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Diamonds and water: a paradox revisited

  • Agricultural Science
  • Economics
  • Law


FRBSF WEEKLY LETTER ,,"~umber 92=43, December 4, 1992 Diamonds and Water: A Paradox Revisited On October 30, President Bush signed legislation into law that makes it possible for recipients of water from California's Central Valley Project to resell that water. This legislation is controversial, because it is expected to plant the seeds for the development of a water market in California, Among the most frequently cited objections to using markets to allocate water are concerns that the results would be unfair and disruptive: In par- ticular, opponents argue that a move to market prices would mean a large shift in water from farms to cities. This change in water allocation, they argue, would lead to reduced agricultural income and production, lower income in agri- culturally dependent communities, and higher food prices. In the extreme, this stylized scenario predicts a world with fountains in Beverly Hills and desolation in California's central valley farm- ing region. This vision of the distributional consequences of a market system for water results, in part, from putting together two statements about price de- termination and drawing the wrong conclusion. These statements are that (a) water is extremely valuable, and (b) that the value of a commodity is reflected in its price. Thus, the conclusion drawn by some is that water prices would be high in a market system and that low income and agri- cultural consumers would be severely limited in their abilities to purchase water. This conclusion does not necessarily follow, however. In fact, a similar debate took place in the economics literature in the eighteenth and nineteenth centuries before being put to rest by Alfred Marshall. Known as the "Diamond-Water paradox:' the issue sought to explain how the observed price of water could be below that of other commodities, such as diamonds, given water's high value in sustaining life. Marshall's solution to the paradox was to recognize that prices reflect the value of the last, or marginal, un

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