ECO204 Assignments Week 4 Market Structures

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ECO204: Principles of Microeconomics

Dr. Akhmedjonov

April 4, 2022

Introduction

In 1776, economist Adam Smith posed the famous Diamond-Water Paradox which asks why diamonds are so much more valued than water when they offer so much less utility. The answer to this question is explained by the law of diminishing marginal utility which asserts “The greater the supply we have of something and the more we use it, the less we value it” (Muhammed, 2018). Like many economists, mathematicians, and philosophers prior, this composition will seek to assess why diamonds are more expensive than water, as well as the relationship between total utility and marginal utility, whether marginal utility can be negative or not, the law of diminishing marginal utility, and how the law of diminishing marginal utility can explain the diamond-water paradox.

 The relationship between total utility and marginal utility

In economics, total utility is used to describe the satisfaction a specific individual derives from consuming a good. Total utility is measured by assigning a quantitative value, known as a util, to the utility of consuming a specific good. Marginal utility can be described as “the amount of utility that one more or one less unit consumed adds to or subtracts from total utility” or “the change in satisfaction provided by one more or one less unit of consumption” (Amacher & Pate, 2019). Marginal utility is found by calculating the change in total utility divided by the one-unit change in quantity consumed. The relationship between these two calculations is represented by the principle of diminishing marginal utility. Although total utility can increase at a constant rate to an extent, the marginal utility will decline as consumption increases due to the total utility from each additional unit consumed diminishing. Simply put, when total utility is increasing, marginal utility is declining. When graphed, one can visually see that the point where total utility begins to decrease is also the point where marginal utility goes negative, which is a possibility.

Why are diamonds more expensive than water?

Diamonds are more expensive than water for the simple fact that there is a large amount of water available compared to the number of diamonds available. Because of these simple facts one can deduce that although the total utility of water is high, the marginal utility of water is low and while the total utility of diamonds is low, the marginal utility of diamonds is high. The solution to this paradox suggests that price is directly related to scarcity through utility.

“If something is relatively scarce and has a high marginal utility, it will be valuable and thus expensive” (Amacher & Pate, 2019).

Exception to the law of diminishing marginal utility

There are exceptions to the law of diminishing marginal utility. For example, stamps are readily available and not at risk for scarcity. To a stamp collector, utility will constantly increase as more stamps are collected. The utility of the stamps would not be reduced by adding more because the utility to this individual is assigned to the addition of new stamps rather than their functional utility. This exception applies to many variations of hobbies and

is derived from utility being an individual, subjective concept.

Conclusion

The law of diminishing marginal utility states that the more there is of a good, and the more that good is used, the less marginal value it has. As discussed, this is sought to be understood by the water-diamond paradox and explained by understanding that scarcity

drives price through utility.

Resources

Amacher, R., & Pate, J. (2019). Principles of microeconomics (2nd ed.). Bridgepoint Education.

Mohammed, F. (2018, February 12).  Why are diamonds more expensive than water?   (Links to an

external site.) JSTOR Daily. https://daily.jstor.org/diamonds-expensive-water

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