The diamond–water paradox is the apparent contradiction that diamonds are priced higher than water despite water being more valuable to humans (we need water to live, but we don’t need diamonds to live).
Scarcity would be one reason. Diamonds are more scarce than water so, naturally, diamonds will be priced higher. But, this still doesn’t explain why something necessary for human survival is priced considerably lower than something which is only really of benefit for aesthetic or social reasons.
Marginal Utility vs. Total Utility
To fully explain this paradox we must look at the difference between the marginal utility and total utility of diamonds and water. Note that the price of a good is determined by its marginal utility (the utility or benefit of the last unit consumed).
Consumers do not choose between all of the diamonds in the world versus all of the water in the world. If they did, they’d obviously choose water as it has a greater total utility; we need water to survive. However, the marginal utility of diamonds is higher than the marginal utility of water. What this means is that consumers value an additional diamond more than an additional unit of water.
And this should make sense when you consider how often you buy diamonds and water. Consumers buy water all the time, everyday even. We don’t value an additional unit of water that highly because we will receive more water in the not too distant future. But we value an additional diamond very highly because we hardly ever buy diamonds. The average person may only ever buy 1 or 2 diamonds in their lifetime, perhaps for a wedding ring. Those few special occasions when we do buy diamonds therefore means we place a high marginal value on them.
A modern example is the pay gap between professional soccer players and teachers. Altogether, society values all the teachers in the world more highly than all the soccer players in the world; we need teachers to teach our kids, we don’t need soccer players to this extent. However, the marginal value of one extra top quality soccer player is a lot higher than the marginal value of one additional teacher.