To Buy or Not To Buy
3. Supply and Demand

The supply/demand theory solves the paradox of inessential-but-expensive diamonds and cheap-but-essential water. The supply-and-demand theory tells us that diamonds are highly priced because they are scarce. There are objectively few of them---relative to demand. If diamonds were as common as gravel we would use them to pave our garden walks. More precisely, the equilibrium point in the market for diamonds is reached at a high price per ounce. Recall that at the equilibrium point the supply and demand curves intersect and the quantity demanded equals quantity supplied. See Figure 5.1.

Figure 5.1 The demand of and supply for diamonds

Diamonds become more costly to produce as more are produced. Consequently, the supply curve slopes up: producers want a higher price (to cover their increasing cost) if they have to produce more. The price is in equilibrium determined at the intersection of supply and demand. Given the unique supply/demand circumstances in this market (people badly want diamonds and diamonds are costly to produce) the intersection occurs at a high price. If the demand curve were to fall back towards the origin, the price would fall.

The diagram shows that supply and demand determine the value of diamonds in unison. Like the two blades of a pair of scissors, both are necessary. If for example the poets and moralists suddenly made numerous converts and people started thinking of a diamond as no more desirable per ounce than the lump of coal it came from (geologically speaking), then clearly the demand curve fall (that is, move to the left). And so, moving along an unchanged supply curve, the price would drop.

Why then in developed countries is the price of tap water almost zero? Again, a supply and demand diagram explains why (see Figure 5.2). The price of water is not of course exactly zero. We still have to pay a nominal sum for the water we consume at home or work or school. But the price is very low per ounce because plenty of water is supplied, relative to demand.

Figure 5.2 The supply and demand curves for water

The Demand Curve and Usual S Curve are positioned so that their intersection is at a very low price. But note the high price that the buyers of water would be willing to pay at the second supply curve, the "Desert Supply Curve." If water were rare enough (on the moon, say) it would be more valuable than diamonds. On the moon, at least.

The diagram does not entirely resolve the paradox. Nineteenth-century economists distinguished value in exchange from value in use. The distinction is still intelligent. The value in exchange is merely the market price, what water and diamonds actually sell for per ounce. Value in use is the subjective value to demanders, that is, the maximum amount a consumer would pay for one ounce of water if she had to. ("Consumer," by the way, is the economist's work for "demander" or "buyer," especially when the buyer in question is a person or a family or, as economists say, a "household" rather than a business.)

She actually pays the market price, the value in exchange, always lower than what she values it at---or else she wouldn't deal. But if she were dying of thirst in the Sahara she would be willing to pay much, much more. That "more," whether in usual circumstances where it is low or in the desert where it is high, is the value in use. The value in exchange is determined by the market. But the value in use is personal, varying from one individual to another. Maria may love diamonds and attach a high value in use to them, and hence be willing to pay a high price. Klamer, by contrast, has little use for diamonds--except to resell them at the value in exchange. He would never buy a diamond, since his value in use for diamonds is below their going price, the value in exchange. If he inherited a diamond he would sell it.

The demand curve in Figure 5.2 indicates how the value in use for water declines as more and more water is consumed. When water is scarce, as it is in the middle of the desert, we would we willing to give up a lot to get one thermos full. With fresh water all around we would not even be willing to pay one dollar---unless for fancy bottled water, of course.

Rodney: I don't see where all this is going. Why have all this complicated vocabulary of objective/subjective, value in exchange and value in use?

McCloskey: It's going towards a crucial idea---also one of Alfred Marshall's inventions---of "consumer surplus." Consumer surplus is how much higher total value in use is than value in exchange.

Rodney: And it's crucial because . . . ?

McCloskey: Because it shows---and we'll show later---why market exchange is good for you and everyone else involved.

Rodney: That does sound crucial.