The Paradox of Value

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Two hundred years ago, economists were stumped by an apparent paradox:

The paradox of value addresses why absolute necessities such as water are valued (priced) so cheaply, while frivolities like diamonds are highly valued and command outrageous prices.

Questions about this paradox were used to stump Ph.D. candidates in economics for generations. It arises from difficulties in distinguishing between total utility and marginal utility.

Suppose that Panel A in this figure depicts your family’s demand for water. If you are typical, water is so cheap that you treat drinking water as if it were free: you drink water until an extra glass would actually detract from your well-being; the marginal utility is zero. However, because you know that your water bill (which averages $20 monthly) reflects total use, you are probably somewhat careful about watering your lawn, washing your car, fixing leaky faucets, running bath water, and so on.

But suppose you were offered an all-or-nothing choice: 100 gallons of water for $500 monthly or no water at all. (Many American families use 100,000 gallons or more a month.) If you could afford it, you would willingly pay at least $500 per month for water, limiting its use to drinking, preparing food, and sponge baths. Your lawn and plants would die, your car would go dirty, and washing machines and flush toilets would be forgotten luxuries. (Do you think this might explain why gold prospectors smell ripe after a few days of roaming the desert?) If you had to, you would pay considerably more for the 10,000 gallons of water you use each month than the $20 or so you do pay, so water yields an enormous consumer surplus.

The total utility of water is substantially higher than its marginal utility and price, while the total utility of diamonds is close to their marginal utility and price. The areas representing consumer surpluses in Figure 4 are shaded. This analysis should help you understand why diamonds, which are not nearly as necessary to life as water is, are valued and priced much higher than water. The total utility, marginal utility, and price of diamonds are nearly identical for those of us who own, at most, a few of the baubles. The lesson to be learned from the paradox of value is that marginal utility, not total utility, determines the value and market price of individual products.

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Author: Ralph Byrns

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