From Samuelson’s Economics

From: Economics (10th ed) by Paul A. Samuelson (1976)

THE PARADOX OF VALUE

The preceding theories help explain a famous question that troubled Adam Smith in The Wealth of Nations.  He asked, How is it that water, which is so very useful that life is impossible without it, has such a low price-while diamonds, which are quite unnecessary, have such a high price?

Today even a beginning student can give a correct answer to this problem.  “That’s simply explained,” he can write on an examination.  “The supply and demand curves for water are such that they intersect at a very low price, while supply and demand curves for diamonds are such that they intersect at a high price.” (Today he could add that water is no longer all that cheap.)

This is not an incorrect answer.  Adam Smith could not have given it because supply and demand curves ae descriptive tools had not yet been invented, and were not to be for 75 years or more.  But after he had mastered the new lingo, old Adam Smith would naturally ask the question, “But why do supply and demand for water intersect at such a low price?”

 The answer is by now easy to phrase.  It consists of two parts:

Diamonds are very scarce, the cost of getting extra ones is high; and water is relatively abundant, with its cost low in many areas of the world.  This first part would have seemed reasonable to even the classical economists of more than a century ago, who would probably have let it go at that, and would not have known how to reconcile these facts about cost with the equally valid fact that the world’s water is more useful than the world’s supply of diamonds.  In fact, Adam Smith never did quite resolve the paradox.  He was content simply to point out that the “value in use” of a good -its total contribution to economic welfare-is not the same thing as its “value in exchange”-the total money value or revenue for which it will sell.  Smith had not arrived at the point where he knew how to distinguish marginal utility from total utility!

Today, we should add to the above cost considerations a second truth:

The total utility of water does not determine its price or demand.  Only the relative marginal utility and cost of the last little bit of water determine its price.  Why?  Because people are free to buy or not buy that last little bit.  If water is priced higher than its marginal utility, then that last unit cannot be sold.  Therefore the price must fall until it reaches exactly the level of usefulness of the last little bit, no more and no less.  Moreover, because every unit of water is exactly like any other unit and because there is only one price in a competitive market, every unit must sell for what the last least useful unit sells for.  (As one student put the matter: The theory of economic value is easy to understand if you just remember that the tail wags the dog: concentrate on marginal and not on total utility.)

Paradox resolved:  The more there is of a commodity the less the relative desirabilty of its last little unit becomes, even though its total usefulness grows as we get more of the commodity.  So, it is obvious why a large amount of water has a low price.  Or why air is actually a free good despite its vast usefulness.  The many later units pull down the market value of all units.

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2 Responses to “From Samuelson’s Economics”

  1. nray Says:

    Great read.

  2. Ex Says:

    Always did like Samuelson.

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