Question

Adam Smith coined the Diamond Water Paradox. Where something that is essential to life has little value where something that does not has great value.

1.) Explain what theory Adam Smith was using and therefore was unable to explain why the paradox existed.

2.) Explain how modern economist have solved the Diamond Water Paradox.

3.) Explain the difference between Marginal Utility and Total Utility

4.) Give an example of Marginal Utility vs Total Utility in today's society.

give each answer an example

Answer 1

1) Adam Smith theory is the theory that focusses on the free trade concept and state that given no restriction by State regulation on freedom of individual (Laissez faire), and if every individual member of society is left to peruse his economic activity, he will maximize the output to the best of his ability. The producers would produce as much they like, earn as much income as they can and save as much they like. According to this theory, the economy operates optimally, if it is allowed to be propelled, regulated and controlled by invisible hand i.e. the market forces of demand & supply. The theory opposes any government intervention in industry and commerce.

Adam Smith was not able to explain Diamond Water Paradox. Water which is essential for sustenance of life has low value whereas diamond which is a luxury has a very high value. Adam Smith could not explain this paradox. Even the free trade and invisible forces of demand & supply fails to provide water higher value than diamond.
The theory failed to explain this paradox because theory did not focus on utility aspects of possessing a commodity. The price as set by invisible hands under Adam Smith is not the reflection of total utility. It is the reflection of marginal utility.  

2).The modern marginal-utility theory of value resolves the diamond-water paradox.

According to this theory, water is more valuable than diamonds as initially known.

The theory focussed on scarcity value, marginal utility and diminishing marginal utility concept. The market forces of demand and supply indicate the scarcity value of a good. Since, water is available in adundance, it is majorly available as free good and has no material value as it is not scarce.

Whereas, Diamond is very scarce and has high perception value and is directly linked to one's social status. The demand for Diamond is very huge in the market , but since this is scarcely available, the value of diamond is very high.

The first few units of water has higher marginal value than diamond. This can be seen as existing as water is primarily life-supporting. One would always value water higher than diamond as long as it quenches thirst.

Since, water is available in abundance, with each additional unit, the marginal value decreases and becomes less than the marginal value of diamond , which is scarcely available. Hence, water appears to be of lesser value than diamond, though it being supportive.

3) The rate of change of total utility per unit change in the quantity is the marginal utility. It is the additional amount of satisfaction that one gets from using or purchasing an additional unit of a particular good or service.

Total Utility is the measure of satisfaction derived from the consumption of given units of good.

4)

An example of marginal utility - WIth respect to Assets - a person with one vehicle has more marginal utility than a person with many vehicle.

An example of total utility -  Utility derived from having financial security and large amount of money deposited in the bank.