Definition: Paradox of value is a puzzle raised by Adam Smith who was one of the great economists in 1700s. Diamond-Water Paradox is defined as the difference between the value in use and the exchange value of any product.
Smith questioned the enigma of a diamond being less useful than water, still, it has a higher exchange value.
As we know that, diamond is a luxury product posed as a status symbol, is highly expensive. While water is indispensable, it cannot be substituted by any other product. Therefore it is listed as extremely cheap.
Why is it so?
It is because of consumer’s surplus, marginal utility, demand and supply of these two commodities.
Content: Paradox of Value
- Consumer Surplus
- Total Utility
- Marginal Utility
- Law of Diminishing Marginal Utility
- Value in Exchange
- Value in Use
- Diamond-Water Paradox
To understand ‘Paradox of Value’, first of all, we need to understand the meaning of various related terms used in this concept:
Consumer surplus can be explained as the excess amount which a consumer is ready to incur for a product or service over its actual price or the exchange value.
In other words, the consumer derives a higher level of contentment from the utilization of any commodity than the price he/she actually pays for it.
Now, let us see the formula for determining the consumer surplus:
- TU is Total Utility;
- MU is Marginal Utility.
A product’s demand tends to become perfectly elastic at a zero consumer surplus, while an infinite consumer surplus indicates perfectly inelastic demand.
Consumer surplus is denoted in utils. Utils is a fictionary unit in which consumer’s satisfaction or product’s utility is depicted.
A product’s total utility is the contentment derived by the consumer from its usage or consumption in a given quantity. Apparently, it emphasizes on the value in use of a particular product.
The following formula is used to compute total utility:
- U1 is the utility acquired on the consumption of the initial unit;
- MU1 is the marginal utility derived on the intake of an additional unit;
- MUn is the marginal utility obtained on the consumption of the final unit.
The further satisfaction obtained by the consumer from the consumption of the supplementary units of any product can be termed as a marginal utility. It helps to analyze the influence of consumers’ satisfaction level over decision making.
Given below is the equation for marginal utility calculation:
- U1 is the utility attained on the consumption of the initial unit;
- U2 is the utility acquired on the intake of the second unit.
Law of Diminishing Marginal Utility
The demand curve of a product slopes downward due to the law of diminishing marginal utility.
This law states that the demand for a product depends on the satisfaction gauged by the consumer from it. And the level of consumer satisfaction drops with the consumption of each additional unit. Therefore, the demand curve shows a downward or falling pattern.
Let us perceive this law with the help of the below example:
|Point||Units Consumed||Utility Derived (Utils)||Marginal Utility (Utils)||Total Utility (Utils)|
Graphically representing the above illustration as follows:
Value in Exchange
Exchange value is the worth of a particular product when swapped to acquire other commodities, i.e., its power to buy the latter. It was a commonly used measure of value at the time of the barter system.
Value in Use
The use-value of any product is said to be the significance it holds for the consumer. The necessity of any commodity can be much more than the expense made by the consumer to acquire it.
To explain the paradox of value, Adam Smith examined the contrasting values of diamond and water in terms of their usage and exchange. The analysis was as follows:
Water is imperative for life but cheap.
Water is indispensable for any human being to be alive. Therefore, its value in use is extremely high.
But if we take a cane of water in the market to exchange it for some other product, we won’t be able to crack any deal. This shows that the exchange value of water is almost negligible.
The reason behind the water being inexpensive is its ease of supply and availability. As we know that when the supply of any product is good enough to meet its demand, its cost tends to be quite low.
Given below is the graph depicting the consumer surplus of water (which is apparently high):
What if the same thing takes place in an island with salty water all around and scarcity of drinking water? Then, of course, there will be a higher exchange value of water.
Diamond is pricey; however negligibly useful.
Diamond is an alembicated stone which is known to be a status symbol. Practically, diamond is hardly useful for individual consumers, although it is a major product for some industries.
Thus, its value in use for the consumers is extremely low. On the other hand, diamond resembles richness or prosperity, therefore, its value in exchange is very high.
Diamonds being rarest of the rare stone are not freely available and therefore, holds an exceptionally high cost.
The following graph represents the consumer surplus of a diamond (which is quite low):
Diamond-Water Paradox Graph
On combining the above two diagrams, we can easily compare the demand curves of diamond and water as below:
Paradox of Value Example
Let us summarize the whole concept with the help of an illustration:
Gold: Gold being a rare element is high in cost, which means it has an upgraded value in exchange. Though, its use-value is meagre for the consumers.
Oxygen: Oxygen in the air is available for zero cost, therefore its exchange value is negligible.
But as we know that no human being can sustain without it, the value in use of oxygen is commendably high.
The same oxygen becomes valuable when used in an emergency ward of a hospital to save a patient’s life.
From the above paradox of value analysis, it is clear that a product’s exchange value is not determined by its usage.
However, the supply or availability of any commodity frames its exchange value. Also, the scarcity of water upgrades its value, is an exception to the diamond-water paradox.