Answer to Question #314721 in Microeconomics for Vivek

Question

Explain the water-diamond paradox using 

the basic principles of Economics.

Answer 1

Diamonds are limited in supply compared to water supply. One diamond is more costly than one bottle of water, yet diamond is not needed to maintain human life. This diamond-water paradox propose that water is more important than diamond to human in order to sustain daily life; however, water is less expensive than diamond. It is explained by the total utility from water is greater than diamond, but marginal utility of water is less than diamond. This means an additional unit of diamond provides greater utility level than an additional unit of water. This is associated with the law of diminishing marginal utility, which means an additional unit of abundant good does not bring higher utility level.

However, additional units of less abundant good will increase utility level. Consumers are more willing to pay a higher demand price for a good that gives higher utility level than for goods with less utility level. Recall that diamonds are limited in supply, so producers act as monopolist and they are able to charge a higher price. Water is plentiful in supply,

so producers have to charge the competitive market price. Therefore, there is a diamond water paradox in which water is more important than diamond, yet it cost less than diamond