Adam Smith’s Diamond and Water Paradox.

Hello readers, welcome back to my blog. I recently came across a concept known as the diamond and water paradox, proposed by the great classical economist, Adam smith in his most famous book, “The Wealth of Nations”. I was intrigued to know what this was all about and how exactly it links to economics. Having researched it further online and in textbooks, I was keen to explain it to you in order to cement my own knowledge and understanding as well as present what I have researched, so that anyone who may be interested can gain an understanding of this idea. Seeing as I gave you a lot to think about and consider in my last post, about oil from the Middle East, I will keep this post short and get directly to the point.

To begin, I think its probably best to give a very short history lesson about Adam Smith and his work in a quick 30 second elevator pitch:

Adam Smith was an economist and philosopher who wrote what is considered as the “bible of capitalism,” The Wealth of Nations, in which he details the first system of political economy. Smith’s ideas are a reflection on Economics in light of the beginning of the Industrial Revolution, and he states that free-market economies (i.e. capitalist ones) are the most productive and beneficial to their societies. He goes on to argue for an economic system based on individual self-interest led by an “invisible hand,” which would achieve the greatest good for all. The book was considered the foundation of classical economics, and is one of the most influential books ever written.

Probably a little more than 30 seconds but you get the idea. He revolutionised the study of economics and for that reason he is sometimes thought of as the father figure of economics. To read more about the invisible hand/refresh your memory of it see my post entitled: key economics concepts, where I look into the ‘invisible hand’ as well as the concept of ‘Homo Economicus’.

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In his book Smith wrote:

“Nothing is more useful than water: but; scarce anything can be had in exchange for it. A diamond, on the contrary, has scare any value in use; but a very great quantity of other goods may frequently be had in exchange for it.”

Essentially what he is referring to is a paradox of value.

In most countries, water has a low price, whereas a piece of diamond jewellery has a high price. Why is it that an economy puts such a low price on something vital to sustaining life compared to something that only has visual/aesthetic effects? Smith suggested that practical things that we use everyday have a ‘value in use’, but often have little or no ‘value in exchange’. On the flipside things that often have the greatest value in the market or in exchange such as a drawing by Picasso, have little or no practical use other than for decoration.

Understanding this paradox is achieved by understanding the economic terms ‘marginal utility’ and ‘scarcity’. Scarcity relates to how little of a good there is compared to what people are demanding. Marginal Utility is the additional welfare a person gains from using or purchasing an additional unit of the good. People are willing to pay a higher price for goods with a greater marginal utility.

Going back to water and diamonds. Water is not scarce in most parts of the world, which means people can consume it up until the point at which the marginal utility they gain from the last drop consumed is very low. In other words they are not willing to pay a lot of money for one more drink of water. Diamonds on the other hand are rare and are scarce. As a result of their limited supply, the marginal utility typically gained from adding one more diamond to a person’s collection is much higher than for one extra drink of water.

That being said, this paradox breaks down if someone is dying from thirst, since the marginal utility gained from another drink of water would be much higher then the additional satisfaction of owning an extra diamond.

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Sources used:

https://www.biography.com/people/adam-smith-9486480

Powell & Powell Economics Text book

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

https://www.tutor2u.net/economics/reference/the-paradox-of-value

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