How Value of Goods and Services Are Determined in A Market Economy: The Water Diamond
Paradox
According to Hall and Lieberman (2021), microeconomics is the study of behaviour of individual
households, firms and governments; the choices they make; and their interaction in their specific
market. There are different economic systems which are used in the economy, one of which is the
market economic system. A market economy is an economic system whereby the production, price
and distribution of goods and services depend on the interaction between supply and demand
within the market. Despite this, prices do not always determine how important a good is. For
example, water is an essential good needed for our survival, but it is sold at quite a low price but
diamonds, which is not essential for survival, are sold at extremely high prices. This is known as the
Water – Diamond Paradox. This essay going to discuss how the value of goods and services are
determined in a market economy, using the Water – Diamond Paradox to explain the role of
demand, supply, and marginal utility in price determination.
To begin with, in a market economy, the value of goods and services is determined by the
interaction of supply and demand. Demand refers to the quantity of goods or services that
consumers are willing and able to purchase at various prices, while supply refers to the quantity of
goods and services that producers are willing and able to offer for sale at different price levels
(Shapiro et al., 2022). The law of demand states that, ceteris paribus, as the price of a good or
service increases, the quantity demanded decreases, while a decrease in price leads to an increase in
quantity demanded. Furthermore, the law of supply states that an increase in price leads to an
increase in the quantity supplied, while a decrease in price results in a reduction in quantity
supplied. In the case of water, both demand and supply are relatively high, resulting in a market
equilibrium at a low price, mainly due to its abundance. In contrast, the supply of diamonds is
limited while demand remains high, which results in a significantly higher market price. This example
clearly demonstrates how the value of goods and services is determined through the interaction of
demand and supply.
The next topic is scarcity, an economic problem where there are unlimited wants and limited
resources to satisfy everybody’s wants. According to Lipsey et al. (2018), Scarcity exists in all
economies because available resources are not enough to meet the needs and wants of the entire
population. As a result, scarcity has an influence on the production, distribution as well as prices of
goods and services. Due to high competition of resources, supply is limited relative to the demand
which leads to higher market prices. Since resources are scarce, societies face the problem of
deciding what to produce and how much each person is going to consume. Scarcity of resources
leads to making a decision of how to use the available resources according to the needs and wants
of the society. Using the example of Water – Diamond Paradox, in this situation, diamonds are very
scarce, meaning they have a limited supply and increased value of the diamond therefore increasing
the price. In contrast, water is mostly abundant making it less scarce, resulting in a much lower
market price despite it being essential for individuals.
This leads to the last point of discussion on needs and wants, in other words utility. Utility is the
satisfaction consumers get from a good or a service, consumers spend their resources on goods and
services because they get satisfaction from using them (Economics Year 1, n.d.). As a consumer, you
buy less of the commodities when your utility is low and more of it when your utility is high.
Different consumers have different levels of utility when they consume the same commodity, one
can have higher satisfaction compared to the other. Moreover, consumers buy commodities which
give them a higher level of satisfaction. Total utility increases as consumption increases while
marginal utility decreases as more units are consumed. Marginal utility is the additional satisfaction
that a consumer derives from one additional unit of commodity consumed. Marginal utility
contributes to the price the consumer will pay for a particular commodity, as more units are
consumed marginal utility will fall and as such, consumers will pay less for any extra unit. According
to the water and diamond paradox, water provides high total utility because it is essential for life,
but because it is not scarce, the marginal utility of an additional unit of water is low, resulting to the
low price. On the other hand, diamonds have a high utility margin because it is scarce, this leads to
consumers placing a higher value on them and pay a higher price even though they have limited use.
To sum up and answer the question of how the value of goods and services are determined, they are
determined by the interaction of supply and demand, scarcity and consumer utility and not
necessarily by how and what they’re used for. Prices come from external factors that show how
scarce a good and how satisfied consumers get from consuming an additional unit of that good. The
example of the Water – Diamond Paradox clearly explains this. Even though water is essential for
individuals and has total high utility, it’s high supply results in low marginal utility and therefore a
lower price. Diamonds, on the other hand are a luxury and do not really have essential use, but
because they are scarce and have high marginal utility, they lead to higher prices. All in all, in a
market economy, the value of goods and services is determined by scarcity and marginal utility and
is shown through demand and supply rather than it’s use alone.
Reference list
Hall, R. E., & Lieberman, M. (2021). Economics: Principles and applications (8th ed.). Cengage
Learning.
Lipsey, R. G., Ragan, C. T. S., & Storer, P. (2018). Economics (13th Canadian ed.). Pearson Canada.
Shapiro, C., Varian, H. R., & Carl, S. (2022). Microeconomics and behaviour (10th ed.). W. W. Norton
& Company.
Economics Year 1. (n.d.). Utility: Consumers’ rational decision-making (Section 3). Ministry of
Education.