When I think "Dwarf paint" I'm not thinking watercolors. I'm thinking furnature and construction. I'm also thinking that paints cover the "natural beauty" of an object.
My in game use: So-and-so likes the color lavender? Paint his room that color. Suddenly his bland boring walls are his favorite color. His room is personalized, giving him some happiness to be there.
On the other hand, I think that painting things should remove the preference bonuses for things that are made with a prefered material (if she likes oak and green, and all of her oak furnature is painted green, it gets the personal value bonus for green, but not oak.) I'm not sure I stated that clearly, but hey, whatever.
As to how it's made... You have powdered color. You have water as a solvent (or better, booze, since irl it evaporates better, and it has it's own colors, too). I think either some of either clay (think white clay), flour or some new mysterious powder for a thickening/opaqueing agent.
I particularly like the idea of some new powder made from grinding stones (stone dust), especially if you consider that first really common paint, whitewash.
wikipedia says : Whitewash, or calcimine, kalsomine, or calsomine is a very low cost type of paint made from slaked lime (calcium hydroxide) and chalk (whiting).
Additives that have been used include water glass, glue, egg white, Portland cement, salt, soap, milk, flour, earth, blood.
Wheat flour has been used as a strength enhancing binder. Salt is usually added to prevent the flour going mouldy later in damp conditions. The use of salt brings its own issues.
Simple lime paints are very low cost. A 25 kg bag of lime makes around 100 kg of paint, and costs around £6 in the UK (2008).
So... a few new mechanics(like the Adams boys don't have enough to do already) and whee, paint! (vastly different than Wii Paint.)