It turns out that the paradox of value has some interesting implications and applications, which I will now tease out.
Is the paradox of value a good or bad thing? That’s a complicated question requiring a complicated answer. First, why it’s good. We saw that value (price) is determined by the last unit bought, even though all the earlier units are more highly valued.
Returning to the example of water, you pay the same for all those essential first gulps of water that keep body and soul together, for all the gallons of water that keeps you and your family and your environment clean, as you do for the few drops you sprinkle on the houseplants. You get those extremely valuable first units of something for the price of the cheaper last unit of something. This is the consumer surplus – you get a lot more value than you pay for. In pictures:
The marginal utility, and the price we are willing to pay, is diminishing when we buy more of something. But we only pay the price for that last quantity. The pink rectangle is how much we pay, but we get the blue triangle thrown in as well. Second, a more ambiguous quality.
Is it fair? You probably have no strong opinions as to whether it’s fair that water is cheaper than diamonds. You may find it slightly strange that the most useful thing is very cheap, and the least useful thing is very expensive. I suspect that you may be very glad that the essentials are cheap. If that’s so, who cares if frivolous luxuries are out of your reach? But I doubt you’re all that emotionally involved.
OK, what if for ‘water’ I substitute ‘a soldier’ (or ‘a nurse’ or ‘a cleaner’), and for ‘diamond’ I substitute ‘footballer’? One provides an essential service for which it is paid very little. The other provides frivolous enjoyment and gets paid huge sums for the privilege. So it’s a reasonably apt analogy. I expect you have stronger opinions and more emotional reactions to that. It seems terribly unfair, but again I’m pretty sure you’d be glad to know that if we were threatened with invasion, we wouldn’t have to offer Wayne Rooney–level wages to recruit more soldiers.
But doesn’t supply and demand determine prices, not marginal utility? Maybe these aren’t such different concepts. Look at that graph showing the law of diminishing marginal utility, showing how the marginal utility slopes downwards as you increase quantity. It looks awfully like a downward-sloping demand curve. Just as you buy more of something when it’s cheaper, we can turn the logic on its head. The more you buy of something, the less you value each extra one.
That’s demand dealt with, what about supply. It’s where the supply curve crosses the demand curve that determines price, after all. Water was cheap because, at least in rich countries like ours, it is abundant – the supply is high. There’s so much to go round that you can use it for all the vital things that you value highly, and still have more left over to do those things that aren’t terribly valuable. On a supply and demand diagram, the supple curve is far to the right, and crosses the demand curve at a low price: Diamonds aren’t so abundant. We never get so many that we use them for mundane reasons. If we did, no doubt we’d end up using them for worthless reasons, and they’d become very cheap. The supply curve is far to the left, and so crosses the demand curve at a high price: So supply and demand, and the logic of marginal utility, really represent the same ideas, but looking at them from different angles. If I were to say what simple concept links these two approaches – I’d say scarcity. The man lost in the desert finds that life-giving water is incredibly scarce, and so values it more than all the diamonds in the world. Supply and demand simply represents how much people want compared to how much there is – again scarcity. Scarcity is a key fact of life, and explains a lot of economics. It is a topic I will return to in the next economics related post. .
Disclaimer: I don’t think it fair, or a cast iron law of the universe, that top-flight footballers get paid much more than soldiers, nurses, or cleaners. I also think the reasons why are a lot more complicated than the ‘paradox of water and diamonds’ argument I’ve presented. I merely point out that we live in a world where people value watching Wayne Rooney play football more than they do seeing him patrol in Afghanistan. Markets aren’t necessarily fair, but they often do a good job of getting scarce resources to where they’re most valued. .