Adam Smith [1723 – 1790] was confounded. One of the greatest economic and social thinkers in the history of ideas struggled with the so-called “diamond-water paradox,” which Smith explained in Chapter 4 of Book I of Wealth of Nations: “Nothing is more useful than water: but it will purchase scarce anything…. 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” )quoted in Skousen and Taylor, 1997). None of us would be able to live beyond a couple of weeks without water, yet its price is relatively cheap compared to the frivolous diamond, which certainly no one needs in order to stay alive.
Most people confronted with this paradox – including Smith – would resolve it by replying the supply of diamonds is sparse compared to water, and hence they command a higher price. This is an intuitive, and very reasonable, solution. After all, water is approximately 71 percent of the earth’s surface, while diamonds are found in only a limited number of places in the world, and the supply is even further restricted by diamond cartels, such as De Beers, which of course did not exist in Smith’s day.
Yet the scarcity theory lacks explanatory power…. Besides being abundant, water tends to be priced based on the marginal satisfaction of the last quantities consumed, so the water you use to wash your car is far less valuable than the first few litres drunk to quench your thirst. Of course, if the water companies knew you were dehydrated in the desert, instead of washing your dog, they would be able to price those precious first litres at a higher price; but learning this type of information about exactly what all of their customers are doing with the water they use is prohibitively expensive. However, bottled water companies have figured out how to extract some of the consumer surplus, since they are partially selling convenience, and able to charge a higher price for water than petrol (R. Baker, Pricing on Purpose, 2006)
No comments:
Post a Comment