No Free Lunch: Economics for a Fallen World: Third Edition, Revised

Chapter Two: Fundamentals of Economic Behavior 41 particular diamond? And the answer to that depends on how much an additional unit of water contributes to our well-being (or as economists like to say, utility) compared to how much an additional diamond does. If we already have plenty of water, an additional gallon is worth next to nothing. But in the desert… It was left to the neoclassical economists Carl Menger, Leon Walras, and William Stanley Jevons to solve the Diamond-Water Paradox. They each independently arrived at a value theory based on marginal utility, which showed that it is each unit’s contribution to utility (the marginal utility) that determines its value. (See chapter 3 for an elaboration of marginal utility.) A different example may bring this closer to home. How much you value a slice of pizza varies tremendously with how hungry you are. For instance, after a long afternoon at the park, you may decide to order a Domino’s Pizza. How much do you value that first slice of pizza? Probably pretty high—after all, you’re ravenous. If you were forced to pay what it was worth to you, you might pay $3 or $4 for that first slice of pizza. But as you keep eating, you slowly get fuller and fuller. Now there is just one slice of pizza left in the box. You’re not even sure you can get it down since you’re so full. How much would you be willing to pay for that slice? Ten cents? No idea? But we can be certain that it will be less than you were willing to pay for the first slice of pizza, because the marginal utility—or the contribution that last slice of pizza makes to your satisfaction—is less than for the first slice. Back to french fries. Think about how good that first hot french fry tastes compared to the last one at the bottom of the package. Everyone likes the first ones better, and not just because they are hotter and fresher. We slowly satisfy the desire for french fries as we eat more and more. We value each additional french fry, the marginal french fry, less and less. THE DIAMOND WATER PARADOX: THE FAILURE OF CLASSICAL ECONOMICS Classical economics made huge contributions to economics, showing us how trade benefits both parties in an exchange, how the division of labor allows greatly expanded production, and what really constitutes the wealth of nations. Yet the classical economists failed to understand the nature of value. They thought value must be objective, and relied on the labor theory of value to predict exchange value. Adam Smith’s famous example of the labor theory of value was the trade of beaver for deer. If catching a beaver takes twice the labor hours as capturing a deer (assuming both are equally pleasant or difficult activities), a beaver ought to exchange for twice the price of a deer. And while labor content often affects long run pricing trends, it really doesn’t explain any individual trade. The classical economists defined two separate classes of value: value in use and value in exchange. Water, after all, is very valuable in use, but worth little in exchange. Diamonds, however, are worth little in use, but very valuable in exchange. The classical economists could not explain why these two values were different, given their acceptance of the labor theory of value—thus the paradox.