Marginalist theory

Marginalism explains choice with the hypothesis that people decide whether to...

Marginalism explains choice with the hypothesis that people decide whether to effect any given change based on the marginal utility of that change, with rival alternatives being chosen based upon which has the greatest marginal utility.

Market price and diminishing marginal utility

If an individual possesses a good or service whose marginal utility to him is less than that of some other good or service for which he could trade it, then it is in his interest to effect that trade. Of course, as one thing is sold and another is bought, the respective marginal gains or losses from further trades will change. If the marginal utility of one thing is diminishing, and the other is not increasing, all else being equal, an individual will demand an increasing ratio of that which is acquired to that which is sacrificed. One important way in which all else might not be equal is when the use of the one good or service complements that of the other. In such cases, exchange ratios might be constant.[10] If any trader can better his position by offering a trade more favorable to complementary traders, then he will do so.

In an economy with money, the marginal utility of a quantity is simply that of the best good or service that it could purchase. In this way it is useful for explaining supply and demand, as well as essential aspects of models of imperfect competition.

Paradox of water and diamonds

Main article: Paradox of value

The "paradox of water and diamonds", usually most commonly associated with Adam Smith,[15] though recognized by earlier thinkers,[16] is the apparent contradiction that water possesses a value far lower than diamonds, even though water is far more vital to a human being.

Price is determined by both marginal utility and marginal cost, and here the key to the "paradox" is that the marginal cost of water is far lower than that of diamonds.

That is not to say that the price of any good or service is simply a function of the marginal utility that it has for any one individual nor for some ostensibly typical individual. Rather, individuals are willing to trade based upon the respective marginal utilities of the goods that they have or desire (with these marginal utilities being distinct for each potential trader), and prices thus develop constrained by these marginal utilities.