Why does water – essential to life – sell for less than diamonds? Any explanation which doesn’t look both at supply and demand will not get you far.
Adam Smith observed the paradox that water, which is essential to life, sells for almost nothing while diamonds, almost useless, command a very high price. The explanation is that price depends on both supply and demand, and any analysis which does not look at both simultaneously goes badly wrong. Which explains why property and haircuts cost more in Beverley Hills and on the Côte d’Azur, where a lot of rich people live, but petrol and lycra leggings do not. And why garbage collectors earn a lot less than stockbrokers, even if their work is harder and probably more useful.
Yet the notion that things have an intrinsic value which is independent of their price remains a powerful one. And there is a term – consumer surplus – for the difference between price and value. Consumer surplus is the difference between what you would be willing to pay for something, and what you actually have to.
For goods like water which are in plentiful supply, the consumer surplus may be very large. The average household water bill is around £2 per week but what would you be willing to pay for water supply? You might grumble if the cost went up to £10 per week; but suppose I came to turn your water supply off. Think of going down to the Thames every morning to get the washing water. Think of boiling it before you peeled the vegetables or prepared the salad. £100 per week? That makes the consumer surplus you get from water at least twenty times what you actually have to pay.
And yet not all the water you use yields much consumer surplus. Most of it actually goes into low value uses – watering the garden, washing the car. As Figure 1 shows, the total consumer surplus – the triangle – is the sum of the consumer surplus you get from the first sip of water you drink to the negligible amount from the water that is barely worth to you what it costs.
Turning consumer surplus into profit is a central business objective. For water, this is such an easy opportunity that we have an Office of Water Services whose primary job is to stop it happening. There is no such agency in the diamond market; just the opposite. Consumer surplus is smaller anyway, precisely because diamonds are not that useful and there are not so many of them around. But it is also smaller because much of the potential consumer surplus has been grabbed by de Beers in the course of its century old control of the world diamond market.
de Beers has split the consumer surplus triangle into three parts by pushing price above the cost of supply. The rectangle is their profit. The upper triangle is the consumer surplus that remains. The triangle on the right measures the consumer surplus that customers have lost but de Beers have not gained – it represents people who would like to buy diamonds for more than they cost but less than de Beers charge.
So how do you get hold of more of the upper triangle, and reduce the size of the lower? Figure 2 shows the most you can get if you are obliged to sell at the same price to everyone and for every unit. There are two ways to do better. One is to sell at different prices to different people. Airlines sell the same essential product for very different revenues to first, business and economy travellers, and often segment the market far beyond that. Publishers sell first in hardback to libraries and aficionados, and in paper at lower prices to a mass market. The manufacturers of new gismos, like video recorders or digital cameras, pick off the enthusiasts first and then sell at progressively lower prices to less interested buyers.
The other route is to sell goods as packages. de Beers does this through its famous system of sights, in which jewels are sold only as collections and buyers are not allowed to pick and choose. Selling a package makes sense only if the customer’s decision to buy one part of the package means that he or she will pay less than other people for the second. There is no reason to sell instant coffee and Kit-Kat together simply because both are made by Nestlé unless (which is unlikely) coffee drinkers are particularly averse to Kit-Kat, or Kit-Kat munchers are only willing to pay low prices for their Nescafé.
But if you buy a lot of water, then the extra you want is for your garden or your swimming pool; so water companies could (and would if they were allowed to) extract lots of consumer surplus by offering tariffs which decrease with the amount you use. If you are already paying for several television channels, then you do not have the same willingness to pay for more, because there are only so many hours in the day you can spend watching television. So Sky Television can (and are allowed to) extract plenty of consumer surplus by selling its channels, like de Beers diamonds, in bundles.
And there is a warning there for water companies de Beers and Sky. You can only extract consumer surplus so long as you have market power. In competitive markets, it all goes to the customers. Which is what differentiates petrol and lycra from property and hair dressing.