Why is Water Cheaper than Diamonds?
Economist Adam Smith once posed an intriguing question. He asked, “Why is water, which is essential for life, so cheap while diamonds which are nothing more than pretty stones so expensive? The question became known as the diamond-water paradox and the answer would take just over one hundred years to solve. But the solution sheds tremendous insights as to why drinking water is stripped from the shelves during hurricane season.
Economists figured out there is a difference between “total value” and the incremental value or “marginal value.” The word “marginal” just means “additional” so the marginal value of any product or service is the value of the next unit consumed.
For instance, assume you are given only a fixed amount of water to use each month, say 15,000 gallons. You have no access to other sources and must make due with your monthly allotment. You would first set aside an amount necessary for the most important use – survival. After that need has been met, you may use some for the next most important use, say bathing. Once that volume has been established, you may decide to use some for washing dishes. The same reasoning continues with each additional use having less value to you. Let’s assume that your list ends with setting water aside for watering the plants, washing the car, and washing windows.
Notice that, as the list grows, the value of each use diminishes. If you discovered that you were short-changed some water for a month, you wouldn’t reduce all activities by a proportional amount. Instead, you’d drop off the least valuable use. For instance, if you were missing a couple gallons of water, you’d simply not wash windows for that month rather than reduce all activities in proportion to make up for the shortage. The value of that last use of washing windows – the marginal use – is very low. While the final gallon may be worth your life, the marginal value of water to you is very low. The marginal value is for washing windows.
However, the total value of your water supply is very high. After all, it does include the amount set aside for survival. The total value is high; the marginal value is low.
Using the same reasoning, because water is so plentiful, at least in the United States, the marginal value of water is very low. If you are forced to cut back by a few hundred gallons per month, there’s not much pain felt because the discarded activities do not have much value to you. Your windows may get a little dirty and the dog may not get a bath but, aside from that, there’s not really any damage to speak of. Therefore, the amount of money you’re willing to spend on your next gallon of water is pretty low. It has a low marginal value.
Diamonds, on the other hand, work in the opposite way and have a low total value. After all, they are just pretty rocks, not necessary for survival. However, because they are so scarce, their marginal value is high. The next diamond you purchase – your marginal purchase – is probably for a wedding, anniversary or other special occasion you value highly. Chances are you are not buying it for a key chain. Diamonds have a low total value and high marginal value.
It is the marginal values that determine price. Because diamonds have a higher marginal value, their price is much higher than water. Water, on the other hand, has a much higher total value but a smaller marginal value. It is the marginal value that determines price and that’s why diamonds cost more than water and the paradox is solved. However, if water was in extremely short supply, so short that your life depended on the next gallon, you can be sure the marginal value of water would be very high indeed – you’d trade in every diamond you had for it.
Many people wonder why go through the trouble of marginal values? Isn’t the paradox solved by simple supply and demand analysis? For example, there is much higher supply of water compared to diamonds and therefore its price should be lower. Yes, but that still doesn’t solve why diamonds cost more than water if they are essential to life while diamonds are not. The distinction emerged once economists figured out there is a difference between total value and marginal value.
Now let’s use our newfound knowledge of marginal and total values to further understand why there’s no water on the supermarket shelves prior to a hurricane. When a hurricane is about to strike, the demand for water skyrockets. People are fearful they may be out of water for weeks. And because of this, the marginal value of water is very high. People should really be stocking up for survival and not for watering plants and changing the goldfish bowl. If the marginal value is high then so should be the price.
If the supermarket was allowed to adjust price to reflect the new, higher demand, water may be priced at $8 per gallon. If so, people would gladly pay it for survival and everybody would get some. However, because the government steps in and artificially keeps the price low, the marginal uses increase. People can easily afford the water necessary for survival but they can also afford more for cooking, watering plants, washing the dog, washing windows, and changing the goldfish bowl. Why won’t they be courteous and take only what they need? That’s economics. People act in their self-interest and do what’s best for them. If the price allows for low marginal uses, they will act accordingly and do so. In the meantime, the majority of the community is left without drinking water. At least the government assures that the goldfish are happy.
Batteries are anther example. Just prior to a hurricane, people should buy batteries to power weather radios and flashlights. But the government tells the supermarket they can’t raise battery prices either. After all, that’s price gouging and wouldn’t be fair to the community. The last time I was in Home Depot during Hurricane Frances, the customer in front of me 80 packages of batteries. So while his children will be entertained with Game Boy and the family will have fun watching DVDs and listening to music during the hurricane, the rest of the community fumbles around in the dark looking for batteries.
Remember that it is always the marginal buyer that determines price. The last bidder is the one that determines the price of the eBay auction. The last person to bid determines the price of the stock or option. The last person to buy the bond determines the interest rate. Many paradoxes appear in finance but can easily be solved if you just remember the difference between total value and marginal value.
We Want More Water
In our previous example, we calculated that people traveling through the desert would buy 6 liters at $6 each. What if they demanded more water? That's easy to fix if they understand economics. They simply need to raise their demand and be willing to pay higher dollar amounts for it. They need to raise the marginal price. The law of supply tells us that, if price is raised, sellers will have an incentive to bring more to market. For example, let's now assume that each tourist is willing to pay an additional $4 per liter so that the first tourist is willing to pay $15 instead of $11, the second tourist is willing to pay $14 instead of $10 and so forth as shown in Table 3:
Table 3:
Using the same reasoning as before, we can see that eight liters will be brought to market and total revenue will be $64. Eight tourists demand water at $8 (or higher) so 8 tourists * $8 per liter = $64 revenue. With the higher demand, economists would predict that you would now bring eight liters to market instead of six. And the market raising the price it is willing to pay for your water controlled all your actions. Remember, it is not supply or demand alone that counts; it is the interaction between the two forces.
Whenever prices are rising, it is a call from the market that more supply is needed. The higher prices give sellers the incentive to step up production and bring the output to market. In other words, if the demand rises, prices rise and sellers respond by increasing the amount they’re willing to sell.
It is exactly this process that keeps the stock exchanges from running out of shares of stock. Many investors wonder why you never hear about shares of Microsoft or Intel running out even though there is a fixed supply. The reason is that as buying pressure rises, the market makers or specialists on the exchanges simply raise the bid and asking prices. The higher bid provides the incentive for investors to sell; the higher asking price reduces the number of buyers. So the reason the exchanges never run out of shares of stock is because they are allowed to raise prices. If there is a sudden increase in demand, the share price rises to a point that exactly clears the market.
For example, on Friday May 1, 1998 shares of Entremed (ENMD) closed the trading day at a price around $13. The next trading day, Monday, May 4, the shares opened at $80 and traded as high as $85 on news that breakthrough drugs angiostatin and endostatin worked by cutting off blood supply to cancerous tumors. That’s an instantaneous price increase of about 515%. Prices fluctuate instantly and without boundaries on stock exchanges and that’s why shares are always available. As soon as there is a surge in demand, the price adjusts to balance the buyers and sellers. The exchanges will never run out of shares.
It’s a curiosity why the government doesn’t consider radical price changes on the stock market as “price gouging” and step in to protect the consumers as they do from the “price-gouging” supermarkets during hurricanes. If they did, you can be sure there’d be days when you couldn’t buy shares of stock since there’d be none available. But if you let the market dictate price, the supply never runs out. The price adjusts in such a way that there is always an equal number of buyers and sellers.
So what determines price gouging? The Office of the Attorney General (found at myFloridaLegal.com) defines “price gouging” as follows:
The law compares the price of the commodity or service to the average price charged over the 30-day period prior to the declared state of emergency. If there is a “gross disparity” between the prior price and the current charge then it is price gouging.
An increase of 515% on a stock is okay while a gallon of water jumping 200% from $1 to $3 is not. During a state of emergency, everyone should be allowed to have water, ice, batteries and other essentials and that means price should be allowed to fluctuate. But apparently the office would rather side with the common misconception that rising prices during a surge in demand is a criminal act. Votes are apparently more important than citizens’ survival.
The ability to change price is the very reason the world’s supply of oil will never run out. Most people say it’s obvious that we will one day since it is a natural resource in fixed quantity. However, corporations own the rights for oil and will thus increase the price as the supply drops or demand increases. If the earth only had one gallon of oil coupled with an insatiable demand for it, the supply would never run out, but it may cost $1 billion per drop. Of course, this high price gives others the incentive (law of supply) to either look for more oil or create alternative sources, thus increasing the supply (or substitutes) thereby lowering its price.
In the previous desert examples, we assumed you were able to bring as much water as possible to market. There were no assumptions about costs to the seller. In the last example, we found that eight liters of water would be brought to market at $8 each; however, if each liter cost you more than $8, we would certainly not see any brought to market. This oversimplified example just makes the concept of how prices are determined easier to follow. But now let’s take the next step and consider another example, which does include costs to both buyer and seller.