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IAI Actuarial Core Principles · Business Economics · Consumer demand and behaviour

Which statement about the diamond-water paradox is correct in terms of marginal utility?

Water is cheap because it is abundant, so the marginal unit adds little utility, even though water's total utility is very high. Diamonds are scarce, so their marginal utility and price are high. Price follows marginal rather than total utility.

  1. AWater has low price because its total utility is low
  2. BDiamonds have high price because their total utility exceeds that of water
  3. CWater has low price because its abundant supply makes its marginal utility low, despite high total utilityCorrect
  4. DDiamonds are priced high because their marginal utility is low
  5. Price depends only on total utility, so the paradox is unresolved

Explanation

Price reflects the value of the marginal unit consumed. Water is abundant, so the last unit adds little utility and price is low even though total utility of water is very high. Diamonds are scarce, so marginal utility and price are high.

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