We found this great article called "A Tale of Two Theories" By Ron Baker and wanted to share it with our readers.
Adam Smith was confounded. One of the greatest economic and social thinkers in the history of ideas struggled with the so-called “diamond-water paradox.”
None of us would be able to live beyond a couple of weeks without water, yet its price is relatively cheap compared to the frivolous diamond, which certainly no one needs to stay alive.
Most people resolve this paradox by replying the supply of diamonds is scarce compared to water. But this theory lacks explanatory power. If it did, those drawings by your kids on your refrigerator would be worth a few mortgage payments. Just because something is scarce does not make it valuable.
The Labor Theory of Value
Karl Marx had a theory, too. The labor theory of value still wields enormous influence over our present-day concept of value and price. Marx explained his theory in Value, Price and Profit, published in 1865:
"A commodity has a value, because it is a crystallisation ofsocial labour. The greatness of its value, or its relative value, depends upon the greater or less amount of that social substance contained in it; that is to say, on the relative mass of labour necessary for its production."
This sounds reasonable, but if Marx’s theory were correct, a rock found next to a diamond in a mine would be of equal value, since each took the same amount of labor hours to locate and extract.
If you have pizza for lunch today, under Marx’s theory, your tenth slice would be just as valuable as your first, since each took the same amount of labor hours to produce.
One glaring flaw in Marx’s theory was it did not take into account the law of diminishing marginal utility, which states the value to the customer declines with additional consumption of the good in question.
The Marginalist Revolution of 1871
Fortunately, three economists developed the theory of marginalism and created a revolution: William Stanley Jevons from Great Britain, Leon Walras from France, and Carl Menger from Austria.
There were forerunners to the marginal theory, but it was not until these three came together that the theory was accepted as valid in the economics profession. The idea that all value is subjective seems obvious is retrospect, given how consumer preferences and tastes can change on a whim.
So what made this new theory so revolutionary? As Menger explains in his book Principles of Economics, written in 1873:
"Value is…nothing inherent in goods, no property of them. Value is a judgment economizing men make about the importance of the goods at their disposal for the maintenance of their lives and well-being. Hence value does not exist outside the consciousness of men…[T]he value of goods…is entirely subjective in nature."
Value is like beauty—it is in the eye of the beholder. This theory has enormous explanatory. Philip Wicksteed, a British clergyman, wrote scientific critique of the Marxian labor theory of value in 1884, where he explained:
"A coat is not worth eight times as much as a hat to the community because it takes eight times as long to make it….The community is willing to devote eight times as long to the making of a coat because it will be worth eight times as much to it."
Still, cause and effect is confused constantly on this principle in businesses to this day. I remember taking a wine tour of Far Niente in Napa where the guide was explaining how one particular vintage had to be bottled by hand, which was why it was more expensive—due to the extra labor this entailed.
I could not help thinking: No, you are willing to invest in the labor necessary to bottle the wine by hand because some customers find it valuable (and delicious!) enough to cover the extra labor costs.
Why Are Diamonds More Expensive Than Water?
The German economist Hermann Heinrich Gossen developed what is known as Gossen’s Law: The market price is always determined by what the last unit of a product is worth to people.
While the first several gallons of water may be vital for your survival, the water used to shower, flush the toilet, and wash the dishes is less valuable. Less valuable still is the water used to wash your dog, your car, and hose down your driveway.
On the other hand, the marginal satisfaction of one more diamond tends to be very high.
If water companies knew you were dehydrated in the desert they would be able to charge a higher price for those first vital gallons consumed, and then gradually adjust the price downwards to reflect the less valuable marginal gallons.
Since they do not possess this information—the cost of doing so would be prohibitive—the aggregate market price for water tends to be based upon its marginal value.
Old Fallacies Die Hard
Thomas Sowell explains in his book, Basic Economics, how the economics profession finally overcame the labor theory of value:
"By the late nineteenth century, however, economists had given up on the notion that it is primarily labor which determines the value of goods. This new understanding marked a revolution in the development of economics. It is also a sobering reminder of how long it can take for even highly intelligent people to get rid of a misconception whose fallacy then seems obvious in retrospect. It is not costs which create value; it is value which causes purchasers to be willing to repay the costs incurred in the production of what they want."
That all value is subjective is difficult for many business people to accept, but it does explain how we humans spend money.