History of Economic Thought: Adam Smith, Galileo, and the Paradox of Value
Adam Smith is one of the most famous economists of all time. His “Wealth of Nations” is recognizable by the title to many and carries a prestigious reputation in economic circles. In “Wealth of Nations”, however, Smith dealt with a paradox of sorts. He looked around him and saw that the prices of goods and their individual values are often out of sync. Water is extremely useful. It has a very low price. Diamonds are, for practical purposes, nearly useless. Diamonds have a very high price.
Smith asked how this could be? How could water have such a low price and be so useful, while the impractical diamonds command a high price. To solve this paradox, Smith had to introduce two different concepts of value. In “Wealth of Nations”, Smith says:
“The word VALUE, it is to be observed, has two different meanings, and sometimes expresses the utility of some particular object, and sometimes the power of purchasing other goods which the possession of that object conveys. The one may be called "value in use;" the other, "value in exchange." The things which have the greatest value in use have frequently little or no value in exchange; on the contrary, those which have the greatest value in exchange have frequently little or no value in use. Nothing is more useful than water: but it will purchase scarcely anything; scarcely anything can be had in exchange for it. A diamond, on the contrary, has scarcely any use-value; but a very great quantity of other goods may frequently be had in exchange for it.” (Wealth of Nations, pg 25.)
Smith thought that to make sense out of the prices, he needed to create an artificial divide between “Value in Use” and “Value in Exchange”. In effect, Smith gave up and said that we have no way to explain this. However, what value does something have in exchange if not for what the consumer will use it for! The reason anyone buys anything is for its use! Smith’s solution does not work here.
What is the solution to this “Diamond-Water Paradox”? The answer is simple: Smith omitted mentioning the supply of the goods involved. Water has such a cheap price because it is so abundant. Diamonds, on the other hand, are relatively scarce, which tends to drive up price. Smith only looked at demand for the items involved, but never at supply.
Additionally, Smith’s alleged paradox had already been solved by previous writers! Galileo Galilei is one of the most famous figures in all of history. He famously defended the Copernician position that the sun revolves around the earth, not vise versa, which landed him in hot water with the Caltholic Church and was forced to recant his views. In his book, “Dialogue Concerning the Two Chief World Systems”, a book mostly about astronomy, he mentions:
“People who do this ought to remember that if there were
as great a scarcity of soil as of jewels or precious metals, there would not
be a prince who would not spend a bushel of diamonds and rubies and a
cartload of gold just to have enough earth to plant a jasmine in a little
pot, or to sow an orange seed and watch it sprout, grow, and produce its
handsome leaves, its fragrant flowers, and fine fruit. It is scarcity and
plenty that make the vulgar take things to be precious or worthless; they
call a diamond very beautiful because it is like pure water, and then would
not exchange one for ten barrels of water.”
Galileo, not at all trained in economics mind you, points out the obvious fact that Smith missed. Namely, that the scarcity or abundance of any particular product is important. He points out that if soil was as scarce as diamonds are, the price of soil would skyrocket accordingly. This is not because the usefulness has greatly increased, but because the supply has greatly decreased.
This leaves us with a question: How was Galileo able to see what Smith and other Classical economists could not? Their failure to see the obvious was a result of their paradigm through which they viewed economics and economic questions. Smith took a top-down approach when examining this “paradox”, as he did in much of his writings. Instead, Smith should have taken the approach of examining this question with individual actions and choices in mind.
Abstract concepts have their place in economics, but Smith did not extend his analysis any farther than “value” and “price”. If Smith had looked at this problem through the lense of an acting individual, he would have seen the obvious fact that nobody would ever pay a high price for water because water is so abundant! Nobody would pay such a high price when there is no reason to.
Smith and the Classical Economists avoided the individualistic approach when it came to the prices of diamonds and water. If only they had asked this question of themselves and why they do not pay a week's wages for a glass of water, we might have been spared the “Paradox of Value”.
Perhaps a trip to the beach would have shown Smith why water is so cheap.
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