Diamonds are forever…

Diamonds are forever…

DIAMONDS are forever


Diamonds are costly because we desire them. But what if that isn’t true? What if they are desirable because they are costly?


 

Money Wise; February-2016

Have you ever purchased something and thought to yourself, “It’s crazy how much I’m paying for this!” This might happen more frequently than you would like, based on the dozens of transactions you may make on a daily basis. Questioning some of your financial transactions may be best answered or explained through something known as the diamond-water paradox.

Water has been the source of life on Earth. Civilizations have flourished along river banks. Harappan civilization flourished along the river Indus. Egypt owes its sustenance to Nile River. The most populous states of Uttar Pradesh, Bihar and West Bengal are dependent on the Ganga. NASA and ISRO are trying to find water sources on the distant planet Mars, with little success.

Now is Water valuable more than Diamonds?

Getting enough water to sustain life typically has a low price, while a piece of diamond jewelry has a high price. Why does an economy put a much lower value on something vital to sustaining life compared to something that simply looks shiny and sparkles?

This question is the diamond-water paradox, also known as paradox of value, and it was first presented by the economist Adam Smith in the 1700s.

In his works, Smith points out those practical things that we use every day often have little or no value in exchange. Things like cups, utensils, socks, and water are a few examples. On the other hand, things that often have the greatest value in the market have little or no practical use. An example may be an old piece of art. Other than looking at it, there isn’t much else we can do with the art.

So, why are things valued this way?

Understanding why the paradox exists can be helped by understanding the economic terms known as marginal utility and scarcity. Scarcity can be simply defined as how readily available a good, skill, or service is. Is there a lot of it compared to what people are demanding?

Marginal utility is the additional satisfaction or gain someone gets from using or purchasing an additional unit of a particular good or service. People are willing to pay a higher price for goods with greater marginal utility. There is plenty of water in most parts of the world (not scarce), which means that as consumers, we usually have a low marginal utility for water. In a typical situation, we aren’t willing to pay a lot of money for one more drink of water. Diamonds, however, are scarce.

Water is very plentiful. You can find water almost anywhere, and because there is so much, the price is very low. Diamonds are extremely hard to find, and because of their rarity, they are much more expensive. If one is dying of thirst, then this paradox might not make sense, and the marginal utility from another drink of water would be much higher than the additional satisfaction of owning a diamond. If water supply were as limited as diamond supply, then the price of water would be many times more than diamonds, because water in the same quantity as diamonds is much more valuable to human life.

Despite being a symbol of magnificence, the diamond fails to save a life by serving as water. But the water, despite being much cheaper by its cost is indispensable, invaluable, incomparable and conspicuous material for all the creatures. Hardly does anyone bother to know that without the water entire world will cease to exist, while the diamond has nothing to interfere in Nature’s dispensation.

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

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.

The theory of marginal utility is based on the subjective theory of value. 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 necessary to produce the good, but instead value is determined by the importance an acting individual places on a good for the achievement of his desired ends.

Paradox Solved

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.

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