Diamond-Water Paradox

Adam Smith and Karl Marx believed that price was determined by input prices, mainly that of labor, from where we get Marx's "labor theory of value" and ultimately his notion of capitalist exploitation. But in time, economists would come to believe that price was also affected by subjective valuations of goods and services by consumers, and not merely by producer costs. These people, now called the "marginalists," argued that people had a willingness to pay for goods and services, and that goods and services had both a total value, but also importantly, and importance at the margin. This distinciton was useful because it helped us better understand why water, which had such a tremendously high value to anyone, was so cheap, yet diamonds, which were not as useful, were so expensive. Water's marginal benefits were much lower, because of declining marginal benefits associated with water consumption. That is, once you had satisifed your thirst, the next unit of water did not have all that much marginal benefit to anyone, and that this helped determine ultimately the price.

In light of the Eliot Spitzer scandal, it's fun to re-read Dwight Lee's old FEE article, "Marriages, Mistresses and Marginalism" which frames the decision to take on a mistress as a kind of water-diamond paradox sort of problem.