The Diamond-Water Paradox revisited

Content by Ramzi Bouzerda and Dr. Christian Hugo Hoffmann

Authored in Smart Water Magazine February 2021 "Efficiency for Asset Management Excellence"

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We live in times of a perplexing paradox: Even though water is overall the most important resource on this planet – tout court, for life to emerge as well as for survival –, reality draws a picture of it that hardly seems consistent. On the one hand, pictures come to mind that support the view of tremendously precious water – and at Droople, it is our core belief that “every drop counts”.

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But on the other hand, we come across daily situations in which water doesn’t seem to be valued because we simply pay more for all other kinds of items. In the country these two authors live in, a glass of water is basically for free while a diamond which is basically of aesthetic value only (if we abstract away the very few industrial settings like drilling where diamonds are employed) costs thousands of Swiss francs in the market. How can that be? How can it be that we pay a high price for a commodity that is mostly useless, especially in times of severe crises, and are unwilling to give little in return for a good that decides over life and death?

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Towards resolving the paradox 1.0: Classical Economics

The philosopher Adam Smith is often considered to be the classic presenter of this paradox, although it had already appeared earlier in the work of John Locke or Plato for example. In a section of Adam Smith’s An Inquiry into the Nature and Causes of the Wealth of Nations, he distinguishes the concepts of value in use and value in exchange, which he observes to differ in some contexts:

What are the rules which men naturally observe in exchanging them [goods] for money or for one another, I shall now proceed to examine. These rules determine what may be called the relative or exchangeable value of goods. The word VALUE, it is to be observed, has two different meanings, and sometimes expresses the utility of some particular object, and sometimes the power of purchasing other goods which the possession of that object conveys. The one may be called “value in use;” the other, “value in exchange.” The things which have the greatest value in use have frequently little or no value in exchange; on the contrary, those which have the greatest value in exchange have frequently little or no value in use. Nothing is more useful than water: but it will purchase scarcely anything; scarcely anything can be had in exchange for it. A diamond, on the contrary, has scarcely any use-value; but a very great quantity of other goods may frequently be had in exchange for it.

Smith explained the value in exchange as being determined by labor: The real price of everything, what everything really costs to the man who wants to acquire it, is the toil and trouble of acquiring it.  Hence, Smith not only denied a necessary relationship between price and value, he could also not envision a world where it takes a lot of effort to clean and purify water or where the supply of drinking water shrinks. Let’s therefore look for a better resolution of the paradox.

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Towards resolving the paradox 2.0: The Austrian economic view

About a century later, the work of Carl Menger, founder of the Austrian School of Economics, brought a different resolution of the Diamond-Water Paradox, based on marginal utility rather than labor and incorporating the point of view of the consumer. It is not the overall utility of a good, nor how much labor was exerted in its production which is relevant for its value, but the marginal utility of a concrete unit that we can give up or gain. Put differently, its price is determined by its utility at the margin. The marginal utility of a good is derived from an additional unit’s use to a person. So, if someone possesses a good, they will use it to meet some need or want, starting with the one that takes highest priority. Eugen von Böhm-Bawerk, a proponent of the Austrian School of Economics, illustrated this with the example of a farmer having five sacks of grain:

With the first, he will make bread to survive. With the second, he will make more bread, in order to be strong enough to work. With the next, he will feed his farm animals. The next is used to make whisky, and the last one he feeds to the pigeons. If one of those bags is stolen, he will not reduce each of those activities by one-fifth; instead he will stop feeding the pigeons.

From the Austrians we can learn that we ought to differentiate between price and value which are often confused. Value in an economic sense is the basis of human decisions, namely the subjective expectations about the suitability of possible means for our respective goals. Prices, on the other hand, are concrete, completed and thus past exchange relationships in which our decisions are expressed in the interplay with decisions of others. Prices influence our future value expectations, but are always above or below them. Prices reflect what we must give in exchange, not what we receive, as Warren Buffett (and probably many before him) already pointed out. The difference between value and price is our subjective profit (which would be negative if the price was higher than our appreciation of the good we buy). Without expecting that positive profit, we would simply not trade with the other.

In resolving the Diamond-Water Paradox, Austrians explain that it is not the total usefulness of diamonds or water that determines their price, but the usefulness of each unit of water or diamonds. Like this, we can acknowledge both that the total value or utility of water to people is tremendous, because they need it to survive, while the marginal utility of water is low, since water is in such large supply in the world. In other words, each additional unit of water that becomes available can be applied to less urgent uses as more urgent uses for water are satisfied.

Therefore, any particular unit of water becomes worthless to people as the supply of water increases. On the other hand, diamonds are in much lower supply. It is of such low supply that the value of one additional diamond is greater than the value of one additional glass of water, which is (but for how long?) in abundant supply. Thus, diamonds are worth more to people and, as a consequence, those who ask for diamonds are willing to pay a higher price for a diamond than for one glass of water. On the other side of the bargain, sellers of diamonds can ask for a higher price than for one glass of water. Conversely, a man dying of thirst in a desert would have greater marginal use for water than for diamonds so would pay more for water, perhaps up to the point at which he was no longer dying.

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Towards resolving the paradox 3.0: Droople’s Addendum to let facts speak louder

Surprisingly or not, we have great sympathies for the Austrian reasoning and don’t question the importance of putting emphasis on the separations of both total from marginal utility and price from value. Therefore, we also make use of those distinctions for finding a new solution to the Diamond-Water Paradox.

Challenging the current value of water to people

We live in a country where the current supply of freshwater is indeed abundant thanks to the last ice age more than ten thousand years ago and the resulting big glaciers in the Alps. But it is no news that most of them, if not all, will disappear by 2050, impacting the size of our big lakes (like Lac Léman and Bodensee), and further down the road, the amount of drinking water available to us. But if rich countries (in water supply) like Switzerland start taking that alleged “abundant supply” of water no longer as a given, then this holds a fortiori for other countries. And, in fact, the UN predicts a 40% shortfall in global water supply by 2030. And quantity is just one side of the coin, the other consists of quality. In Switzerland, we take great pride in our high water quality, but this actually only holds true with regards to the quality at the source. But as most of us don’t actually live next to a mountain spring, do we actually know what of that quality remains in the pipe system? Sadly, we still lack the data to assess what happens from source to tap, even in Switzerland. That is where Droople steps in to change things for the better: No consistent and transparent water quality as well as higher valuation of water without data, tracking and monitoring.

About 96% of the Earth’s total water supply is found in oceans, and there is a broad consensus that extensive use of desalination – desal for short – will be required to meet the needs of a growing world population. We have been told desal would one day turn oceans of salt water into fresh water, thereby quenching the world’s thirst. But progress has been slow. Worldwide, more than 300 million people now get their water from desal plants, according to the International Desalination Association. However, energy costs (provided by fossil fuels) and environmental impacts, leading to more greenhouse gas emissions, damage to marine life as well as to extra-salty wastewater (brine), are currently the principal barriers to its greater use. This is only one aspect of water treatment as we have to account for the cost of removing industrial water pollution (heavy metals and other contaminants) from groundwater and the range of micropollutants that are not necessarily removed from drinking water by utilities (such as pharmaceutical by-products). We can then conclude that water treatment can come at a high price. Adelaide in Australia, for example, as a result of increasing uncertainty in water imports from the Murray-Darling basin, is now turning towards water recycling and desal to supplement its water supply in coming years. The high cost of Adelaide’s water supply plans is posing a serious challenge for city residents because water prices have risen more than 400% in Adelaide since 2007, in large part due to the cost that came with the installation and operation of the desal plant. The high increase, as we speculate, is also an echo of historically outrageously low water prices that did not reflect actual costs.

Overall, in light of trends of drastically declining water supply coupled with an exploding population size of humans that eat more and more meat (requiring more water) and high as well as increasing costs of maintaining water quality (etc.), one might really wonder why people do not value water more. There is no straightforward answer, but rather a patchwork of different partial explanations. Firstly, the changes from high to low water supply and from low to high costs do not happen within a day, and a lesson from the connected anthropological climate change is that people lack the faculty to grasp complex problems that come with non-linear developments, many dimensions and a mix of little change over many years vs. radical tipping points. Secondly, the trends above characterize an abstract global level whereas their manifestations in different parts of the world are very different. For example, while the water quantity and quality is high in Switzerland with a shrinking population that, in parts, switches to vegan or in vitro meat, reality is just the opposite in Malawi: low water quantity/quality meets a growing population that more and more is able to afford meat. Or thirdly, people struggle with buying into speculations even if they turn out to be reasonable scenarios backed-up by science. Rather, they orientate themselves towards what they know, that is to what they experienced in the past where water was cheap and abundant, where there was no data on water quality, where ignorance prevailed about what happens from source to tap, and so on. Where does that leave us?

Switzerland is the land of liberalism, and in a liberal manner, we do not wish to dictate to people what they should think or value. From that does not follow though that we stand back and wait for the tipping point to be passed. Instead, we point to and work on eradicating the concrete disgrace that the principle of liberalism according to which you only pay for what you actually consume, applies to electricity, heating, but surprisingly not to water. Of course, if you’re a homeowner this is not of concern to you, but in Switzerland most people, namely 60%, that is more than 5 million live in a multi-tenant building. The surface-based billing results in water and energy waste (19% overhead on average) as well as opaque and unfair billing practices. Indeed, out of the 5.1M of tenants in Switzerland, roughly half pay too much and half too little. Is that fair?

Challenging the current price of water

One of our key takes from the Austrians is that prices follow people’s individual value judgments (not the other way round) and emerge from past exchange relationships in which our decisions are expressed in the interplay with decisions of others. Thus, we do not question the current price of water itself even though we believe it’s too low. But it is too low because people’s value statements about water are ill-informed and once that changes (hopefully before the tipping point is passed), the price will be corrected too. Yet, there is more to add for making sense of the price of water. We observe that price mechanisms are not free from fair criticism (like from Droople’s Christian or Posner & Weyl’s latest book) because many markets, including the market for water, where prices are formed, are plagued by distortion through market power of few players dominating the market. This ranges from oligopolies to countries with corrupt governments that keep water prices artificially low even if resources are scarce. The ideal picture of perfectly competitive markets portrayed by economists in their textbooks is frighteningly far from reality in our economies. In fact, market power, the ability of legal and private persons to manipulate prices in their favor, permeates our markets in many places and is perhaps even omnipresent in or inherent to the current institutional structure of capitalism, which closes the loop to the economic-theoretical opening of our article. We’re looking forward to a continued vivid discussion about water, the future of water as well as its fair value and pricing. It is an urgent and important discussion to have and we are ready to take our part in it, just in accordance with our motto: Water matters to people, Droople matters to water!

Ramzi Bouzerda is Founder and CEO of Droople SA, a Swiss IoT company that makes the world aware water is our shared source of life by providing water intelligence. ‍