Adam Smith's Diamond-Water Paradox

This is one of Adam Smith's most famous and enduring puzzles in economics, found in his 1776 work, An Inquiry into the Nature and Causes of the Wealth of Nations.

Smith used the paradox to highlight the crucial difference between value in use (utility) and value in exchange (price).

The Paradox Stated

Smith observed that nothing is more useful than water; it is essential for life. Without it, we die. Therefore, its value in use is extremely high.

On the other hand, diamonds are largely frivolous. They have little practical use and are not necessary for survival. Therefore, their value in use is very low.

Yet, in the market, the situation is completely reversed:

Water, which is so useful, has a very low price (or is even free). Diamonds, which are so useless, have a very high price.

This is the paradox: Why is something so essential for life so cheap, while something so unnecessary so expensive?

The Explanation: Supply, Demand, and Marginal Utility

While Adam Smith framed the paradox, the complete solution came later with the theory of marginal utility. The explanation hinges on the concepts of supply, demand, and marginal decision-making.

The Role of Scarcity (Supply)

Water is relatively abundant. Its total supply is large, making it easy to access. Because it is not scarce, it commands a low price.

Diamonds are intrinsically scarce. Their supply is limited and expensive to extract. This scarcity is a primary reason for their high price.

The Role of Marginal Utility (Demand)

This is the key to solving the paradox. Price is not determined by the total utility of a good but by its marginal utility (the usefulness of one additional unit).

The Marginal Utility of Water is low. Because water is abundant, we use it for many purposes. The first units we consume (for drinking) have an incredibly high marginal utility. However, each additional unit is used for less critical purposes (e.g., filling a swimming pool). Therefore, the marginal utility of one more cup of water is very low, so people are only willing to pay a very low price for it.

The Marginal Utility of Diamonds is high. Because diamonds are so scarce, we possess very few of them. The marginal utility of acquiring one more diamond is still very high for a consumer, as it fulfills a strong desire for status or beauty. Since people are willing to pay a lot for that one additional unit, the price is high.

Aspect	Water	Diamonds
Total Utility	Extremely High (Essential for life)	Very Low (Luxury, non-essential)
Scarcity (Supply)	Abundant	Very Scarce
Marginal Utility	Very Low (Because we have so much)	Very High (Because we have so few)
Price (Value in Exchange)	Low	High

Conclusion

Adam Smith used the diamond-water paradox to illustrate that the labor theory of value was not the whole story and to highlight the critical distinction between utility and price.

The solution to the paradox is that price is determined by marginal utility, not total utility. The combination of high marginal utility (driven by scarcity and desire) and low supply leads to a high price for diamonds. The combination of low marginal utility (driven by abundance) and high supply leads to a low price for water, despite its immense total utility.