Léon Walras is considered by some to be the greatest economist ever, for his marginal theory of value and general equilibrium theory. He put the concepts of Supply and Demand, and Adam Smith’s Invisible Hand, on a solid mathematical footing, including explaining circumstances where they wouldn’t work, where governments and therefore the public must intervene. We have seen many such cases, most notably monopolies, hyperinflations, and asset bubbles, but also the Republican program of tax cuts and deregulation as the answer to every problem. Gérard Debreu much later gave a deeper mathematical treatment of these same concepts and issues.
Let us see how the idea of marginal value helps to explain the diamond–water paradox, which goes back to before Adam Smith.
- What is the marginal utility of water? The first few units, necessary for life, can be assigned infinite value. Further units for drinking and cooking, and then for washing or for growing crops have various finite values based on personal preferences or opportunities for profit. Then again we get into market distortions, as when allocations of river or lake or ground water add up to more water than there is. Apart from that, the world’s supply of water from rain is huge, and its marginal value is therefore quite low in most places, so that many of us can waste it on lawns.
- What is the marginal utility of a diamond? Nobody needs to own diamonds in order to live. There are industrial and scientific uses of diamond, and strong social preferences for diamond jewelry. Blood diamonds are a major distortion of the market, as is the deBeers monopoly on diamond marketing. The supply of diamond is limited by geology. Diamonds formed in the Earth’s mantle in vast quantity billions of years ago, but only rarely come to the surface in volcanoes.
Supply and demand are such familiar and foundational concepts that they are introduced right at the beginning of economics textbooks and courses, with little examination of the complications that occur in real markets. But it was not so in the times of Adam Smith and his successors. Walras took his time getting through these complexities in his book. One of his great contributions was to talk about the nature and value of frictionless or competitive markets. He compared this to the study of frictionless systems in physics before taking up the complexities of mechanical friction.