Figure 6-6 Resolving the Paradox of Value
Predictions of the Theory
Early economists and philosophers, struggling with the problem of what
determines the relative prices of products, encountered what they called
the paradox of value. Why is it that water, which is essential to life, has a
low price, while diamonds, which are mainly used for jewellery (and a
few industrial uses), have such a high price? Surely we value water more
highly than diamonds? This paradox could not adequately be explained
until the theory of marginal utility was developed.
The early economists thought the price, or “value” of a good, depended
only on the demand by consumers. This view left out two important
aspects of the determination of price that we now understand. First,
supply plays just as important a role as demand in determining price.
Second, consumers purchase units of a good until the marginal value of
the last unit purchased is equal to its market price. Figure 6-6 shows a
demand-and-supply diagram for water and for diamonds. Water has a
plentiful supply and hence a low price; diamonds have a relatively scarce
supply and hence a high price.