Economist John Stuart Mill saw utility as “the feelings of pain and pleasure”. The utility, or usefulness, of something depends on how much it satisfies a person's needs or wants. Positive utility might be thought of as 'pleasure', negative utility as 'pain'. 

While utility is subjective (some people may hate music that others love), people reveal the utility of something to them by how much they are willing to pay for it.

The utility of water is high, because it is necessary for survival. So why is water cheap while diamonds, which are dispensable, are dear?

The Labour Theory of value proposed that the price of something is determined by the “toil and trouble” of the labour. Perhaps a nervous young man slipping a diamond ring onto his true love's ring finger is thinking of nothing more than the workers in the diamond mines as he considers the two month’s salary just spent.

But the theory of Marginal Utility was revolutionary in resolving the water-diamond paradox.

Marginal utility is the additional utility to the same person from a tiny bit more of the same thing. If you only have access to one litre of water per day, you would likely drink it. With ten litres, you might also prepare food. With 100 litres you could also bathe your family. And with 1,000 litres you might fill your swimming pool.

Each of these activities – drinking, cooking, bathing and swimming for pleasure, is of less value than the preceding activity. The law of diminishing marginal utility proposes that the more we have of something, the less value we will put on having a little bit more.

When water is plentiful, the value of another litre (i.e. the marginal utility) is low. Conversely, diamonds are scarce and coveted, even at the margin. Water is cheap because its marginal utility is low; and diamonds are dear because their marginal utility is high.   

That diamond rings are so highly desired brings us back to the subjective nature of utility. Studies show that when people are tricked by cheap wine in a fancy bottle, they will perceive that it tastes better than the same wine served in a plain bottle. Brain scanning technology shows that when participants drink the supposed fancy wine, “the parts of the brain associated with reward and pleasure light up like a Christmas tree”.

The smiles on the faces of the newly engaged pair suggest they are experiencing the same rush of pleasure chemicals. For her, perhaps this is because the diamond is her new best friend. And he is not likely thinking of the diamond mine workers.

Since he so highly values her commitment to him, the diamond’s utility is worth the price.  

Loosely coinciding with this year’s election campaign, Insights is campaigning for economic literacy from A to Z. Coming up next week: ‘V’ for volatility.