LEADING ECONOMIC INDICATOR: One of eleven economic statistics that tend to move up or down a few months before the expansions and contractions of the business cycle. These leading indicators are -- manufacturers new orders, an index of vendor performance, orders for plant and equipment, Standard & Poor's 500 index of stock prices, new building permits, durable goods manufacturers unfilled orders, the money supply, change in materials prices, average workweek in manufacturing, changes in business and consumer credit, a consumer confidence index, and initial claims for unemployment insurance. Leading indicators indicate what the aggregate economy is likely to do, business-cycle-wise, 3 to 12 months down the road. When leading indicators rise today, then the rest of the economy is likely to rise in the coming year. And when leading indicators decline, then the economy is likely to decline in 3 to 12 months.
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The apparently conflicting and perplexing observation that water, which is more useful than diamonds, has a lower price than diamonds. This paradox was proposed by economists in the 1800s as a means understanding the role utility plays in the demand price of a good by differentiating between total utility and marginal utility. The diamond-water paradox poses the perplexing observations: Even though water is obviously important to human activity (life cannot exist without water), the price of water is relatively low. Alternatively, diamonds are clearly much less important to human existence, but the price of diamonds is substantially higher. In other words, the utility obtained from water is obviously very great, while the utility obtained from diamonds is substantially less.
The key question that arises is: Why are diamonds so much more expensive than water?
Total and MarginalInsight into, and clarification of, the diamond-water paradox results by differentiating between total utility and marginal utility.
Water provides humans with an enormous amount of total utility. Water satisfies A LOT of wants and needs for A LOT of people. Water provides a high level of total utility because it is plentiful--water, water everywhere! However, because it is so plentiful, the marginal utility of water is relatively low. An extra ounce of water provides very little additional satisfaction.
- Total Utility: This is the overall satisfaction of wants and needs obtained from consuming a good. That is, total utility is the accumulated amount of satisfaction, or the total value, generated by several units of a good.
- Marginal Utility: This is the extra satisfaction of wants and needs obtained from consuming one additional unit of good. That is, marginal utility is the incremental satisfaction generated by, and the value of, a single unit of a good.
In contrast, the total utility generated by diamonds is relatively limited. Diamonds do not provide much overall satisfaction of wants and needs, compared to water. Many humans spend their entire lives without achieving ANY satisfaction from diamonds.
Diamonds have very little total utility because they are not nearly as plentiful as water. Most houses do not have hot and cold running diamonds. Most people do not drink eight glasses of diamonds a day, take showers in diamonds, or fill their Olympic-sized swimming pools with hundreds of gallons of diamonds. However, because they are less plentiful, the marginal utility of diamonds is relatively high. An extra ounce of diamonds provides a great deal of extra satisfaction.
The Law of Diminishing Marginal UtilityThe key to the marginal utility difference between water and diamonds is the law of diminishing marginal utility. Because water is plentiful, marginal utility is quite low. The law of diminishing marginal utility works its magic on water, driving marginal utility down... to a very low level... to near zero.
However, because diamonds are substantially less plentiful, marginal utility is much higher. The law of diminishing marginal utility is not active to the same degree for diamonds.
Enter Demand PriceMarginal utility, not total utility, is the critical determinant of price. The price of water is relatively low because the marginal utility is relatively low. The price of diamonds is relatively high because the marginal utility is relatively high.
In general, people are willing to pay a relatively higher demand price for a good that generates relatively more satisfaction. However, because goods are sold on an incremental basis--one unit at a time--the additional satisfaction generated by each unit--that is, marginal utility--is the prime determinant of demand price.
Going to a Graph
Additional light can be shed on the diamond-water paradox using the generic marginal utility curve displayed to the right. Like any marginal utility curve, this one has a negative slope. As the quantity increases, the marginal utility decreases due to the law of diminishing marginal utility. Total utility is indicated by the area beneath the marginal utility curve.
|A Generic Demand Curve
Most importantly, marginal utility determines the demand price that buyers are willing and able to pay for the good. As marginal utility declines, so too does demand price.
Consider how the availability of diamonds and water might be reflected with this marginal utility curve.
- Diamonds: Because diamonds are limited in supply, people are likely to operate relatively high on the marginal utility curve, near the vertical axis. That is, the quantity consumed is relatively small. Click the [Diamonds] button to highlight this option.
Because the quantity is low, the marginal utility is high. The high marginal utility corresponds with a relatively high demand price. The total utility of diamonds, however, is indicated by the yellow area beneath the marginal utility curve. Because the quantity is limited, the total utility area is relatively small.
- Water: Because water is abundant in supply, people are likely to operate relatively low on the marginal utility curve, near the horizontal axis. That is, the quantity consumed is relatively large. Click the [Water] button to highlight this option.
Because the quantity is high, the marginal utility is low. The low marginal utility corresponds with a relatively low demand price. The total utility of water, however, is indicated by the yellow area beneath the marginal utility curve. Because the quantity is abundant, the total utility area is relatively large.
Paradox SolvedThe apparent contraction between price and utility is cleared up by distinguishing between marginal utility and total utility, and with the understanding that marginal utility, not total utility, is the key to determining price.
Moreover, this paradox can be turned on its head by considering what might happen should the relative abundance of water and diamonds change.
- If water were as limited as diamonds, then the marginal utility and thus price would also be quite high. In fact, if water and diamonds were equally limited in supply, the price of water would likely be several times the price of diamonds.
- If diamonds were as plentiful as water, then the marginal utility and price would also be quite low. If water and diamonds were equally abundant in supply, then the price of diamonds would likely be only a fraction of the price of water.
DIAMOND-WATER PARADOX, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2024. [Accessed: February 27, 2024].
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