Theories of value
Adam Smith (1723–90)
1691 English philosopher John Locke connects a commodity’s value to its utility (the satisfaction it affords).
1737 Swiss mathematician Daniel Bernoulli poses the “St Petersburg Paradox,” examining how players can evaluate options involving chance. The paradox is resolved by applying the concept of marginal utility.
1889 Austrian economist Eugen von Böhm-Bawerk develops the subjective theory of value (the value of an object depends on a person’s needs rather than the object itself), using the idea of marginal utilities.
In 1769, Anne-Robert-Jacques Turgot noted that despite its necessity, water is not seen as a precious thing in a well-watered country. Seven years later Adam Smith took this idea further, noting that although nothing is more useful than water, hardly anything can be exchanged for it. Although a diamond has very little value in terms of use, “a very great quantity of other goods may frequently be had in exchange for it.” In other words, there is an apparent contradiction between the prices of certain commodities and their importance to people.
This paradox can be explained with the help of a concept known as marginal utility: the amount of pleasure gained from the last unit of the commodity consumed. In 1889, the Austrian economist Eugen von Böhm-Bawerk explained it through the example of a farmer with five bags of wheat. The farmer’s use of the wheat ranges from important—feeding himself—to trivial—feeding birds. If he loses a bag of wheat, he will merely stop feeding the birds. Even though the farmer needs wheat to feed himself, the price he is willing to pay to replace the fifth bag of wheat is low, because it only generates a small amount of pleasure (feeding birds).
Water is abundant, but diamonds are scarce. One extra diamond has a high marginal utility and so commands a much higher price than an extra cup of water.
Diamonds are worth more than water because each one is extremely valuable no matter how many you have, while water becomes less valuable, per unit, as quantities increase.