As with so many things in economics, this story begins with Adam Smith. Smith considered, and rejected, the idea that demand must be related to "utility." This may seem self-evident: the more useful a thing is, the more satisfaction it gives, the more people would be willing to pay for it.
However, Smith saw a difficulty with this argument. The problem Smith posed has come down to us as the "Paradox of Diamonds and Water." As Smith observed, water is very useful -- indeed it is necessary for life. But water is very cheap. By contrast, diamonds have little utility. They are only useful for adornment. It is possible to do without diamonds entirely, and most people do. Yet diamonds are very costly. This is Smith's "paradox:" if demand depends on the usefulness of the product, then we would expect the more useful product, water, to command the higher price -- yet diamonds are more costly. Not only do we know that water is cheaper as a matter of fact, but most people would agree that they would not pay as much for diamonds as for water.
Because of this "paradox," Smith came to the conclusion that willingness to pay is not related to utility. To make sense of this strange result, he distinguished between "value in use" and "value in exchange." Value in exchange, he said, is unrelated to usefulness and must be based on other principles. What other principles? It was here that Smith relied on the labor theory of value. For a century, most economists felt that Smith had settled all this -- that value in exchange was based on different principles than value in use and specifically on labor value. Late in the nineteenth century, though, a new generation of economists found an answer to Smith's Paradox of Diamonds and Water, and returned to the idea that demand is based on utility. The Labor Theory of Value had come to play a key role in Marxism, and had a history of its own. We will have to leave this history for the chapter on Marxist economics, and for now go on to show how the New Economists of 1880 answered Smith's paradox.
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