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October 31, 2014 

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EUROPEAN UNION: The economical and political integration of a dozen European nations created by the Maastricht Treaty signed in 1992. The twelve nations forming the European Union (commonly abbreviated EU) are Belgium, Denmark, Greece, Germany, Spain, France, Ireland, Italy, Luxembourg, Netherlands, Portugal, and Great Britain. Three additional nations that have joined the original dozen are Austria, Finland and Sweden. The Economic Union was actually one of several steps by European nations after the end of World War II to promote integration. This Economic Union was established to reduce or eliminate many tariffs and nontariff barriers, create a single monetary unit (the euro), establish of a common military and defense policy, and centralize monetary policy.

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DIAMOND-WATER PARADOX:

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 Marginal

Insight into, and clarification of, the diamond-water paradox results by differentiating between total utility and marginal utility.
  • 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.
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.

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 Utility

The 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 Price

Marginal 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

A Generic Demand Curve
The Paradox

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.

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 Solved

The 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.

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Recommended Citation:

DIAMOND-WATER PARADOX, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2014. [Accessed: October 31, 2014].


Check Out These Related Terms...

     | consumer surplus | marginal utility and demand | utility measurement |


Or For A Little Background...

     | utility | total utility | marginal utility | marginal utility curve | consumer demand theory | marginal analysis | law of diminishing marginal utility | law of demand | demand | demand price |


And For Further Study...

     | cardinal utility | ordinal utility | util | utilitarianism | marginal utility-price ratio | utility maximization | constrained utility maximization | consumer equilibrium | rule of consumer equilibrium | marginal utility-price ratio | utility analysis | income change, utility analysis | price change, utility analysis | preferences change, utility analysis |


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