The Best Things in Life are Free
“Why is an essential commodity like water so cheap while a vain, impractical commodity like diamonds so expensive?”
I’m reading through a book called “The Making of Modern Economics” right now, my first serious look into economics, and this passage stuck out to me. It’s a description of the diamond water paradox, something that I’m sure most people have noticed at one point or another (although perhaps the luxury item in question was a rare pokemon card or something with a supreme logo).
The answer the author gives is as follows:
“Resolving the diamond-water paradox, the marginalists demonstrated that the difference in value between water and diamonds is due to the relative abundance of water and the relative scarcity of diamonds (given the demands). Since the supply of water is abundant, the demand for each additional unit is low.” (Emphasis mine)
Now this is completely satisfactory if the point is to discuss marginal utility, but I wanted to pursue the question one level deeper. Why is it that water is so abundant and diamonds are so scarce?
My theory is that in any economic context, the resources that are absolutely necessary for any production or exchange will be very close to maximally cheap. This is because minimizing the cost of these necessities will have major impacts on the cost of production.
Water is the perfect example of this rule, why is it that so many human societies are clustered around fresh water sources? Well, it’s because water is ground zero in our hierarchy of needs. The cost of building a house away from a source of water is very high, you’d need to constantly cart water over from some other area. Meanwhile, even if building near a river includes other costs, the benefit of having a fresh water supply for free is too valuable. Because water is so inherently valuable, it naturally is cheap in the marketplace!
Going back to the water-diamond paradox, I’d imagine if diamonds were necessary for our survival, they’d be a lot cheaper. Suppose we needed to consume a little bit of diamond every night, being deprived of this new vitamin d would result in death within a week. I’d imagine in this scenario, cities and human society would cluster around areas rich in diamonds. I’d also imagine that we’d have a lot more miners employed, as well as being far more advanced and efficient in extracting diamonds from the earth. While the demand for diamonds would be higher than ever, I’d imagine that the supply and production of diamonds would be even greater proportionally.
But does that necessarily follow? Let’s try to work out why the price of diamonds would drop dramatically in our world where carbon is even more important for life than before.
When diamonds are a necessity, the quantity of diamonds being sold increases by many magnitudes. This means that any marginal decrease in cost results in a much larger profit.
Another change would be that the value of diamonds is now no longer tied to ephemeral things like brand value or cut or aesthetic preference or any of that. When you need to consume diamonds every week, you’d have to be a fool to pay high prices for vapor distilled “smart-diamonds” infused with antioxidants and electrolytes (although there is admittedly a market for fools). No, diamonds would be extremely inelastic, since the vast majority of people would simply buy the cheapest diamonds possible that would satisfy their vitamin d deficiency.
Because of these two new changes, I’d expect the cost of diamonds to quickly approach their maximally cheap cost. Any society that still operated with high cost diamonds would quickly find labor prices skyrocketing and no productive work would be possible.
But does this rule hold for commodities other than water or the diamond example above? After all, there’s a lot of fresh water available on Earth, perhaps that’s the real reason for its abundance and low market value. Shelter is also a basic human necessity, does the rule apply there as well?
Initially as I thought about it, it seemed like the rule didn’t hold. After all, rent prices vary wildly across the nation, it seems a little hard to believe that what I paid in NYC was “maximally cheap.”
My first response is that perhaps NYC rent prices ARE maximally cheap! It would make sense that rent goes up in areas where land is scare. In an area like Manhattan, even if shelter is a necessity, it doesn’t mean that we can just continue packing people into a constant amount of land. After all, if we tried to fit 100 million people on that island, even though everyone needs shelter, we can’t just magically meet that need. IE, you may have a right to water, but if you’re in a desert, nature has no obligation to respect that right (If you crash land on a desert island, litigation is probably not the best course of action for getting fresh water).
So since land is scarce in cities, the prices of shelter must be naturally higher, but that does not contradict my theory! In an area where an acre of land has a value of $1000/month (perhaps because a Starbucks would generate that much money on it), a maximally cheap housing unit will still have an inherent cost of $1000/month. Perhaps that feels “too expensive” for someone who grows up elsewhere (or simply doesn’t like shelling out that much money), but it’s still maximally cheap.
My second response is that rent prices are already super twisted. I don’t understand very much about housing prices, but I know that extremely distorted by volumes of legislation in cities. So I’m not particularly worried that my theory doesn’t apply when market principles are violated.
My third response to that is that perhaps “shelter in Manhattan” is not a base need. Living in Manhattan is far closer to a luxury than a necessity, and my theory only applies to resources that are a necessity. It would probably be more fair to measure the cost of shelter in Manhattan to be the cost of commuting in from New Jersey or something like that, which is significantly cheaper than living in East Village.
In conclusion, I like my theory and I think it makes sense. I’ll continue to think about it though, perhaps there are exceptions. But my impression is that it will hold in every scenario simply because deserts are known for not being conducive to human flourishing. If a resource is a necessity, you’re not going to settle down somewhere where it’s impossible to find.
On Michigan and California:
As I was thinking on this topic, my mind wandered to the fact that water’s value will continue to rise in the future as climate change makes droughts and wildfires more common across the world. I have some thoughts about how we ought to think about the value of water in this future, but I think I’ll put that on another article.
