One of the main principles behind mainstream, neoclassical economic theory is th
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Question
One of the main principles behind mainstream, neoclassical economic theory is that individuals act to optimize their own utility. Utility is generally defined as a satisfaction (pleasure) that an individual derives from consuming or using a specific good or service. One of the most interesting areas in utility theory is the paradox of value. There is a paradox of value due to the fact that absolute necessities such as water and air are valued (priced) very cheaply, whereas other goods like diamond, which are not necessities, are highly valued and command the most outrageous prices.
In order to understand the paradox of value, there is a need to distinguish total utility from marginal utility. The total satisfaction obtained from all units of a particular good or service consumed over a period of time is called total utility. An additional or incremental utility derived from consuming one more unit of a good or service is called marginal utility. Thus marginal utility is the change in the total utility that results from one unit change in consumption of a good or service within a given period of time.
Using the Diamond-Water Paradox as a guide (refer to page 124 of the textbook) and two other goods of your choice, illustrate the paradox of value. Explain the roles total utility and marginal utility play to understand this paradox.
Please be detailed and do not use picture answers
Explanation / Answer
The diamond-water paradox poses the perplexing observations: Even though water is obviously important to human activity (life cannot exist without water), the price of water is relatively low. Alternatively, diamonds are clearly much less important to human existence, but the price of diamonds is substantially higher. In other words, the utility obtained from water is obviously very great, while the utility obtained from diamonds is substantially less.
The key question that arises is: Why are diamonds so much more expensive than water?
Insight into, and clarification of, the diamond-water paradox results by differentiating between total utility and marginal utility.
In contrast, the total utility generated by diamonds is relatively limited. Diamonds do not provide much overall satisfaction of wants and needs, compared to water. Many humans spend their entire lives without achieving ANY satisfaction from diamonds.
Diamonds have very little total utility because they are not nearly as plentiful as water. Most houses do not have hot and cold running diamonds. Most people do not drink eight glasses of diamonds a day, take showers in diamonds, or fill their Olympic-sized swimming pools with hundreds of gallons of diamonds. However, because they are less plentiful, the marginal utility of diamonds is relatively high. An extra ounce of diamonds provides a great deal of extra satisfaction.
The apparent contraction between price and utility is cleared up by distinguishing between marginal utility and total utility, and with the understanding that marginal utility, not total utility, is the key to determining price.
Moreover, this paradox can be turned on its head by considering what might happen should the relative abundance of water and diamonds change.
Role of marginal utility
The theory of marginal utility, which is based on the subjective theory of value, says that the price at which an object trades in the market is determined neither by how much labor was exerted in its production, as in the labor theory of value, nor on how useful it is on a whole (total utility). Rather, its price is determined by its marginal utility. The marginal utility of a good is derived from its most important use to a person. So, if someone possesses a good, he will use it to satisfy some need or want. Which one? Naturally, the one that takes highest-priority. Eugen von B
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