People Evaluate Goods Based on “Marginal Utility,” i.e., People Value Goods Unit by Unit

One of the most important advances in economic theory was the realization that people valued goods unit by unit, rather than comparing entire classes of goods against each other. Using their jargon, economists now say that people evaluate goods based on marginal utility.

The classic illustration of this new way of thinking is the so-called “water-diamond paradox.” At first glance, it seems odd that the price of water should be so low—restaurants will serve it for free!—while the price of diamonds should be so high. (Try asking your waiter for a complimentary glass filled with diamonds.) If economists think that the value of goods is ultimately related to humans trying to satisfy their subjective goals, how can diamonds possibly be more valuable than water? After all, you can’t satisfy too many goals if you die of thirst.

In the early 1870s, three different economists independently worked out the solution to this problem: Yes, it’s true that the way to explain the value of an object, is to get inside the head of the person who values it and understand his goals. But when this person makes actual choices in the real world, he never faces the tradeoff of “all the water” versus “all the diamonds.” If that really were the choice, then the person would most probably pick the water. But in normal life, there is so much water available that any particular gallon of it, has a very low value. In contrast, there aren’t enough diamonds to go around to satisfy all the uses people have for diamonds. That’s why any particular diamond is still quite valuable. Economists would say that diamonds are scarcer than water.

—Robert P. Murphy, Lessons for the Young Economist (Auburn, AL: Ludwig von Mises Institute, 2010), 59-60.