The Hindu Business Line : The diamond-water paradox

WHY is diamond costlier than water? Called the diamond-water paradox, this is a classic problem posed to students of economics. This issue is considered important because water is more useful to mankind than diamonds, and yet the latter is costlier. Why?

The answer has to do with utility and scarcity. Suppose you are in the middle of a desert, and dying of thirst. What if you are offered diamonds and a bottle of water and asked to pick one?

You will surely choose the bottle of water to quench your thirst. This is because you find water more useful than diamonds; in economics, your utility for water is higher than that of diamonds.

Suppose you are offered more bottles of water. Having quenched your thirst, your demand for water decreases. In economic parlance, your marginal utility for water diminishes.

Now, suppose you are offered diamonds instead. You may hoard them in your bank locker. But what if you are offered more diamonds? Will your marginal utility for diamonds also diminish?

Yes, but at a lower speed than that of water. Why? The reason has to do with the demand and supply for diamonds.

Being a natural resource, its supply is limited. The demand is, however, high because people buy diamonds as a way to tell the world that they have money (termed as conspicuous consumption in economics).

The high demand and limited supply is the reason why the marginal utility for diamonds decreases at a lower rate than that of water. Hence, diamonds carry higher monetary value than water, even though we find more use for water.

If you are still not convinced, consider this: Assume your basic need for water is satisfied. You are now offered more water and plenty of diamonds. What will you choose?

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The diamond-water paradox