[Related to Solved Problem 3.3 on page 88\(]\) In The Wealth of Nations, Adam Smith discussed what has come to be known as the "diamond and water paradox": Nothing is more useful than water: but it will purchase scarce anything; scarce anything can be had in exchange for it. A diamond, on the contrary, has scarce any value in use; but a very great quantity of other goods may frequently be had in exchange for it. Graph the market for diamonds and the market for water. Show how it is possible for the price of water to be much lower than the price of diamonds, even though the demand for water is much greater than the demand for diamonds.

Understanding the supply and demand curves is fundamental in economics. These graphical representations illustrate how much of a good or service is desired by consumers at various price points (demand), and how much can be provided by suppliers (supply). The demand curve typically slopes downward, showing that as the price falls, more consumers are willing and able to purchase the good. Conversely, the supply curve generally slopes upward because as the price increases, suppliers are more inclined to produce and sell more.

For instance, water has a high demand at almost any price, because it is a necessity; this would be depicted as a demand curve far to the right on a graph. Diamonds, with less necessity, have lower demand at higher prices. Graphically, the diamond demand curve would start further left compared to water. It's by examining where these curves intersect with their respective supply curves that we find the market equilibrium.

Market equilibrium occurs at the point where the supply curve intersects with the demand curve. At this crossroads, the quantity of the good consumers are willing to buy exactly matches the quantity suppliers are willing to sell at a particular price. This means the market is in balance; there is neither an excess of supply (surplus) nor a deficiency (shortage).

For water, the equilibrium price is likely to be low because the supply is plentiful; the curves meet at a low price point. In the case of diamonds, the natural scarcity shifts the supply curve to the left and its steepness indicates that the quantity available doesn’t increase much even with higher prices, positioning the equilibrium at a much higher price level.

Scarcity is a pivotal concept in economics, emphasizing that the limited availability of a resource can lead to increased prices. The more scarce an item is, the steeper its supply curve, indicating that even small increases in quantity supplied require large price increases. Pricing relies on this balance of scarcity and the perceived value of an item by consumers.

In the 'diamond and water paradox', water's abundance leads to a flat supply curve and low prices, whereas diamonds' rarity results in a steep supply curve and high prices. This helps explain why certain goods that are crucial to life—like water—might be cheaper than luxury items like diamonds, which are far less essential but much rarer.

Adam Smith, often known as the father of modern economics, explored fundamental economic concepts in his seminal work, 'The Wealth of Nations'. Smith discussed the 'diamond and water paradox' to illustrate disparities in value and price. He attributed the paradox to what he termed 'value in use' versus 'value in exchange'. In short, although water has immense 'value in use' due to its necessity for survival, its 'value in exchange' is low because it is so plentiful. Diamonds have little 'value in use' but a high 'value in exchange', due to their allure and rarity. Smith’s explanation emphasizes how markets assign prices not merely based on utility but also on scarcity and consumer preferences.