Why are diamonds more expensive than water even though the demand for water is higher?
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When you think about the price of a good or service, you must not just consider demand. You must also consider supply. It is because of this other factor (supply) that diamonds cost so much more than water does.
The price of an item (if there is no government interference) is determined by both supply and demand. If you graph the supply curve and the demand curve, the good will be sold at the price (and quantity) where the two curves intersect.
Because water is so much more abundant than diamonds, there is a much larger supply of it. In general, the greater the supply of something, the lower the equilibrium price. This is why diamonds cost more than water even though water is a necessity and diamonds are not.
In spite of being a necessity and having a lot more utility than diamonds water has a very low price when compared to that of diamonds.
This is something that has puzzled economists for a long time and is has popularly come to be known as the water- diamond paradox.
One way of explaining this phenomenon is with the use of a concept called marginal utility. Marginal utility refers to how much is one can extra unit of a product able to satisfy the requirements of a person. In the case of water, the marginal utility is very low, while in the case of diamonds it is very high. This is due to the fact that we already consume such a large quantity of water that the extra satisfaction we gain from a little more water is very less. On the other hand, people usually do not have more than a few diamonds with them. This gives an extra diamond the ability to provide a lot of satisfaction.
The price of a product is totally dependent on its marginal utility. Higher marginal utility increases the price and a lower marginal utility decreases it. This explains the pricing of water and diamonds.
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