The Diamond-Water Paradox

JULIA: Welcome to tonight's show. I'm Julia Sanders. We have with us Mr. John Tabbot. It's great to have you here with us tonight.

TABBOT: Thank you for inviting me here today.

JULIA: OK. So, today we are going to discuss why diamonds are more valuable than water.

TABBOT: Yes, it is a very strange notion isn't it? After all, water not diamonds is essential for life. Classical economists puzzled over this question and named it the "value paradox".

JULIA: OK, so why are diamonds more valuable?

TABBOT: Well, scarcity of goods is what causes humans to attribute value. If, we were surrounded by an unending abundance of both water and diamonds, we probably would not value either very much.

JULIA: That makes sense.

TABBOT: Scarcity is an important factor in how we value an economic good.

JULIA: What defines an economic good?

TABBOT: Economic goods have three attributes - first of all, there must be a human need or want. Secondly, there must be an opinion that the thing in question will satisfy that need or want. The last point is that there must be command or control over the ability to satisfy this want or need.

JULIA: So something, like good weather would not be an economic good?

TABBOT: Exactly, I may know that a nice sunny day would improve my mood. But, we do not have control over the weather. Therefore, it is not an economic good.

JULIA: So now you have defined what economic goods are and say that scarcity is how we value them?

TABBOT: Yes. We value an economic good only if there is an insufficient quantity to satisfy all human desires for that thing. Scarcity implies that we will rank our wants and this process results in economic activity.

JULIA: So something like, the air we breathe would not be economically valuable?

TABBOT: Under normal circumstances yes. In the case of a SCUBA diver it is very much an economic good with value.

JULIA: Right!

TABBOT: Consumers will use whatever resources they have at their disposal to satisfy their most important wants. Our value system is determined by our ranking of wants.

JULIA: Can you provide an example?

TABBOT: Yes. Assume you are a farmer with three horses and two cattle. Each of the horses is interchangeable with one another.

JULIA: So all horses are identical?

TABBOT: Yes, we have in a sense turned them into a commodity. And not only the horses, but each cow is interchangeable as well. Now let us assume that you rank the importance of the animals as follows - tilling the fields is the most important and you need a horse for that. Secondly, you need a horse to pull your wagon to town.

JULIA: This must be a historical example.

TABBOT: Seems to be, yes. So the two top needs are fulfilled both by horses. Now we proceed down our ranking of wants and see that we require one cow to produce milk. Then another cow is required for cheese and butter.

JULIA: So it goes horse, horse, cow, then cow?

TABBOT: Correct. The third horse, and final animal, is required for recreational riding. This is regarded as being the least important of the five wants. Okay. So now comes my question - which is the most valuable animal in this example?

JULIA: The horse.

TABBOT: Wrong.

JULIA: But the horse fulfills the most valuable want.

TABBOT: Yes, it does. But you see, you have fallen into the same trap as the classical economists.

JULIA: Please explain?

TABBOT: I will prove to you that the cow is the more valuable animal through the following scenario. Imagine that these animals are all inside a barn that is on fire and you can save only one of them. Which one would it be?

JULIA: It would be the horse of course.

TABBOT: Yes, if only one animal could be saved it would be the horse. If you could save two animals?

JULIA: I would save the second horse.

TABBOT: Yes. And now, if you had sufficient time what would be the third animal?

JULIA: The cow used for milk.

TABBOT: And the fourth animal?

JULIA: The second cow.

TABBOT: So, the remaining animal would be a horse? That is my point. As this example shows, the cow is more valuable than the horse. But, only if you have the third horse.

JULIA: So, if you only have two horses and two cows, than the horse is more valuable?

TABBOT: Yes. But since you have three horses, the value of a horse is less to you than a cow. This is what economists refer to as "marginal utility". We can say that the marginal utility of the cow is greater than that of the horse.

JULIA: But only because the farmer has more horses than cows.

TABBOT: Yes. But we must keep in mind our ranking of wants. If we had deemed the recreational riding as being more important than making cheese and butter, then the horse would be the more valuable animal, even though they outnumber the cows. So raw numbers alone do not determine which is more valuable.

JULIA: Okay. I understand that.

TABBOT: Now we have a framework to understand why diamonds are valued more than water even though water is ultimately the more important of the two.

JULIA: Which explains why a person in the desert dying of thirst would trade his diamonds for water?

TABBOT: Yes, and how under normal circumstances diamonds are much more valuable.

JULIA: Thank-you for your explanation. We will now take a short commercial break.