Put forth by Adam Smith in “The Wealth of Nations”, the paradox of value tries to explain why luxuries such as diamonds are incredibly expensive, whereas goods such as water which are critical to the survival and existence of human being are so cheap. The real question here is that why such items, luxuries like gold and diamonds, which do not even have high levels of demand are priced so much more than the necessities of everyday life.
One of the approaches to answer this paradox is that the true value of an item is not determined just by the demand side, but it is also affected by the supply side too. Here, scarcity explains a lot. Simply put, although gold has lower levels of demand compared to water, its supply is also very limited, which gives it such great value. On the other hand, despite its high demand, water is very cheap because its supply is way more than the demand.
Another important factor is that, diamonds and gold are highly accepted in almost any society as a means of exchange. That is to say, you can easily exchange such luxuries for other goods and even change them with money, while water cannot be exchanged for other goods as it is currently abundant in many parts of the world and is not believed to have much intrinsic value.
So, what would happen, if someday water becomes extremely scarce in a certain geographic location?
Further Reading
– Resolving the paradox of value
– How can marginal utility explain the ‘diamond/water paradox’?