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diti 3.5 (Related to Solved Problem 3.3 on page 88) In The Wealth gra of Nations, Adam Smith discussed what has come to be known as the diamond and water paradox: hig ply Nothing is more useful than water: but it will purchase scarce anything; scarce anything Sou can be had in exchange for it. A diamond com on the contrary, has scarce any value in use; 3.8 If a bu Bri 3.9 An glo shr but a very great quantity of other goods may frequently be had in exchange for it. Graph the market for diamonds and the market for water. Show how it is possible for the price of water to be much lower than the price of diamonds, even though the demand for water is much greater than the demand for diamonds. a. Source: Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, Vol. I, Oxford, UK: Oxford University Press, 1976; original edition, 1776. b. C.
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It all has to do with what is called marginal utility. It was not long ago when people were confused about the water-diamond paradox If we need water to live, wouldnt it be worth more than a diamond? People thought about this via total utility which is how happy you get from consuming a unit of water or diamonds and does not change as you consume more of it. Obviously the water is more important, so should be worth more. What economists like Adam Smith did not think about was decreasing marginal utility This theory states that as you consume more of something, you gain less utility (happiness) each time vou consume an additional unit. So, if you are dying of thrust in a desert and you find a machine that sells water for $150 you would probablybe willing to pay that price, but after you consume a few bottles of water, you are willing to pay less and less for each additional bottle, as you do not gain as much utility off each unit. So, at first you would take the water over the diamond, but as you consume more and more water, your utility gained per unit shrinks each time and so that diamond starts to look better and better.That pretty much sums it up. As vou consume more and more of something, you demand less of it or at least are not willing to give up as much of something else to gain another unit of it. As water is all over the place, you drink it often AS VOu drink it often and dont need more than what you consume to live, you start to spend your money on other things until you get thirsty again and so the utility gained from the water goes back up until it is greater than any other item So really, what you are willing to pay for the diamond or the unit of water depends totally on how much utility you gain from consuming the item in question at the specific time

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