Question

Classical economists could not understand how utility could be the basis of prices when water, which is so necessary for life, is cheap, while diamonds, which are not at all necessary for life, are expensive. Explain how the neoclassical (marginalist) school solved the diamond-water paradox.

Short answer

The neoclassical (marginalist) school solved the diamond-water paradox by introducing the concept of marginal utility. The law of diminishing marginal utility states that the additional satisfaction derived from consuming an additional unit of a good decreases as more of the good is consumed. While water's total utility is high due to its essential role in life, its marginal utility is low because it is abundant and the satisfaction derived from additional units decreases. Conversely, the marginal utility of diamonds is high due to their scarcity and rare consumption, even though their total utility may be lower than water. Thus, marginal utility explains why diamonds are more expensive than water despite their lower overall importance to life.

Step-by-step solution

Understanding the Diamond-Water Paradox

The diamond-water paradox is a concept in classical economics that questions why diamonds, which are not essential for life, are more expensive than water, which is essential for life. The paradox highlights a discrepancy in the pricing system and challenges the notion that the value of a good is based solely on its utility.

Introduction to Marginal Utility

The neoclassical or marginalist school of thought introduces the concept of marginal utility to help explain the diamond-water paradox. Marginal utility is the additional satisfaction or benefit that a person receives from consuming an additional unit of a good or service. In this context, it helps explain how the market prices of a good can be determined not just by its total utility, but also by its marginal utility.

Declining Marginal Utility

According to the neoclassical school, the marginal utility of a good decreases as more of that good is consumed. This is known as the law of diminishing marginal utility. When people consume more of a good, the satisfaction they receive from each additional unit begins to decrease. This principle applies to both diamonds and water.

Applying Marginal Utility to the Diamond-Water Paradox

First, let's consider water. Water is essential for life, and its total utility is very high. However, due to its abundance, the marginal utility of an additional unit of water is relatively low. In essence, because water is so readily available and we consume it regularly, each additional unit of water consumed provides less and less satisfaction. On the other hand, diamonds are extremely rare and not consumed regularly. While their total utility may be lower than water, the marginal utility of an additional diamond is quite high due to their scarcity and infrequency of consumption. Essentially, each additional diamond acquired provides a significant increase in satisfaction compared to each additional unit of water.

Conclusion

The neoclassical (marginalist) school of thought resolves the diamond-water paradox by introducing the concept of marginal utility. By considering the additional satisfaction derived from each additional unit of a good, it explains how scarce, non-essential goods like diamonds can command higher prices than abundant, essential goods like water. This is because the marginal utility of diamonds is higher than that of water, as the satisfaction derived from additional units of water decreases due to its abundance, while the satisfaction from additional diamonds remains high due to their scarcity.

Key concepts

Marginal Utility

Marginal utility is a cornerstone concept in economics that plays a crucial role in explaining consumer behavior. When consumers decide to purchase goods or services, they do so based on the additional satisfaction or utility they anticipate from consuming one more unit of that good or service. This additional satisfaction is referred to as marginal utility.

For instance, imagine enjoying your favorite chocolate bar. The first bite is delightful, providing you with high utility. However, as you continue eating, each subsequent piece of chocolate may not feel as satisfying as the first bite. This personal valuation of satisfaction influences how much one is willing to pay for more of the chocolate, hence affecting its price in the market. Marginal utility quantitatively represents this decreasing satisfaction and is a key mechanism behind price determination in the realm of neoclassical economics.

Neoclassical Economics

Neoclassical economics is a school of thought that revolutionized economic theory by introducing concepts like marginal utility and subjective value. It suggests that the value of goods and services is derived from their ability to satisfy human wants, which is assessed individually by each consumer.

Within neoclassical economics, the behavior of consumers and firms is analyzed in terms of choices made under constraints, such as budgets for consumers or production technologies for firms. It replaces the classical economics notion of objective value—such as the labor theory of value—with the subjective theory of value. This mindset shift helps to solve riddles like the diamond-water paradox, where the subjective valuation based on scarcity and personal satisfaction levels takes center stage.

Law of Diminishing Marginal Utility

The law of diminishing marginal utility is a fundamental principle of economics, stating that, all else being equal, as consumption of a good or service increases, the marginal utility derived from each additional unit decreases. Essentially, it is the declining satisfaction or benefit someone gets from consuming another increment of a good or service.

Let’s take the example of drinking water on a hot day. The first glass quenches your thirst greatly—a high marginal utility. However, by your fourth or fifth glass, you may feel no additional thirst-quenching effect; the marginal utility of each extra glass has diminished significantly. This principle impacts the price we are willing to pay for goods and services and explains why people are not prepared to pay much for additional water while scarce items like diamonds retain high marginal utility and therefore command higher prices.

Classical Economics

Classical economics, pioneered by figures like Adam Smith and David Ricardo, centers around the idea that the value of goods and services can be objectively measured. A key tenet of classical economics is the labor theory of value, which asserts that the value of a good should be proportional to the labor required to produce it.

However, classical economics struggled to justify why non-essential items like diamonds could be more valuable than essentials like water. It was the introduction of marginal utility by the neoclassical economists that eventually addressed this shortfall by suggesting value is subjective and determined by individual preferences. By linking satisfaction and scarcity to value, neoclassical economics overcame the constraints of classical thought and provided a more comprehensive explanation for market prices.