A Tale of Two Theories

In the final analysis, I find nothing as intellectually satisfying as the history of ideas. … [W]ithout the history of economics, economic theories just drop from the sky; you have to take them on faith. The moment you wish to judge a theory, you have to ask how they came to be produced in the first place and that is a question that can only be answered by the history of ideas.

—Mark Blaug, Not Only an Economist, 1997

Adam Smith (1723–1790) was confounded. One of the greatest economic and social thinkers in the history of ideas struggled with the so-called diamond-water paradox, which Smith explained in Chapter 4 of Book I of The Wealth of Nations: “Nothing is more useful than water: but it will purchase scarce anything. … A diamond, on the contrary, has scarce any value in use; but a very great quantity of other goods may frequently be had in exchange for it” (Skousen and Taylor 1997: 27). 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. This conundrum led to some incredible discoveries, advancing our understanding of value.

Most people confronted with this paradox—including Smith—would resolve it by replying the supply of diamonds is sparse compared to water, and hence they command a higher price. This is an intuitive and very reasonable solution. Water is approximately 71 percent of the earth’s surface, while ...

Get Implementing Value Pricing: A Radical Business Model for Professional Firms now with the O’Reilly learning platform.

O’Reilly members experience live online training, plus books, videos, and digital content from nearly 200 publishers.