Why does water, which keeps you alive, cost less than diamonds?
Water is essential and nearly free; diamonds are almost useless and very expensive. Thinkers from Plato to Adam Smith puzzled over this. The answer that won out is subtle: price reflects not how useful something is in total, but how much one more unit is worth to you.
The diamond-water paradox is usually credited to Adam Smith, who set it out in The Wealth of Nations in 1776, though a version already appears in Plato's Euthydemus, and Copernicus, John Locke and John Law had all tried to explain it. Smith distinguished two meanings of value: value in use, meaning how useful something is, and value in exchange, meaning what it will buy. The two, he noticed, often point in opposite directions.
Smith's own resolution was that exchange value comes from labour, the toil and trouble of getting something. Diamonds take a great deal of effort to find; water does not. Supporters of the labour theory of value still see this as the answer.
Mainstream economics settled on a different one, called marginal utility. The Austrian economist Eugen von Böhm-Bawerk illustrated it with a farmer holding five sacks of grain. The first becomes bread to survive, the second more bread so he can work, the third feeds his animals, the fourth makes whisky and the fifth feeds pigeons. Lose one sack and he does not cut everything by a fifth; he stops feeding the pigeons. So any single sack is worth only what the least important use is worth to him.
Water is so plentiful that the next glass matters little, even though water as a whole is priceless. Diamonds are scarce, so each extra one matters more. Change the circumstances and the ranking flips: someone dying of thirst in a desert would gladly swap diamonds for a drink. Price, in this view, lives at the margin, not in the average.
Source: Wikipedia — Paradox of value · Text summarised from Wikipedia (CC BY-SA 4.0)
