How much should be paid for a good? Why?
Adam Smith was one of the first to notice that goods have both value in use and value in exchange.
(value in use - a capacity to satisfy a need, called utility; value in exchange - in relation to other goods and ultimately money and the can therefore be expressed as a price).
There did not seem to be any relationship between utility and price. The phenomenon, known as the water and diamond paradox, is best known - water (which is indispensable) is cheap in comparison with diamonds (which is of little practical use - that was before we started using them in industry!).
Smith also noticed that goods having value have another property in common - it takes time and effort to produce and bring them to market. Thus different quantities of labour are incorporated into the product - diamonds take more effort than water to produce. This gave rise to the labour theory of value. The Classical School expanded on this concept by incorporating cost of the other factors of production into the price as well.
Proponents of the Austrian School however pointed out that if a product has no value in use, though it may have cost a great deal to produce, it would not be able to be sold. Compare cookies baked with flour and others baked with cement powder instead. Unless one wanted ready made rocks in a riot, the cement cookies wil have no utility at all. Therefore one can clearly see that the utility of a product holds the key in price formation.
Still the problem of the value of diamonds versus water has not yet been resolved, surely the utility of water is greater than the utility of a sparkling stone? An important aspect play a role here - the first is that there is normally a lot of water going around and it is the loss of one unit in relation to the total quantity does not mean a lot (the marginal utility - more about this later) and diamonds are scarce...
The issue of price depends on the subjective value that buyers and sellers place on a product - sellers have the cost of production in mind and buyers the utility of the good. Alfred Marshall combined these approaches into a cohesive system. It is as useless arguing about which blade of a scissors does the cutting as it is to argue who determines price on a market. It is the market process that is important. One can even say that the definition of a market is the process wherby prices of goods and services are established.
C.M. Heydenrych - February 2011.