Imagine you’re on a game show and you get to choose between two prizes: a diamond or a bottle of water! It’s an easy choice. Diamonds are clearly more valuable. Now imagine being given the same option again, only this time, you’re not on a game show, but dehydrated in the desert after wandering for days. Do you choose differently? Because? Aren’t diamonds even more valuable?
This is the value paradox, famously described by pioneering economist Adam Smith. And what he tells us is that defining value is not as simple as it seems.
In the game show, you were thinking about the trade value of each item, what you might get for them later, but in an emergency, like in the desert setting, what matters much more is their use value, what so useful they are in your current situation. situation. And because we can only choose one of the options, we must also consider its opportunity cost, or what we lose by giving up the other option. After all, it doesn’t matter how much you can get from selling the diamond if you never make it out of the desert.
Most modern economists romanticize with the paradox of value by trying to unify these considerations under the concept of utility, how well something satisfies a person’s wants or needs.
Utility can apply to anything from the basic need for food to the pleasure of listening to a favorite song, and will naturally vary for different people and circumstances.
A market economy provides us with an easy way to track profit. Simply put, how useful something is to you is reflected in how much you would be willing to pay for it.
Now imagine yourself back in the desert, only this time you are offered a new diamond or a fresh bottle of water every five minutes. If you’re like most people, you’ll first choose enough water for the trip, and then as many diamonds as you can carry. This is due to something called marginal utility, and it means that when you choose between diamonds and water, you compare the utility gained from each additional bottle of water to each additional diamond. And you do this every time an offer is made.
The first bottle of water is worth more to you than any number of diamonds, but eventually you have all the water you need. After a while, each additional bottle becomes a burden. That’s when you start picking diamonds over water.
And it’s not just necessities like water. When it comes to most things, the more you buy, the less useful or enjoyable each extra bit becomes. This is the law of diminishing marginal utility.
You could gladly buy two or three servings of your favorite food, but the fourth would make you nauseous and the hundredth would go bad before you could get to it. Or you could pay to watch the same movie over and over until you get bored or use up all your money. Either way, you’ll eventually reach a point where the marginal utility of buying another movie ticket becomes zero.
Utility applies not just to buying things, but to all of our decisions. And the intuitive way to maximize it and avoid diminishing returns is to vary the way we spend our time and resources. Once our basic needs are met, we would theoretically decide to invest in options only to the extent that they are useful or enjoyable.
Of course, how effectively any of us manages to maximize utility in real life is another matter. But it helps to remember that the ultimate source of value comes from us, the needs we share, the things we enjoy, and the decisions we make.
