In his famous work The Wealth of Nations, Adam Smith articulated a paradox that he could not resolve: water is essential to life; diamonds a mere decoration. Yet for all that, we are willing to lavish enormous sums on pretty rocks while taking clean water for granted. What could explain this disconnect?
Smith’s confusion stemmed from his understanding of the source of economic value. The eighteenth century, while an age of enlightenment and revolution, was still very much mired in the religious worldview of the Medieval era, and many great thinkers believed that God imbued the world with value. It must have been quite difficult to imagine any sort of value, let alone that of economic goods, originating from some source other than the Creator of all things. Indeed, Smith, like many of his contemporaries, ascribed to an intrinsic understanding of value, one which saw prices as a manifestation of some “objective” quality of the thing being sold.
That quality was the amount of labor that went into the production of the commodity in question. “The real price of everything, what everything really costs to the man who wants to acquire it, is the toil and trouble of acquiring it,” asserted Smith. His view has a certain intuitive appeal to it. Now known as the “labor theory of value,” this perspective holds that the prices of goods on the market are ultimately determined by the effort expended in their production.
This, of course, begs the question: what determines the price of labor? On Smith’s account, there is nothing else to turn to:
Labor was the first price, the original purchase-money that was paid for all things. It was not by gold or by silver, but by labor, that all the wealth of the world was originally purchased; and its value, to those who possess it, and who want to exchange it for some new productions, is precisely equal to the quantity of labor which it can enable them to purchase or command.
In this way, labor can be understood as the genesis of all value, the first building block upon which all economic goods rest. It is easy to see why this account took hold in the eighteenth and nineteenth centuries. It seemed to explain the inflated prices of labor-intensive goods such as cotton and saffron, which demanded hours of sweat from peasants (and slaves) for a relatively small amount of raw material. It also entails that an informed expert could, with the proper information, calculate the “true price” of a good. Yet that’s not all: the labor theory of value instills a sense of justice into market transactions.
According to the labor theory of value, those goods that people must work hard to produce are highly valued. On the other hand, those goods that are produced with ease do not fetch an impressive price. This characterization of market value has an obvious appeal, because it seems to reward human effort.
Many great thinkers followed Smith in ascribing to this view. David Ricardo, the famous nineteenth-century defender of free trade, further refined Smith’s position, which was taken up by another famous economist, Karl Marx. Marx was careful to differentiate between what may be simply called “effort” and “labor.” For example, he believed that there is a difference between skilled and unskilled labor, so that one hour of skilled labor may be equal to two hours of unskilled labor.
Yet despite this differentiation, Marx was obsessed with aggregates, and his formulation of social necessity is just one example. To a Marxist proper, the amount of time actually expended in the production of a good does not matter as much as the amount of time that it should take to produce something. As Marx put it, “that which determines the magnitude of the value of any article is the amount of labor socially necessary, or the labor time socially necessary for its production.” Social necessity is derived from the average level of productivity in a given society, regardless of the time spent on any item in particular.
Marx wrote Das Kapital nearly 100 years after Smith’s The Wealth of Nations made its debut in 1776. The continuity of the labor theory of value between these two otherwise diametrically opposed works is remarkable, and speaks to its hegemony in classical economics. It also gives evidence of the intractability of the diamond-water paradox: in 1860, there was still no explanation for the fact that diamonds fetch a higher price than water. Yet a few years before Marx published his magnum opus, a new theory arrived on the scene, proposed by three thinkers almost simultaneously.
Three economists developed an alternative explanation of economic phenomena in the 1860s and 1870s. While working independently, William Stanley Jevons (British), Carl Menger (Austrian), and Marie-Esprit-Léon Walras (Swiss) all proposed that economic value comes not from any quality of the good in question, but from the human mind.
Menger gives an unusually artistic description of this development in his Principles of Economics:
If the locks between two still bodies of water at different levels are opened, the surface will become ruffled with waves that will gradually subside until the water is still once more. The waves are only symptoms of the operation of the forces we call gravity and friction. The prices of goods, which are symptoms of an economic equilibrium in the distribution of possessions between the economies of individuals, resemble these waves. The force that drives them to the surface is the ultimate and general cause of all economic activity, the endeavor of men to satisfy their needs as completely as possible, to better their economic positions. But since prices are the only phenomena of the process that are directly perceptible, since their magnitudes can be measured exactly, and since daily living brings them unceasingly before our eyes, it was easy to commit the error of regarding the magnitude of price as the essential feature of an exchange, and as a result of this mistake, to commit the further error of regarding the quantities of goods in an exchange as equivalents. The result was incalculable damage to our science since writers in the field of price theory lost themselves in attempts to solve the problem of discovering the causes of an alleged equality between two quantities of goods. Some found the cause in equal quantities of labor expended on the goods. Others found it in equal costs of production. And a dispute even arose as to whether the goods are given for each other because they are equivalents, or whether they are equivalents because they are exchanged. But such an equality of the values of two quantities of goods (an equality in the objective sense) nowhere has any real existence. The error on which these theories were based becomes immediately apparent as soon as we free ourselves from the one-sidedness that previously prevailed in the observation of price phenomena.
This theory of value thus focuses not on visible economic phenomena, but on the forces that bring them into being: “the endeavors of men to satisfy their needs as completely as possible.” Indeed, all three of the authors of what is now known as the Marginal Revolution emphasize the role that an individual’s mental states play in the creation of value.
What explains economic value, in this new system? On Menger’s view, “value is the importance that individual goods or quantities of goods attain for us because we are conscious of being dependent on command of them for the satisfaction of our needs” (115). This implies that goods that are always and everywhere readily available do not attain an economic value—we are not dependent on command for them for the satisfaction of our needs if we already have them at hand. Only scarce goods can come into our consciousness in this way. It also implies that “true prices” do not exist, because prices are the result of subjective valuations.
This focus on mental phenomena helps explain why certain goods that might be seen as important resources today had no monetary value hundreds of years ago. It is not any immutable and unchanging feature of an item that gives it value. Rather, value comes from human perception.
Yet how does the subjective theory of value resolve the diamond-water paradox? Put another way, why do human subjects not recognize the greater importance of water in their purchases?
The answer lies in the crucial focus on individual goods and services. Classical economists saw diamonds and water as aggregates, or categories. However, Jevons, Menger, and Walras perceived that people interact only with individual goods. In other words, no one chooses between “all of the diamonds” and “all of the water.” Rather, people select discrete units of water and discrete units of diamonds. Hence the “Marginal” Revolution.
When people ascribe value to a good, they value each unit of each good according to the least urgent need that can be satisfied by that good. Or put another way, goods attain their value through their marginal utility. As one classic example goes, a farmer who has five sacks of grain may devote the first two to foodstuffs, then, one to feeding her animals, the fourth to distilling hard liquor, and the final sack to feeding birds that perch on her barn. If the farmer were to lose one sack of grain, she wouldn’t reduce each of these activities by one-fifth. Instead, she would stop the least valuable activity—that of feeding birds—and preserve the most valuable activities intact. Thus, the value of one sack of grain to the farmer is precisely the satisfaction she stands to lose if she is unable to feed birds. This is the marginal utility of each sack.
In normal circumstances, people intent on buying diamonds have no further need for any concrete quantity of drinking water. They don’t stand to lose any amount of satisfaction if they pass up the chance to use more water. Yet the same isn’t true of diamonds, which are typically scarce enough so that, in Menger’s words, “even the least significant satisfactions assured by the total quantity available still have a relatively high importance to economizing men.” This explains the higher price of a unit of diamonds compared to a unit of water. It’s also worth noting that the marginal approach also holds true in unusual circumstances. If someone on a desert island must choose between a chest full of diamonds and a gallon of water, chances are they’ll prefer the water.
Jevons, Menger, and Walras succeeded in explaining diverse economic phenomena, and resolved a paradox that had befuddled Adam Smith, Karl Marx, and all who came between and before them. Their insistence on the subjective nature of economic value, and the impossibility of calculating the “true cost” of any good, continues to challenge many notions widely held today.
 Smith, Wealth of Nations, 28.
 Menger, Principles of Economics, 40.
Adam De Gree is a freelance writer and homeschool history teacher based in Prague. He studied Philosophy at UC Santa Barbara and can be reached by email here.