Utility of Diamonds and Water

The explanation of the Paradox of Diamonds and Water will need a little special terminology. We will use the concept of marginal utility, and marginal utility will play an important part in some of the sections to follow.

It is best to begin with an example. In the example, we will assume that a person can buy water or diamonds or both. We assume that the satisfactions she gets from diamonds and from water can be measured in money terms. Following a long tradition in economics we will speak of the amount of satisfaction as the "utility" of diamonds and water. We assume:

1. that her total satisfaction is the sum of the utility of water and the utility of diamonds,
2. that the utility of diamonds increases as she consumes more diamonds,
3. that the utility of water increases as she consumes more water, and
4. that she tries to spend her income in such a way as to get the most satisfaction that she can -- that is, that she "maximizes" utility.