Economic Tales: The Irony of the Diamond-Water Paradox

ECONOMIC TALES: THE IRONY OF THE DIAMOND-WATER PARADOX

By Renee Gomez

The diamond-water paradox, also known as the paradox of value, is one of economics’ most well know fairy-tales, told to young economists crowded around the lecture board in Econ 101. This tale is a fable, told to teach budding economists a very important lesson: namely, the concepts of scarcity and marginal utility. On upon first hearing, the story seems obvious. Question: why are diamonds considered more valuable than water when water is essential to life? Answer: diamonds are scarce, and water is not, therefore one would place more value on the next diamond obtained. Simple enough, right? Except, perhaps the stars’ roles should be swapped, because as the truth behind the story shows, so-called scarcity of a resource is a function of management more than natural occurrence – and the effects on pricing and valuation can be messy.

Question: why are diamonds considered more valuable than water when water is essential to life? Answer: diamonds are scarce, and water is not, therefore one would place more value on the next diamond obtained.

For example, our underdog here is water, assumed to be boundless whilst actually being disturbingly limited. Indeed, whilst the world’s surface is 70% covered in water, only 2.5% is fresh, and of this freshwater only 0.3% is easily accessible (Earthwatch, 2005). In practice, only 0.007% of the world’s water is available to 6.8 billion people (National Geographic, 2020). Even then, we still have enough for everyone to access, yet we feel the pinch of the water crisis. This crisis has two faces: physical scarcity and economic scarcity. Physical scarcity occurs in arid regions such as the Middle East, where there is not enough water to physically meet demand – although this can be managed with the right infrastructure in place. Receiving the right infrastructure can be difficult however, due to factors ranging from cost to incompetence: thus, economic scarcity occurs.

Physical scarcity occurs in arid regions such as the Middle East, where there is not enough water to physically meet demand – although this can be managed with the right infrastructure in place.

For decades, there has been a trend of governments allowing poor infrastructure that leads to a lack of access to clean water and inefficiency in its supply. Take for example Mexico City, a land where it’s amazing downpours are enough to hydrate its 21 million inhabitants – and one where over half of its pipes are over 60 years old, leading to 40% of its water being wasted (NPR, 2018). The lack of infrastructure for capturing its heavy rains is due to the government’s unfocused urban development. Poor demand-side management isn’t unusual either; in Australia, rules put in place to manage the Darling River system have allowed irrigators to extract excess water (SBSNews, 2019), whilst in Mexico, farmers – the largest water consumers – have historically been allowed tax exemptions (OECD, 2004). Consumers utilize water as a free resource, whilst suppliers make it an economic good – a good with a degree of scarcity and therefore an opportunity cost. This is known as ‘the tragedy of the commons’ and reflects two issues: the first being that the market mechanism for pricing water is broken, and the second that in order water’s cost to be as low as possible, this man-made scarcity must be dealt with.

So, what of the story’s champion, diamonds? They are not even in the top 10 list of rarest gemstones. They are one of the most common gems in the world. Recently, it has been revealed that in the 1970s Russia had found diamond reserves in the Popigai crater that could supply the market for 3000 years (Mining Technology, 2012). Their total supply in the earth’s crust is limited of course, but no more so than most natural resources. More myths about diamonds abound, such as their supposed value as longterm investments – in fact, a diamond loses 50% of its value as soon as it is bought from a jeweller (Priceonomics, 2013). Unlike gold and other commodities, it is neither liquid (easily exchanged) nor fungible (easily split) thus the market for resale is limited. Therefore, what causes the thousand-dollar price mark-ups? The answers lie in a monopolist’s favourite supply tactic: artificial scarcity.

In practice, only 0.007% of the world’s water is available to 6.8 billion people (National Geographic, 2020). Even then, we still have enough for everyone to access, yet we feel the pinch of the water crisis. This crisis has two faces: physical scarcity and economic scarcity.

For over 100 years, De Beers has been the monopoly supplier of diamonds and followed the monopolist’s script perfectly. After gaining first-mover advantage by buying the massive diamond mines found in South Africa in 1888, De Beers gained an immovable stranglehold on the industry. Through De Beers Consolidated Mines Ltd, the company bought out competitors – or rather, they cooperated and formed a cartel – thus gaining control over the world’s supply of diamonds. A stockpile was established; De Beers carefully controlled how many diamonds would be released to the market for the year, whilst access to information about the stockpile was virtually unobtainable. By 1987, De Beers owned 80% of the market share (Paul Zimnisky, 2019), and diamond prices were at an all-time high. Demand was locked down as well. After prices plummeted during the Great Depression, De Beers drove demand through perhaps the most successful marketing feat in history. The slogan ‘diamonds are forever’ inextricably linked diamond rings to marriage, so that the percentage of brides receiving diamonds increased from 20% in 1939 to 80% in 1980 (De Beers Group, 2018). Rarity, love, financial success – _these were all words that caused diamond sales to follow the scarcity principle, which is the theory that limited supply drives higher demand. This in turn, gave diamonds the status of Veblen goods: items where a higher price leads to higher demand.

De Beers carefully controlled how many diamonds would be released to the market for the year, whilst access to information about the stockpile was virtually unobtainable.

In the end, what should we learn from the diamondwater paradox instead? Maybe it is that the natural availability of resources is not always reflected by the supply on the market. In addition, there are a range of factors that cause interference, whether it is due to opportunism, shortsightedness, or pure laziness. Or, maybe it is that the creation of scarcity in a market, whether artificial or accidental, tends to conflict with consumer perceptions to create an illusion of said goods’ value, which implies a failure of the price mechanism in said market. Ultimately, however we choose to reconsider the paradox, it is clear that the tale is much more complex than it appears; it’s kind of like finding out how much less wholesome the original tales that inspired our beloved Disney films really are.

References

“Water: A Limited Resource?” Earthwatch Fresh Water Watch, May 13, 2015. https://freshwaterwatch.thewaterhub.org/content/water-limited-resource.

“Competing for Clean Water Has Led to a Crisis.” Clean Water Crisis Facts and Information, April 6, 2020. https://www.nationalgeographic.com/environment/ freshwater/freshwater-crisis/.

Kahn, Carrie. ”Mexico City Keeps Sinking As Its Water Supply Wastes Away.” NPR. NPR, September 14,2018. https://www.npr.org/2018/09/14/647601623/mexicocity-keeps-sinking-as-its-water-supply-wastes-away?t=1590827503570.

Bhole, Aneeta. ”In Rural Australia, People Are Struggling to Access Reliable Water.” SBS News, October 16, 2019. https://www.sbs.com.au/news/in-rural-australiapeople-are-struggling-to-access-reliable-water.

“Sustainable Development in OECD Countries: Getting the Policies Right.” Paris: Organisation for Economic Co-operation and Development, 2004.

“Awash in Diamonds: Russia’s Secret Stash Revealed.” Mining Technology | Mining News and ViewsUpdated Daily, September 19, 2012. https://www.miningtechnology.com/features/featurediamonds-russias-secret-stash-siberia-crater/.

Dhar, Rohin. “Diamonds Are Bullshit.” Priceonomics, March 19 2013. Accessed January 13, 2020. https://priceonomics.com/post/45768546804/diamonds-arebullshit.

Zimnisky, Paul. “A Brief History of De Beers -Paul Zimnisky: Diamond Industry Analysis.” Paul Zimnisky | Diamond Industry Analysis, March 20 2019. Accessed January 5, 2020. http://www.paulzimnisky.com/a-brief-history-of-de-beers.

“The Diamond Insight Report 2018.” London: De Beers Group, 2018.