total utility area is relatively large.

XIII
CONCLUSION

The apparent contraction between price and utility is cleared up by distinguishing between
marginal utility and total utility, and with the understanding that marginal utility, not total utility,
is the key to determining price.

Moreover, this paradox can be turned on its head by considering what might happen should the
relative abundance of water and diamonds change.

 If water were as limited as diamonds, then the marginal utility and thus price would also
be quite high. In fact, if water and diamonds were equally limited in supply, the price of
water would likely be several times the price of diamonds.

XIV
  If diamonds were as plentiful as water, then the marginal utility and price would also be
quite low. If water and diamonds were equally abundant in supply, then the price of
diamonds would likely be only a fraction of the price of water.

 REFERENCES

1. https://en.wikipedia.org/wiki/Paradox_of_value

2. http://study.com/academy/lesson/diamond-water-paradox-in-economics-definition-
examples.html

3. http://www.investopedia.com/ask/answers/032615/how-can-marginal-utility-explain-
diamondwater-paradox.asp

4. http://www.amosweb.com/cgi-bin/awb_nav.pl?s=wpd&c=dsp&k=diamond-water+paradox

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