Question

I could not find the solutions manual for Mark Skousen's, Economic Logic, Revised 5th Edition.

Chapter 5 - 4th Problem to Ponder: "Diamonds are expensive, but they have little practical value: water is cheap, but has great utility in everyday life." Adam Smith was perplexed by this diamond-water paradox. Use price and demand curves, show how you could explain this diamond-water dichotomy to Adam Smith.

Thanks a lot - my e-mail address is: [email protected]

Scott Petrie

Answer 1

This paradox arises because a person’s willingness to pay for a good is based on the marginal benefit that an extra unit of the good would yield. The marginal benefit, in turn, depends on how many units a person already has. Water is essential, but the marginal benefit of an extra cup is small because water is plentiful. By contrast, no one needs diamonds to survive, but because diamonds are so rare, people consider the marginal benefit of an extra diamond to be large.

This is shown below.

At low levels of consumption, water has a much higher marginal utility than diamonds and thus is more valuable. People usually consume water at much higher levels than they do diamonds and thus the marginal utility and price of water are lower than that of diamonds.