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DIAMOND-WATER PARADOX: The perplexing observation that water, which is more useful than diamonds, has a lower price. If price is related to utility, how can this occur? This paradox was first proposed by classical economists in the 19th century and was subsequently used as a stepping stone for developing the notion of marginal utility and the role it plays in the demand price of a good. The paradox is magically cleared up with an understanding of marginal utility and total utility. People are willing to pay a higher price for goods with greater marginal utility. As such, water which is plentiful has enormous total utility, but a low price because of a low marginal utility. Diamonds, however, have less total utility because they are less plentiful, but a high price because of a high marginal utility.

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Lesson 13: Aggregate Demand | Unit 1: The Concept Page: 2 of 22

Topic: Circular Flow <=PAGE BACK | PAGE NEXT=>

Aggregate demand and the aggregate market are all about the flow of production through the product markets of the circular flow.

The circular flow is the continuous flow of production, income, and resources between households and businesses.

  • Businesses acquire the services of productive factors through the factor markets
  • Households acquire the resulting production from businesses through the product markets
  • The aggregate market combines all of the individual markets for individual goods and services into a overall, comprehensive, complete, aggregate product market.
  • This is the demand side of the aggregate market.

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MARGINAL REVENUE CURVE, MONOPOLISTIC COMPETITION

A curve that graphically represents the relation between the marginal revenue received by a monopolistically competitive firm for selling its output and the quantity of output sold. Because a monopolistically competitive firm is a price maker and faces a negatively-sloped demand curve, its marginal revenue curve is also negatively sloped and lies below its average revenue (and demand) curve. A monopolistically competitive firm maximizes profit by producing the quantity of output found at the intersection of the marginal revenue curve and marginal cost curve.

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