AL. Econ Q.

Price, Value, Diamonds, and Water

In addition to the downward-sloping demand curve, another interesting result follows from the analysis of marginal value. As I pointed out earlier, there is no obvious relation between price (what you must give up to get something) and value (how much it is worth to you--what you are willing, if necessary, to give up to get it), a point nicely summarized in the saying that the best things in life are free. But if you are able to buy as much as you like of something at a per-unit price of P, you will choose, for the reasons discussed above, to consume that quantity such that an additional unit is worth exactly P to you. Hence in equilibrium (when you are dividing your income among different goods in the way that maximizes your welfare), the marginal value of goods is just equal to their price! If the best things in life really are free, in the sense of being things of which you can consume as much as you want without giving up anything else (true of air, not true of love), then their marginal value is zero!

This brings us back to the "diamond-water paradox." Water is far more useful than diamonds, and far cheaper. The resolution of the paradox is that the total value to us of water is much greater than the total value of diamonds (we would be worse off with diamonds and no water than with water and no diamonds), but the marginal value of water is much less than that of diamonds. Since water is available at a low cost, we use it for all its valuable uses; if we used a little more, we would be adding a not very valuable use, such as watering the lawn once more just in case we had not watered it quite enough. Diamonds, being rare, get used only for their (few) valuable uses. Relative price equals relative marginal value; diamonds are much more expensive than water.