Diamond-Water Paradox | Definition, Explanation & Examples

Theory of Marginal Utility

The theory of marginal utility was based on the subjective theory of value, further developing the idea of value with a focus on utility. It was also developed by several 19th-century economists, including Carl Menger, William Stanley Jevons, Leon Walras, Friedrich von Wieser, and Eugen von Bohm-Bawerk. The theory of marginal utility suggests that an object's price is not solely based on how much labor is required to produce it nor on subjective preferences; it also considers how much marginal utility it can provide. Marginal utility refers to the satisfaction, utility, or marginal benefit that a person gets from consuming an additional unit of a good. This is important because it breaks these economic concepts into smaller units and allows for a more detailed analysis. For example, the first glass of water you drink in a day will have a higher marginal utility than the second glass because you are thirstier.

The theory of marginal utility explains that diamonds are more expensive than water because they have a higher marginal utility for many people. In other words, people are not making a valuation of all the world's diamonds versus all the world's water. Instead, they are concerned with how much additional marginal utility they will get from purchasing a singular next diamond versus a singular next glass of water. So for many people, the value or marginal utility of an extra diamond is higher than the marginal utility of an extra glass of water.

Supply and Demand

This paradox can also be thought of in terms of supply and demand. The law of supply and demand is a basic economic principle that states that when there is more of a good available, the price of the good will go down; when there is less of a good available, then the price of the good will go up. This happens because people are willing to pay more for a scarce resource.

When applied to the diamond-water paradox in conjunction with the theory of marginal utility, it becomes more clear why diamonds are more expensive than water. In most places, water is relatively easy to obtain and thus has a low marginal cost when measured against demand. While diamonds are much more scarce, they are high in demand and have a relatively high marginal utility. A few key economists solved the diamond-water paradox, such as Carl Menger, William Stanley Jevons, and Leon Walras. Their work played a crucial role in developing an understanding of how scarcity, satisfaction, and marginal utility play a role in the value we place on goods and services.

One final aspect to consider is opportunity costs, which are the costs of foregone opportunities. In other words, it is what people give up when they make a choice. For example, if someone chooses to buy a diamond instead of a car, that person gives up the opportunity to buy a car. Opportunity cost is an important concept because it helps explain why diamonds are valued more than water. The opportunity cost of purchasing a diamond is higher than the opportunity cost of buying water. In other words, there are more forgone opportunities when someone chooses to buy a diamond; that person could have bought a car, a house, or a trip instead of the diamond. Thus, the opportunity cost of buying a diamond is higher than the opportunity cost of water, which helps explain why diamonds are more expensive than water.