MICRO ECONOMICS (Principles of Economics)
THE WATER-DIAMOND PARADOX
The water diamond paradox or puzzle was a mystery of Adam Smith; one of the historical economists. He observed that the price of diamonds was much higher than that of water even though water seemed to offer for more utility than diamonds. This puzzle raises a question that “why is water which is more essential to human life cheaper than diamonds which is less essential?” The resolution of this puzzle or paradox is based on the distinction between marginal utility and total utility.
We note that total utility of water, that is its life giving benefit is indeed much higher than that of diamonds. But also as we have noted, price is directly related to marginal utility rather than to total utility. And indeed the optimal purchase rule states that price will tend to be equal to marginal utility. This means that the higher the marginal utility, the higher the price and the lower the marginal utility, the less the price, clearly there is every reason to expect the marginal utility of water to be very low while the marginal utility of diamonds to be very hence their corresponding prices. Indeed water is extremely plentiful in many parts of the world, so its price should generally be very low. This means that consumers will correspondingly use large quantities of water. But according to the law of diminishing marginal utility. The marginal utility of water to any household will be very low, hence he is willing to pay a low price for water.
On the other hand, diamonds is very scarce, implying that less quantities of diamonds will be consumed by any household. Therefore the marginal utilities of diamonds is very high and so consumers are willing to pay higher prices for diamond, than for water.
The above analysis leads to a deduction that the more scarce a commodity is, the higher its marginal utility and its market price will be, regardless of the size of its total utility. In other words, scarcity raises price and marginal utility but not necessarily total utility.
Written By A. B. Kintu, B. Comm (Hons) Marketing Makerere University (2007).