The great 18th century economist and philosopher Adam Smith once wrote: "Nothing is more useful than...

The great 18th century economist and philosopher Adam Smith once wrote: "Nothing is more useful than water: but it will purchase scarce any thing; scarce any thing 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."

In the late 19th century some economists posited that this apparent anomaly could be explained by the law of diminishing marginal utility. Does this serve as a genuine scientific explanation of the anomaly?

Expert Solution

Adam Smith defined Marginal Utility is as "the additional advantage or benefit that a consumer receives from the consumption of an extra unit of the good or service".

In his theory, Adam Smith said that water is an urgent necessity and even though people cannot survive without consuming the same, it is yet much cheaper in value than diamonds. It is correctly said and even evident that the same is true.

But the very reason for this was given in the 19th Century when economists said that cost of a good is decided by how scarce it is and the utility which we derive from consumption of an additional unit. While water is essential it is widely available in abundance. With consumption of an additional unit of water, you are expected to get lesser returns than the very first unit because your thirst is satisfied with one unit itself to a certain extent. The additional units thus are not required on one and on the other the resource itself is abundant which does not make the cost of one unit too high.

On the other hand, diamonds are scarce and require significant investment in labour to produce the same. An additional unit of diamond does leads to addition in utility than reduction. With extra consumption the satisfaction goes up and adding to the fact that diamonds are scarce is the reason why it is priced up and over water.

Thus, we can conclude by saying that a good or service is priced on the basis of the net benefit which the consumer gets from an additional unit as well as the availability of the same. Water being abundant does not attract the same price as diamonds which is firstly scarce and secondly adds value on each unit of consumption and does not reduce.

Please feel free to ask your doubts in the comments section.

Rahul Sunny answered 9 months ago

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