More than two centuries ago, in The Wealth of Nation.s, Ada in Smith posed the paradox of value.

Nothing is more useful than water; but h will Carve purchase anything. A diamond. on the Contrast, has scarce any value in use: but a use)’ great quantity of other goods Ray frequently be had in exchange for it.

In other words. how is it that rater, which i essential to life, has little value, while diamonds. which are generally used for conspicuous consumption, command an exalted price? ‘

Although this paradox. troubled Adam Smith 200 years ago, we can imagine a dialogue between a probing student and a modern-day Adam Smith as follows:

Student: How can we resolve the paradox of value? Modern Smith: The simplest answer is that the supply and demand curves for water interject at a very monds. yield a very high equilibrium price.

Student: But you have always taught me to go behind the curves. Why do supply and demand for water intersect at such a low price and diamonds at a high price?

Modern Smith: The answer is that diamonds are very scarce and the cost of getting extra ones is high. while water is relatively abundant and costs little in ‘many areas of the world.

Student: But where is utility in this picture?

does not reconcile the cost information with the eqally valid fact that the world’s water is vastly more critical aha the world’s supply of diamonds. So, we need to add a second truth: The total utility from water consumption does not determine it’! price or demand. Rather, water’s price is determined by its marginalia utility, by the usefulness of the last glass of water. Because there is so much water, the last glass sells for very little. Even though the first few drops arc worth life itself, the last few are needed only for watering the lawn or washing the car.

Student: Now I get it. The theory of economic value is easy to understand if you-just remember that in economics the tail wags the dog. It is the tail of marginal utility that Wags the dog of prices and quantities.

Modern Smith: Precisely! An immensely valuable commodity like water sells for next to nothing because its last drop is worth next to nothing.

We can restate this dialogue _.follows: The more there is of a commodity, the less is the relative desirability of its last little unit, It is therefore clear why water has a low price and why an absolute necessity like air can become a free good. In both cases, it is the large quantities that pull the marginal utilities so far down and Julius reduce the prices of these vital commodities.

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