A Solution to the Diamond-Water Paradox
Mark Beyer is the former Chief Economist (retired) at the New Jersey Board of Public Utilities. He is the author of articles on the pricing of electricity, financing new generation, mergers and acquisitions, risks of owning regulated assets, and the price of natural gas relative to electricity.
Adam Smith in the 1760s suggested that the price of a commodity must depend on what that good is worth to consumers — on the utility that the commodity offers. Yet, there are situations in which a good’s utility has little influence on its price.
The two examples that Smith used were diamonds and water. Water, which is essential to life and therefore of tremendous value to most consumers, usually sells at relatively low prices, while diamonds are normally very expensive even though their uses such as for jewelry are quite limited. This situation is referred to as the diamond-water paradox.
The paradox can be explained based on the economic concepts known as marginal utility and scarcity. Marginal utility is the satisfaction realized from consuming an additional unit of a good while scarcity is how much of a good is readily available.
Water is normally abundant and relatively inexpensive in most places, which means that consumers obtain low marginal utility from consuming additional units of water. As more water is consumed, each additional unit provides less and less utility to the consumer.