Course Hero. "The Wealth of Nations Study Guide." Course Hero. 28 Sep. 2017. Web. 21 Apr. 2018. <https://www.coursehero.com/lit/The-Wealth-of-Nations/>.
Course Hero. (2017, September 28). The Wealth of Nations Study Guide. In Course Hero. Retrieved April 21, 2018, from https://www.coursehero.com/lit/The-Wealth-of-Nations/
(Course Hero, 2017)
Course Hero. "The Wealth of Nations Study Guide." September 28, 2017. Accessed April 21, 2018. https://www.coursehero.com/lit/The-Wealth-of-Nations/.
Course Hero, "The Wealth of Nations Study Guide," September 28, 2017, accessed April 21, 2018, https://www.coursehero.com/lit/The-Wealth-of-Nations/.
Smith now turns his attention to money, a topic that will occupy much of the remainder of The Wealth of Nations. Without a system of currency, he observes, the division of labor can only go so far—people end up with surplus goods and no way to profitably get rid of them. A baker, for example, might need meat, but if the butcher already has plenty of bread, no trade will be possible. To get around this inconvenience, people trade a portion of their "produce" (the farmer's grain, the baker's bread, etc.) for a commodity everybody is willing to accept. Metals—precious metals in particular—are a natural candidate for this purpose, since they don't decay and can be easily divided into smaller pieces. The minting of coins adds to these advantages by producing metal pieces of uniform weight and proven fineness.
In the last few paragraphs, Smith develops a definition of value, which will be the central topic of the next three chapters. There are two related kinds of value: "value in use," which is the usefulness of a commodity, and "value in exchange," which is "the power of purchasing other goods which the possession of [an] object conveys." Water, for example, has high use value but no exchange value, whereas diamonds have little use value but tremendous exchange value. The remainder of Book 1 will deal primarily with exchange value along with the related ideas of price and profit.
Smith is neither the first nor the last thinker to address the seeming disparity between the high price of diamonds, a merely ornamental good, and the low price of water, which is necessary to sustain life. The illustration he uses here is sometimes referred to as the diamond-water paradox, or the paradox of value. Smith's approach to the apparent paradox is to simply to distinguish between use value and exchange value, without further elaborating either of those concepts. This is not so much a solution as a re-labeling of the problem, since the question then becomes: "Why do diamonds have such a high exchange value despite having such a low use value?"
Roughly a century after The Wealth of Nations appeared, thinkers of the Austrian school proposed the explanation now widely taught in undergraduate economics courses. Their solution was grounded in the concept of utility, the subjective value of a commodity to a specific economic actor. The marginal utility of a pound of diamonds—the amount of extra, subjective value placed on having an additional pound of diamonds—would for most people be very high, and the marginal utility of a pint of water would be very low. These people already have all the water they need for drinking, washing, and other household purposes, but hardly any of them have appreciable amounts of diamonds. To a person dying of thirst in a desert, however, the marginal utility of diamonds might not be high at all, as she might not expect having more diamonds to improve her situation in any way. The marginal utility of water for such a person would, however, be very high, as even a small amount of water might make the difference between life and death. Smith largely ignores such subjective considerations in later chapters, although in a few places he hints at them. In Book 1, Chapter 11, for example, he correctly recognizes that the exchange value of gemstones is tied to their scarcity, rather than to their usefulness in any practical sense.