Diamond-Water Paradox in Economics: Definition & Examples

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Lesson Transcript
Instructor: Aaron Hill

Aaron has worked in the financial industry for 14 years and has Accounting & Economics degree and masters in Business Administration. He is an accredited wealth manager.

Learn what the diamond-water paradox is. Find out why we are often willing to pay more for items we get very little use out of as compared to practical items we need for everyday life.

Definition of Diamond-Water Paradox

Have you ever purchased something and thought to yourself, 'It's crazy how much I'm paying for this!'? This might happen more frequently than you would like, based on the dozens of transactions you may make on a daily basis. Questioning some of your financial transactions may be best answered or explained through something known as the diamond-water paradox.

Getting enough water to sustain life typically has a low price, while a piece of diamond jewelry has a high price. Why does an economy put a much lower value on something vital to sustaining life compared to something that simply looks shiny and sparkles? This question is the diamond-water paradox, also known as paradox of value, and it was first presented by the economist Adam Smith in the 1700s.

In his works, Smith points out that practical things that we use every day often have little or no value in exchange. Things like cups, utensils, socks, and water are a few examples. On the other hand, things that often have the greatest value in the market have little or no practical use. An example may be an old piece of art or 1920s baseball card. Other than looking at it, there isn't much else we can do with the art or baseball card. So, why are things valued this way?

Understanding why the paradox exists can be helped by understanding the economic terms known as marginal utility and scarcity. Scarcity can be simply defined as how readily available a good, skill, or service is. Is there a lot of it compared to what people are demanding? Marginal utility is the additional satisfaction or gain someone gets from using or purchasing an additional unit of a particular good or service. People are willing to pay a higher price for goods with greater marginal utility.

So, let's go back to water and diamonds. There is plenty of water in most parts of the world (not scarce), which means that, as consumers, we usually have a low marginal utility for water. In a typical situation, we aren't willing to pay a lot of money for one more drink of water. Diamonds, however, are scarce. Because they are harder to find and attain, our marginal utility (additional satisfaction), for adding a diamond to our collection is much higher than someone offering us one more drink of water. If one is dying of thirst, then this paradox might not make sense, and the marginal utility from another drink of water would be much higher than the additional satisfaction of owning a diamond. Let's look at a few examples.


Does paying $300-$400 dollars for an Xbox compared to $50 for a solid pair of shoes make sense? From a practical and survival standpoint, it certainly doesn't. In order to get around and enable our most basic form of transportation (walking), we need shoes to protect our feet. They are certainly more important and practical than an Xbox. The price difference comes back to the satisfaction, or marginal utility, we get from purchasing a pair of shoes compared to an Xbox. If you were in the middle of the jungle and trying to survive, you might pay more for those shoes, but until that happens, most of us will continue to pay more for our electronics!

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