The Diamond-Water Paradox : The Indicator from Planet Money The Diamond-Water Paradox poses the question: If we need water to survive and we don't need diamonds, why are diamonds expensive and water cheap?

The Diamond-Water Paradox

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STACEY VANEK SMITH, HOST:

I am from the West. I'm from Idaho. And in the West, we are obsessed with water. And I grew up with this kind of innate defensiveness around water. Somehow I always had this feeling that Californians, like, evil Californians were coming after our water.

CARDIFF GARCIA, HOST:

I'm just going to go ahead and interrupt our show real quick to tell you that I think that both I and our listeners are delighted to discover this kind of emotional water-based insecurity on your part.

VANEK SMITH: And the reason for this is agriculture is really big in Idaho - I mean, the potatoes and many other things. And most of the water for those crops comes from aquifers and rivers and streams. It does not come from rain. And so during droughts, some farmers would have their water shut off in the middle of a growing season, and they would lose their whole crop. So water is a big deal. It's very emotional. And that is probably why I've always been fascinated by this fundamental question in economics call the diamond-water paradox.

GARCIA: And, in fact, this paradox is one of the first economic conundrums that was ever formally articulated by Adam Smith, the founder of economics. And to better understand it, we called up Linda Yueh.

LINDA YUEH: Hello, I'm Linda Yueh. I'm an economist, and I'm the author of "What Would The Great Economists Do?: How 12 Brilliant Minds Would Solve Today's Biggest Problems."

VANEK SMITH: And one of the brilliant minds is, in fact, Adam Smith.

YUEH: Yes, the brilliant mind, you might say, the father of economics himself.

GARCIA: Adam Smith, you might recall, believed in the power of the market, the so-called invisible hand that guides our economic interactions every single day. And he thought that the free market was really good at placing the right value on things, the right price on things.

VANEK SMITH: But for Smith, there were a couple of thorns in the side of this elegant theory. And one of them was the diamond-water paradox. This is THE INDICATOR. I'm Stacey Vanek Smith.

GARCIA: And I'm Cardiff Garcia. Today on the show - the diamond-water paradox, plus who eventually cracked it.

(SOUNDBITE OF DROP ELECTRIC SONG, "WAKING UP TO THE FIRE")

GARCIA: OK. The diamond-water paradox - here it is. We need water to survive. We absolutely do not need diamonds to survive. So why is it that diamonds are so expensive and water is so cheap? Why do we value diamonds so much more than we seem to value water?

VANEK SMITH: Which we literally cannot live without.

YUEH: And yet, diamonds are priced more highly, implying that prices and value don't quite match. And this is a real conundrum because when Adam Smith put forward his theory about how we should leave it to the market, it's on the basis that the market can efficiently price the goods and services that we consume based on supply and based on what we demand. And implicitly within that, it's also a reflection of the value (inaudible). Adam Smith actually really struggled with this.

GARCIA: The first - good old-fashioned supply. There's water literally falling out of the sky, gushing down from mountain peaks, just sitting in big open lakes. And then there's diamonds, which do not fall out of the sky. They're...

VANEK SMITH: Unfortunately.

GARCIA: Yeah, they're deep underground.

VANEK SMITH: Well, maybe fortunately. That would be terrible (laughter).

GARCIA: They're surrounded by rocks so, like, they're hard to get to, hard to get out of the ground. And that especially applies back in the 1700s when Adam Smith was writing.

YUEH: I think the way that Adam Smith began to view it is that diamonds are more scarce than water, and that could explain some of the paradox.

VANEK SMITH: But not all of it. Linda says scarcity does not quite solve the diamond-water paradox because water is not always abundant.

YUEH: But the minute you start to realize that, actually, in some places of the world, water is scarce, then the supply there begins to look more like diamonds. So then you would expect a higher price.

VANEK SMITH: But, says Linda, you usually don't really get a higher price. And even if the price of water does go up, it does not typically get into diamond price territory.

GARCIA: Linda says that another solution Adam Smith and other economists have considered was that maybe the value of diamonds versus water had to do with the amount of labor involved in getting them. Like, maybe we value things based on how hard it is, how much work we have to do to produce them. But that wasn't really quite there either. That one also wasn't watertight.

VANEK SMITH: (Laughter) I'm sorry.

GARCIA: Watertight.

VANEK SMITH: Sorry, Cardiff.

YUEH: But just looking at labor wouldn't explain the diamond-water paradox because, for instance, yes, diamonds can be hard to mine, but water can sometimes be hard to get as well if you live in, for instance, a desert.

VANEK SMITH: Linda says Adam Smith died in 1790 never having truly cracked the diamond-water paradox. And for a hundred years, economists were wrestling with this question.

YUEH: But the paradox - it wasn't really fully explained until the neoclassicists emerged. So I'm talking specifically about Alfred Marshall.

GARCIA: Alfred Marshall - famous economist, he was at Cambridge and he was very much in the school of Adam Smith in the tradition of Adam Smith. And the way that Marshall cracked the diamond-water paradox was by recognizing that the way we value things is not totally fixed.

YUEH: It's not the absolute price or the absolute level of utility that matters. It's the marginal utility.

GARCIA: The idea is that when you set a price for something like a diamond or a barrel of oil or a gallon of water, you don't just price it according to how much you value it writ large, by how much you value its very existence, because, in that case, water would trump diamonds every single time. I mean, you literally need it to stay alive. Instead, the value of something is dictated at least in part by the extent to which you want that thing or you need that thing in a given moment.

VANEK SMITH: Exactly. So, OK, Cardiff, say that I have all the water. I own all the water, and you need water. So the first gallon of water - the value for that is going to be really high. I mean, you need it to survive. You would probably pay me anything I asked to get that first gallon of water. The second gallon - also very valuable. You could use it to brush your teeth or wash your dishes - all kinds of uses. But what about the 20th gallon or the 50th gallon? I mean, how much would you pay me for those? It's more than you can use. And now, it's just taking up space in your apartment. And, you know, New York apartments...

GARCIA: It's not a very big apartment.

VANEK SMITH: That is - that becomes a problem. By the 50th gallon, in fact, you might not want that water at all anymore. It is not valuable to you. Let's say you won't pay me anything for it at all. Its value for you has now dropped to nothing.

GARCIA: Right. Because, like, I started by using it for the thing that I vitally needed it for - to stay alive, to hydrate, right? Then I started using it for some things that were luxuries, I guess, like taking a shower or brushing my teeth or whatever.

VANEK SMITH: (Laughter).

GARCIA: And beyond that, I start to get a diminishing amount of enjoyment from the added gallon of water. So, yeah, that first gallon - going to pay you all the money. The last gallon - I might not pay you anything. I might just pass it up.

VANEK SMITH: Exactly. But now imagine that I am selling diamonds. That is a different story.

YUEH: Yes. So you can imagine you get one diamond. Maybe you get another diamond. Now it's a pair of diamond earrings. You get another few diamonds. Maybe you make a bracelet, you know.

VANEK SMITH: All of a sudden, Cardiff's all blinged-out.

(LAUGHTER)

GARCIA: And showered.

VANEK SMITH: (Laughter).

GARCIA: So the first diamond I get - awesome; the 20th diamond - still awesome; the 50th diamond - still actually kind of awesome. The value of diamonds has less of a relationship to how many diamonds I've already got. So I'd probably pay, you know, close to the same amount for the 50th diamond as I would for the first in part because I would expect those diamonds to hold their value. And that might be why I bought them in the first place. So we can say that the marginal value of diamonds, the extra value you get for another diamond, is higher than the marginal value of water.

VANEK SMITH: Exactly. More diamonds - more value. More is more. More water - not necessarily more value. More is relative. Diamond-water paradox - solved.

GARCIA: Boom.

VANEK SMITH: It is funny the way we value things. It is confusing. It's good to know that also Adam Smith struggled with this.

YUEH: (Laughter) Well, I think when economists struggle with something, they call it a paradox. It can't be explained either.

VANEK SMITH: They're not confused. They are struggling with the paradox. This is the nature of what it means to be an economist.

(SOUNDBITE OF DROP ELECTRIC SONG, "WAKING UP TO THE FIRE")

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