- Prior to beginning work on this discussion, read Farah Mohammed’s article, Why Are Diamonds More Expensive Than Water? (Links to an external site.), as well as Chapter 5 in your textbook, especially Sections 5.1 and 5.3, and respond to the following:
- Describe the relationship between total utility and marginal utility.
- Explain if marginal utility can be negative.
- Examine the diamond-water paradox. Why are diamonds more expensive than water?
- Evaluate the law of diminishing marginal utility.
- Identify some items, explaining your reasoning, that do not follow the law of diminishing marginal utility.
- Evaluate how the law of diminishing marginal utility can explain the diamond-water paradox
Amacher, R., & Pate, J. (2019). Principles of microeconomics (2nd ed.). Bridgepoint Education.
The History of Utility Theory: The Diamond–Water Paradox
In the early development of economic theory, economists often posed questions that they then debated. One of the popular debate topics was what determined value. Adam Smith wrote that value could mean either “value in use” or “value in exchange.” He posed (in 1776) what became known as the diamond–water paradox:
The things that have the greatest value in use have frequently little or no value in exchange; and on the contrary, those which have the greatest value in exchange have frequently little value in use. Nothing is more valuable than water, but it will purchase scarce anything; scarce anything can be had in exchange for it. A diamond, on the contrary, has scarce any value in use; but a very great quantity of other goods may frequently be had in exchange for it. (Smith)
The diamond–water paradox was the problem that classical economists used when they argued that value in use could not determine price (value in exchange). Diamonds, although less useful than water, are more expensive than water. The dialogue about the diamond–water paradox went on for a long time. Many famous mathematicians, economists, and philosophers took part in the debate. The confusion over the diamond–water paradox arose in part over disagreement as to what the term useful meant. In the 1870s William Stanley Jevons, Carl Menger, and Léon Walras, all writing separately, solved the paradox by developing a theory of value in which demand and utility came to the forefront. Their solution played a major role in developing the theory of consumer demand.
5.2 Utility and Consumer Behavior
The concepts of utility and price can be combined to show how consumers make choices in the marketplace. Consumers are confronted with a range of items and also a range of prices. A consumer may not necessarily choose based solely on which item has the greatest utility; price and the consumer’s income are also important factors. In other words, consumers don’t always buy their first choice. You may prefer a Tesla to a Toyota but decide to purchase the Toyota. The explanation for this behavior lies in the relationship between price and utility.
Suppose, for example, you are considering purchasing a six-pack of soft drinks. You are presented with the three possibilities shown in Table 5.2. Coca-Cola is your first choice because to you it yields the most utility. But the relevant question is not which soft drink has the most utility but rather which has the most utility per dollar. Therefore, you choose to buy a six-pack of Pepsi. This choice implies that the extra satisfaction of Coca-Cola over Pepsi is not worth $0.75, but the extra satisfaction of Pepsi over RC Cola is worth $0.25. There are other things you can do with the extra $0.75. You are saying that $0.75 spent on something other than soda will yield more additional utils than the difference between the utility of Coke and the utility of Pepsi, but that $0.25 spent on other goods will not yield more utils than spending it on Pepsi instead of RC Cola.
The Diamond–Water Paradox Explained
Adam Smith (and others) argued that utility (and thus demand) could not be a determinant of price because diamonds, while less useful than water, are more expensive than water. The paradox disappears if we distinguish between total utility and marginal utility. The total utility of water is high. However, since there is a great deal in existence and large quantities are consumed, its marginal utility is low. The total utility of diamonds, on the other hand, is relatively low. However, since diamonds are rare, their marginal utility is high. Price, then, is determined by marginal utility, not total utility. Economists say that marginal utility determines value in exchange (price) and that total utility determines value in use. Price, then, is related to scarcity through utility. If something has a low marginal utility at all quantities consumed, it will have a low price, regardless of how scarce it is. If something is relatively scarce and has a high marginal utility, it will be valuable and thus expensive.
Shopping for Bargains
Economists have used the concept of utility-maximizing behavior to analyze shopping behavior. The idea is that a buyer will search for bargains until the expected savings in value or utility equals the cost of continued searching.
Several predictions can be made from this theory. The first is that the larger the amount individuals expect to save, the longer they will continue to search. In other words, the bigger the item in terms of your budget, the more you will shop around. You will search longer for a good price on a car than for a good price on a loaf of bread. You might even buy bread at a convenience store, where you know the price is higher, to save some shopping time. The second prediction is that, in percentage terms, the variation in prices for bigger budget items should be smaller than the variation in prices for smaller budget items. The search process will drive high-price sellers of large items out of business or force them to reduce their prices. The third prediction is that when search costs are higher, price differences between sellers could be higher without driving the high-priced sellers out of business. Have you ever noticed that prices of gasoline are higher near freeways than in towns? Utility-maximizing theory can explain this phenomenon. Users of freeways are going somewhere, often in a hurry. Their search costs are high. They therefore do less shopping around and as a result pay higher prices.
The Internet plays an important role by drastically reducing search costs, which may also have an impact on prices and buying behavior. Price comparison websites like GoSale.com and PriceGrabber now do the work for consumers by providing prices from a variety of sellers at the click of a button. Chiou and Pate (2010) found evidence of greater searching by price-sensitive shoppers, which generally leads to lower prices for all goods on the Internet.