Question

1. Explain why Adam Smith (Classical School) failed to solve the diamond-water paradox

Answer 1

Classical economists like Adam Smith believed that a commodity that yields a high total utility to the consumer is most likely to command a much higher price in the market.

But what they observed in real life was almost exactly the opposite.

Water, that is so essential for the existence of human life, has a greater practical utility than a Diamond but is almost available free of cost, while Diamond ( with lesser practical utility ) is sold in the market at an exorbitant price

Classical economists called this the Diamond-water paradox

Classical economists like Adam Smith failed this because :

1. They were not able to make the distinction between total and marginal utility
2. Neo-classical economists solved this paradox with the help of the concept of marginal utility
3. According to them, the clue to the solution lies in marginal utility as they rightly pointed out that the price of a commodity depends on its marginal utility and not total utility
4. It is true that the total utility of water is, of course, much greater than the total utility of a diamond. But, the price of a commodity is not equal to total utility, but it is equal to the marginal utility
5. Since water is available and consumed in large quantities, its marginal utility is very small. That's why its market price is almost zero
6. On the other hand, a diamond is a scarce commodity, it is consumed in very small quantities, hence its marginal utility is very high. Hence, its market price is also very high

Therefore, classical economists failed to explain the paradox as they wrongly assumed that

• The price of a commodity depends on its total utility. Whereas, the Neo-classical economists resolved this paradox by saying that the price of a commodity depends on its marginal utility