Water Diamond Paradox

The paradox of value (also known as the diamond–water paradox) is the contradiction that,

although water is on the whole more useful, in terms of survival, than diamonds, diamonds
command a higher price in the market . The philosopher Adam Smith is often considered to be the
classic presenter of this paradox.

In a passage of Adam Smith's An Inquiry into the Nature and Causes of the Wealth of Nations, he
discusses the concepts of value in use and value in exchange, and notices how they tend to differ:
What are the rules which men naturally observe in exchanging them [goods] for money or for one
another, I shall now proceed to examine. These rules determine what may be called the relative or
exchangeable value of goods. The word VALUE, it is to be observed, has two different meanings,
and sometimes expresses the utility of some particular object, and sometimes the power of
purchasing other goods which the possession of that object conveys. The one may be called "value
in use;" the other, "value in exchange." The things which have the greatest value in use have
frequently little or no value in exchange; on the contrary, those which have the greatest value in
exchange have frequently little or no value in use. Nothing is more useful than water: but it will
purchase scarcely anything; scarcely anything can be had in exchange for it. A diamond, on the
contrary, has scarcely any use-value; but a very great quantity of other goods may frequently be had
in exchange for it.
Furthermore, he explained the value in exchange as being determined by labor:
The real price of every thing, what every thing really costs to the man who wants to acquire it, is the
toil and trouble of acquiring it.
Hence, Smith denied a necessary relationship between price and utility. Price on this view was
related to a factor of production (namely, labor) and not to the point of view of the
consumer. Proponents of the labor theory of value see that as the resolution of the paradox.

Indifference Curve Analysis

What Is an Indifference Curve?
An indifference curve, with respect to two commodities, is a graph showing those combinations
of the two commodities that leave the consumer equally well off or equally satisfied—hence
indifferent—in having any combination on the curve.

 An indifference curve shows a combination of two goods that give a consumer equal
satisfaction and utility thereby making the consumer indifferent.
 Along the curve, the consumer has an equal preference for the combinations of goods
shown—i.e. is indifferent about any combination of goods on the curve.
 Typically, indifference curves are shown convex to the origin, and no two indifference
curves ever intersect.
Understanding an Indifference Curve
Standard indifference curve analysis operates on a simple two-dimensional graph. Each axis
represents one type of economic good. Along the indifference curve, the consumer is indifferent
between any of the combinations of goods represented by points on the curve because the
combination of goods on an indifference curve provide the same level of utility to the consumer.
For example, a young boy might be indifferent between possessing two comic books and one
toy truck, or four toy trucks and one comic book so both of these combinations would be points
on an indifference curve of the young boy.

Indifference Curve Analysis

Indifference curves operate under many assumptions; for example, typically each indifference
curve is convex to the origin, and no two indifference curves ever intersect. Consumers are
always assumed to be more satisfied when achieving bundles of goods on indifference curves
that are farther from the origin.

As income increases, an individual will typically shift their consumption level because they can
afford more commodities, with the result that they will end up on an indifference curve that is
farther from the origin—hence better off.

Most economic textbooks build upon indifference curves to introduce the optimal choice of
goods for any consumer based on that consumer's income.

The slope of the indifference curve is known as the MRS. The MRS is the rate at which the
consumer is willing to give up one good for another. If the consumer values apples, for example,
the consumer will be slower to give them up for oranges, and the slope will reflect this rate of
substitution.

Criticisms and Complications of the Indifference Curve

Indifference curves, like many aspects of contemporary economics, have been criticized

for oversimplifying or making unrealistic assumptions about human behavior. For
example, consumer preferences might change between two different points in time
rendering specific indifference curves practically useless.

Other critics note that it is theoretically possible to have concave indifference curves or
even circular curves that are either convex or concave to the origin at various points.
Consumer preferences might also change between two different points in time
rendering specific indifference curves practically useless.

Graph Analysis

The indifference curve Um has four points labeled on it: A, B, C, and D (see Figure 1).
Since an indifference curve represents a set of choices that have the same level of
utility, Lilly must receive an equal amount of utility, judged according to her personal
preferences, from two books and 120 doughnuts (point A), from three books and 84
doughnuts (point B) from 11 books and 40 doughnuts (point C) or from 12 books and 35
doughnuts (point D). She would also receive the same utility from any of the unlabeled
intermediate points along this indifference curve.

Indifference curves have a roughly similar shape in two ways: 1) they are downward
sloping from left to right; 2) they are convex with respect to the origin. In other words,
they are steeper on the left and flatter on the right. The downward slope of the
indifference curve means that Lilly must trade off less of one good to get more of the
other, while holding utility constant. For example, points A and B sit on the same
indifference curve Um, which means that they provide Lilly with the same level of utility.
Thus, the marginal utility that Lilly would gain from, say, increasing her consumption of
books from two to three must be equal to the marginal utility that she would lose if her
consumption of doughnuts was cut from 120 to 84—so that her overall utility remains
unchanged between points A and B. Indeed, the slope along an indifference curve as
the marginal rate of substitution, which is the rate at which a person is willing to trade
one good for another so that utility will remain the same.
Indifference curves like Um are steeper on the left and flatter on the right. The reason
behind this shape involves diminishing marginal utility—the notion that as a person
consumes more of a good, the marginal utility from each additional unit becomes lower.
Compare two different choices between points that all provide Lilly an equal amount of
utility along the indifference curve Um: the choice between A and B, and between C and
D. In both choices, Lilly consumes one more book, but between A and B her
consumption of doughnuts falls by 36 (from 120 to 84) and between C and D it falls by
only five (from 40 to 35). The reason for this difference is that points A and C are
different starting points, and thus have different implications for marginal utility. At point
A, Lilly has few books and many doughnuts. Thus, her marginal utility from an extra
book will be relatively high while the marginal utility of additional doughnuts is relatively
low—so on the margin, it will take a relatively large number of doughnuts to offset the
utility from the marginal book. At point C, however, Lilly has many books and few
doughnuts. From this starting point, her marginal utility gained from extra books will be
relatively low, while the marginal utility lost from additional doughnuts would be
relatively high—so on the margin, it will take a relatively smaller number of doughnuts to
offset the change of one marginal book. In short, the slope of the indifference curve
changes because the marginal rate of substitution—that is, the quantity of one good that
would be traded for the other good to keep utility constant—also changes, as a result
of diminishing marginal utility of both goods.

Each indifference curve represents the choices that provide a single level of utility.
Every level of utility will have its own indifference curve. Thus, Lilly’s preferences will
include an infinite number of indifference curves lying nestled together on the diagram—
even though only three of the indifference curves, representing three levels of utility,
appear in Figure 1. In other words, an infinite number of indifference curves are not
drawn on this diagram—but you should remember that they exist.

Higher indifference curves represent a greater level of utility than lower ones. In Figure
1, indifference curve Ul can be thought of as a “low” level of utility, while Um is a
“medium” level of utility and Uh is a “high” level of utility. All of the choices on
indifference curve Uh are preferred to all of the choices on indifference curve Um, which
in turn are preferred to all of the choices on Ul.

To understand why higher indifference curves are preferred to lower ones, compare
point B on indifference curve Um to point F on indifference curve Uh. Point F has
greater consumption of both books (five to three) and doughnuts (100 to 84), so point F
is clearly preferable to point B. Given the definition of an indifference curve—that all the
points on the curve have the same level of utility—if point F on indifference curve Uh is
preferred to point B on indifference curve Um, then it must be true that all points on
indifference curve Uh have a higher level of utility than all points on Um. More generally,
for any point on a lower indifference curve, like Ul, you can identify a point on a higher
indifference curve like Um or Uh that has a higher consumption of both goods. Since
one point on the higher indifference curve is preferred to one point on the lower curve,
and since all the points on a given indifference curve have the same level of utility, it
must be true that all points on higher indifference curves have greater utility than all
points on lower indifference curves.

These arguments about the shapes of indifference curves and about higher or lower
levels of utility do not require any numerical estimates of utility, either by the individual
or by anyone else. They are only based on the assumptions that when people have less
of one good they need more of another good to make up for it, if they are keeping the
same level of utility, and that as people have more of a good, the marginal utility they
receive from additional units of that good will diminish. Given these gentle assumptions,
a field of indifference curves can be mapped out to describe the preferences of any
individual.

Assumptions of Indifference Curve Analysis:

The indifference curve analysis retains some of the assumptions of the cardinal theory,
rejects others and formulates its own. The assumptions of the ordinal theory are the
following:
(1) The consumer acts rationally so as to maximise satisfaction.

(2) There are two goods X and Y.

(3) The consumer possesses complete information about the prices of the goods in the
market.

(4) The prices of the two goods are given.

(5) The consumer’s tastes, habits and income remain the same throughout the analysis.

(6) He prefers more of X to less of У or more of Y to less of X.

(7) An indifference curve is negatively inclined sloping downward.

(8) An indifference curve is always convex to the origin.

(9) An indifference curve is smooth and continuous which means that the two goods are
highly divisible and those levels of satisfaction also change in a continuous manner.

(10) The consumer arranges the two goods in a scale of preference which means that
he has both ‘preference’ and ‘indifference’ for the goods. He is supposed to rank them
in his order of preference and can state if he prefers one combination to the other or is
indifferent between them.

(11) Both preference and indifference are transitive. It means that if combination A is
preferable to В, and В to C, then A is preferable to C. Similarly, if the consumer is
indifferent between combinations A and B, and В and C, then he is indifferent between
A and C. This is an important assumption for making consistent choices among a large
number of combinations.

(12) The consumer is in a position to order all possible combinations of the two goods.

Properties of Indifference Curve:

From the assumptions described above the following properties of indifference curves

can be deduced.

(1) A higher indifference curves to the right of another represents a higher level of

satisfaction and preferable combination of the two goods. In Figure 12.3, consider the

indifference curves I1 and I2 and combinations N and A respectively on them. Since A is

on a higher indifference curve and to the right of N. the consumer will be having more of
both the goods X and Y. Even if the two points on these curves are on the same plane

as M and A, the consumer will prefer the latter combination, because he will be having

more of goods X though the quantity of goods Y is the same.

(2) In between two indifference curves there can be a number of other indifference

curves, one for every point in the space on the diagram.

(3) The numbers I1, I2, I3, I4….etc. given to indifference curves are absolutely arbitrary.

Any numbers can be given to indifference curves. The numbers can be in the ascending

order of 1, 2, 4, 6 or 1, 2, 3, 4, etc. Numbers have no importance in the indifference

curve analysis.

(4) The slope of an indifference curve is negative, downward sloping, and from left to

right. It means that the consumer to be indifferent to all the combinations on an

indifference curve must leave less units of good Y in order to have more of good X. To

prove this property, let us take indifference curves contrary to this assumption. In Figure

12.4 (A) combination В of OX1 +OY1 is preferable to combination A which has a smaller

amount of the two goods. Therefore, an indifference curve cannot slope upward from

left to right. It is not an iso-utility curve. Similarly, in Figure 12.4 (B) combination В is

preferable to combination A, for combination В has more of X and the same quantity of

Y. So an indifference curve cannot be horizontal. In Figure 12.4 (C) the indifference

curve is shown as vertical and combination В is preferred to A as the consumer has

more of Y and the same quantity of X. Therefore, an indifference curve cannot be

vertical either. Consequently, an indifference curve will be of negative slope, as shown

in Figure 12.4 (D) where A and В combinations give equal satisfaction to the consumer.

As he moves from combination A to 6 he gives up less quantity of Y in order to have

more of X.

(5) Indifference curves can neither touch nor intersect each other so that one

indifference curve passes through only one point on an indifference map. What

absurdity follows from such a situation can be shown with the help of Figure 12.5 (A)

where the two curves I1 and l2 cut each other. Point A on the I1 curve indicates a higher

level of satisfaction than point В on the I 1 curve, as it lies farther away from the origin.

But point С which lies on both the curves yields the same level of satisfaction as point A

and B. Thus

on the curve I1 : A =C

and on the curve l2: B = C

A =B
This is absurd because A is preferred to B, being on a higher indifference curve I 1.

Since each indifference curve represents a different level of satisfaction, indifference

curves can never intersect at any point. The same reasoning applies if two indifference

curves touch each other at point С in Panel (B) of the figure.

(6) An indifference curve cannot touch either axis. If it touches X-axis, as I 1; in Figure

12.6 at M, the consumer will be having OM quantity of good X and none of Y. Similarly,

if an indifference curve I2 touches the Y-axis at L, the consumer will have only OL of Y

good and no amount of X. Such curves are in contradiction to the assumption that the

consumer buys two goods in combinations.

(7) An indifference curve is convex to the origin. The convexity rule implies that as the

consumer substitutes X for Y, the marginal rate of substitution diminishes. It means that

as the amount X is increased by equal amounts that of Y diminish by smaller amounts.

The slope of the curve becomes smaller as we move to the right. To prove this, let us

take a concave curve where the marginal rate of О substitution of X for K increases

instead of diminishing, i.e., more of Y is given up to have additional units of X. As in

Figure 12.7 (A), the consumer is giving up ab< cd< ef units of Y for bc= de=fg units of X.

But an indifference curve cannot be concave to the origin.

 
If we take a straight line indifference curve at an angle of 45° with either axis, the
marginal rate of substitution between the two goods will be constant, as in Panel (B)

where ab of Y= be of X and cd of Y= de of X. Thus an indifference curve cannot be a

straight line.

Figure 12.7(C) shows an indifference curve convex to the origin. Here the consumer is

giving up less and less units of Y in order to have equal additional units of X i.e., ab>

cd> ef of Y for bc= de= fg= of X. Thus an indifference curve is always convex to the

origin because the marginal rate of substitution between the two goods declines.

(8) Indifference curves are not necessarily parallel to each other. Though they are

falling, negatively inclined to the right, yet the rate of fall will not be the same for all

indifference curves. In other words, the diminishing marginal rate of substitution

between the two goods is essentially not the same in the case of all indifference

schedules. The two curves l1, and l2 shown in Figure 12.8 are not parallel to each other.
(9) In reality, indifference curves are like bangles. But as a matter of principle, their

‘effective region’ in the form of segments is shown in Figure 12.9. This is so because

indifference curves are assumed to be negatively sloping and convex to the origin. An

individual can move to the higher indifference curves and I 1 until he reaches the

saturation point S where his total utility is the maximum.

If the consumer increases his consumption beyond X or K, total utility will fall. If he

increases his consumption of X so as to reach the dotted portion of the I 1 curve

(horizontally from point S), he gets negative utility. If to compensate himself for this loss

of utility, he increases the consumption of Y, he may be again on the dotted portion of

the curve (vertically from point S). Thus the consumer may be on the concave portion of

the circular curve. Since by moving to the dotted portion he gets negative utility, the

effective region of the circular curve will be the convex portion.

Budget line definition
The budget line, also known as the budget constraint, exhibits all the combinations of two
commodities that a customer can manage to afford at the provided market prices and within the
particular earning degree.

The budget line is a graphical delineation of all possible combinations of the two commodities that
can be bought with provided income and cost so that the price of each of these combinations is
equivalent to the monetary earnings of the customer.

It is important to keep in mind that the slope of the budget line is equivalent to the ratio of the cost
of two commodities. The slope of the budget constraint possesses distinctive importance.

In other words, the slope of the budget line can be described as a straight line that bends
downwards and includes all the potential combinations of the two commodities which a customer
can purchase at market value by assigning his/her entire salary. The concept of the budget line is
different from the Indifference curve, though both are necessary for consumer equilibrium.

The two basic elements of a budget line are as follows:

 The consumer’s purchasing power (his/her income)

 The market value of both the products

Equation of a Budget Line

To understand the concept of a budget line in a detailed manner, it is important to understand the
mentioned equation. The equation of the budget line equation can be represented as follows:
M = Px × Qx + Py × Qy

Where,

Px is the cost of product X.

Qx is the quantity of product X.

Py is the cost of product Y.

Qy is the quantity of product Y.

M is the consumer’s income.

Example of a Budget Line

Radha has ₹50 to buy a biscuit. She has a few options to allocate her income so that she receives
maximum utility from a limited salary.

Budget schedule

Combination Cream biscuit Plain biscuit Budget allocation

(@ ₹10 per packet) (@ ₹5 per packet)

A 0 10 10 × 0 + 5 × 10 = 50

B 1 8 10 × 1 + 5 × 8 = 50

C 2 6 10 × 2 + 5 × 6 = 50

D 3 4 10 × 3 + 5 × 4 = 50

E 4 2 10 × 4 + 5 × 2 = 50

F 5 0 10 × 5 + 5 × 0 = 50

To get an appropriate budget line, the budget schedule given can be outlined on a graph.
The budget set indicates that the combinations of the two commodities are placed within the
affordability margin of a consumer.

Features of Budget Line

Some of the properties of the budget line are as follows:

Negative slope: If the line is downward, it shows a reverse correlation between the two products.

Straight line: It indicates a continuous market rate of exchange in individual combinations.

Real income line: It denotes the income and the spending size of a customer.

Tangent to indifference curve: It is the point when the indifference curve meets the budget line. This
point is known as the consumer’s equilibrium.

Assumptions of a Budget Line

The budget line is mostly based on the assumption and not reality. However, to get clear and precise
results and summary, the economist considers the following points in terms of a budget line:

Two commodities: The economist assumes that the customers spend their income to purchase only
two products.

Income of the customers: The income of the customer is limited, and it is designated to buy only
two products.

Market price: The cost of each commodity is known to the customer.

Expense is similar to income: It is assumed that the customer spends and consumes the whole
income.
A shift in Budget Line
A budget line includes a consumer’s earnings and the rate of a commodity. These are the two
important factors that shift the budget line.

Shift due to change in price: The amount of the product either increases or decreases from time to
time. For instance, if the price and income of product A remains constant and the price of product B
decreases, then the buying potential of product B automatically increases. Similarly, if the price of B
increases and the other factors remain steady, the demand for product B automatically decreases.

Shift due to change in income: Change in income makes a huge difference that leads to a change in
the budget line. High income means high purchasing possibility and low income means low
purchasing potential, making the budget line to shift.

Consumer Equilibrium

“A consumer is said to be in equilibrium at a point where the price line touching the
highest attainable indifference curve from below”

Consumer’s equilibrium permits a consumer to get the most satisfaction possible from his income.

Conditions
The consumers equilibrium under the indifference curve theory must need the following two
conditions:

First:A given price line should be tangent to an indifference curve or marginal rate of satisfaction of
good X for good Y(MRSxy) must be equal to the price ratio of the two goods

MRSxy=Px/Py [Slope of indifference curve=slope of budget line]

Px/Py=MUx/Muy

Second:The second order condition is that indifference curve must be convex to the origin at the
point of tangency

Explain consumer’s equilibrium with the help of Indifference Curve Analysis:

Consumer equilibrium refers to a situation, in which a consumer derives maximum satisfaction, with
no intention to change it and subject to given prices and his given income. The point of maximum
satisfaction is achieved by studying indifference map and budget line together. On an indifference
map, higher indifference curve represents a higher level of satisfaction than any lower indifference
curve. So, a consumer always tries to remain at the highest possible indifference curve, subject to
his budget constraint.

Conditions of Consumer’s Equilibrium:The

consumer’s equilibrium under the
indifference curve theory must meet the
following two conditions:(i) MRSXY =
Ratio of prices or PX/PY:Let the two goods
be X and Y. The first condition for
consumer’s equilibrium is thatMRSXY =
PX/PY

(a) If MRSXY &gt; PX/PY, it means that the

consumer is willing to pay more for X than the
 price prevailing in the market. As a result, the
consumer buys more of X. As a result, MRS
falls till it becomes equal to the ratio of prices
and the equilibrium is established.
(b). If MRSXY &lt; PX/PY, it means that the
consumer is willing to pay less for X than the
price prevailing in the market. It induces the
consumer to buys less of X and more of Y. As a
result, MRS rises till it becomes equal to the
ratio of prices and the equilibrium is established.
(ii) MRS continuously falls:The second
condition for consumer’s equilibrium is that
MRS must be diminishing at the point of
equilibrium, i.e. the indifference curve must be
convex to the origin at the point of equilibrium.
Unless MRS continuously falls, the equilibrium
cannot be established.Thus, both the conditions
need to be fulfilled for a consumer to be in
equilibrium.
In Fig, IC1, IC2 and IC3 are the three
indifference curves and AB is the budget line.
With the constraint of budget line, the highest
indifference curve, which a consumer can reach,
is IC2. The budget line is tangent to indifference
curve IC2 at point ‘E’. This is the point of
consumer equilibrium, where the consumer
purchases OM quantity of commodity ‘X’ and
ON quantity of commodity ‘Y. All other points
on the budget line to the left or right of point ‘E’
will lie on lower indifference curves and thus
indicate a lower level of satisfaction.
Thus, we can conclude that if the consumer is
consuming any bundle other than the optimum
one, then he would rearrange his consumption
bundle in such a manner that the equality
between the MRS and the price ratio is
established and he attains the state of
equilibrium.
Assumptions
Consumer’s equilibrium through indifference curve analysis is based on the following
assumptions.

1. The consumer is rational and seeks to maximize his satisfaction through the
purchase of goods.
 2. The consumer consumes only two goods (X and Y).
3. The goods are homogenous and perfectly divisible.
4. Prices of the goods and income of the consumer are constant.
5. The indifference map for goods X and Y are given. The indifference map is based
on the consumer’s preferences for the goods.
6. The preference or habit of the consumer does not change throughout the analysis.
7. The income of consumer is given and constant.

Ex:

Consumers Surplus and Producers surplus:

Consumer Surplus is the difference between the price that consumers pay
and the price that they are willing to pay. On a supply and demand curve, it is
the area between the equilibrium price and the demand curve

For example, if you would pay 76p for a cup of tea, but can buy it for 50p –
your consumer surplus is 26p
Diagram of Consumer Surplus

Producer Surplus

 This is the difference between the price a firm receives and the
price it would be willing to sell it at.
 Therefore it is the difference between the supply curve and the
market price.
Consumer Surplus and Marginal Utility

The demand curve is derived from our marginal utility. If the marginal utility
of a good is greater than the price, then that is our consumer surplus.
Can firms reduce consumer surplus?

1. Firms can reduce consumer surplus if they have market power. –

This enables them to raise prices above the competitive
equilibrium.
2. In a monopoly, a firm will maximise profits by reducing consumer
surplus. See monopoly diagram
3. Another way to reduce consumer surplus is to engage in price
discrimination. – Charging different prices to different groups of
consumers. Those with inelastic demand will see their consumer
surplus reduced. More on Price discrimination. To completely
eliminate consumer surplus, a firm would need to engage in first-
degree price discrimination – this means charging the consumer
the highest price they are willing to pay.
4. To gain market power, a firm could advertise to create brand
loyalty, this will make demand more inelastic
What is the significance of consumer surplus?

 In competitive markets, firms have to keep prices relatively low,

enabling consumers to gain consumer surplus. If markets were
not competitive, the consumer surplus would be less and there
would be greater inequality.
 A lower consumer surplus leads to higher producer surplus and
greater inequality.
 Consumer surplus enables consumers to purchase a wider
choice of goods.
Consumer Surplus and Producer Surplus in a market
A producer surplus combined with a consumer surplus equals overall economic
surplus or the benefit provided by producers and consumers interacting in a free
market as opposed to one with price controls or quotas. If a producer could price
discriminate correctly, or charge every consumer the maximum price the
consumer is willing to pay, then the producer could capture the entire economic
surplus. In other words, producer surplus would equal overall economic surplus.

However, the existence of producer surplus does not mean there is an absence
of a consumer surplus. The idea behind a free market that sets a price for a good
is that both consumers and producers can benefit, with consumer surplus and
producer surplus generating greater overall economic welfare. Market prices can
change materially due to consumers, producers, a combination of the two or
other outside forces. As a result, profits and producer surplus may change
materially due to market prices.

Theory of production(Book)

Theory of cost(Book)

Market types(Books)

*National income

GDP,GNP,NNP,NDP

Calculating method of national income