The economic value of water

The River Cam in Cambridge.

Recently, we looked at why water can be more expensive than beer, even though water doesn’t attract excise duty

Water is the most important commodity in the world, it is indispensable for life, yet, it is also one of the cheapest. In many circumstances we can say water is a free good.

• Definition of a Free Good – a good without any opportunity cost. A good that is not scarce
• e.g. if you collect rainwater falling on your house, no one loses out. Or take a drink from the River Cam, there’s still enough water for others.

Yet, a diamond, which is completely dispensable can be thousands of times more expensive than water.

At the same time, if you were stuck in a desert, running out of water, how much would you be willing to pay for a litre of water, to enable you to get the next oasis?

The contrast between the price of water and diamonds has been explored many times. The first issue is one of quantity. Diamonds are bought only once or twice a lifetime, water is bought every day. The total amount people spend on water is probably greater than diamonds during their lifetime.

The marginal utility of diamonds quickly falls, the marginal utility of water doesn’t.

One diamond makes your wife very happy. She may be happy with that diamond for the rest of her life. The marginal utility of the first diamond is very high. This explains why people are willing to pay a lot for one or two diamonds.  But, if she got a diamond every week, the increase in utility would be very low. If diamonds are too common they lose their appeal.

But, drinking water, you will want to do everyday, the marginal utility stays constant throughout your life.

The other issue is of scarcity. Diamonds are expensive because they are so scarce. Water is usually cheap because of its abundance.

The price of water could dramatically increases when it becomes very scarce.

Usually we can get water for a low price because the supply is very elastic, it is only in some extreme circumstances where the price of water may increase dramatically. The price of water then may simply depend on our effective demand. e.g. an oil sheikh could rationally spend billions of dollars on a glass of water, if it was necessary for survival.