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Wednesday, 25 August 2010

Economic Value in Aitch-Two-Oh

Odd Water
"The world's supply of fresh water is running out. Already one person in five has no access to safe drinking water. "
Well, so says the BBC. But water’s an odd thing. You can’t live without it but it’s not particularly valuable. In fact the stuff in your faucet is free, it’s just the cost of getting it there that we pay for.

Water is, perhaps, the pre-eminent example of the old truism that price is what you pay but value is what you get. Only thing is, how do you value something that has no market price? Fortunately teams of highly trained thinkers have been working on this, just so we know the price of everything even if we’re not willing to pay it.

Paradoxical Water

While we absolutely require water every day to survive we can live a lifetime without diamonds, although don’t tell my mother. Yet water’s effectively free while if you want a diamond you need to pay an arm and a leg. This is a paradox that Adam Smith noted:
“Nothing is more useful than water; but it will purchase scarce anything; scarce anything can be had in exchange for it. A diamond, on the contrary, has scarce any value in use; but a very great quantity of other goods may frequently be had in exchange for it”.
As ever, there’s a difference between price and value and that makes all the world of difference. Especially if you’re thirsty. Michael Haneman gives a fabulous review of the economic principles surrounding the use of water in The Value of Water, which we’ll only summarise here, but it’s a great starting point for anyone wondering why intangibles are invaluable.

Marginal Value

Basically the difference between value and price is a pretty important one for investors and economists because it makes clear that the economic value of something isn’t the same as its market price. There are things that have economic value that price doesn’t accurately measure and this fact makes investment analysis rather more tricky than simple share price followers would like.

The critical key to understanding the difference in valuation between water and diamonds is the idea of marginal value. If you have twelve litres of water to hand – which is roughly what you need each day to survive – then the marginal value to you of a further litre is insignificant. However, if you have a hundred diamonds the marginal value to you of a further diamond is quite high. This is why the apparent value of water is less than that of diamonds; because, at the margin, a litre of diamonds is worth a lot more than a litre of water.

Utility Revisited

This idea has been around for over 150 years but became quite unpopular amongst economists because they got themselves confused between concepts of ordinal and cardinal utility: roughly speaking the difference between ranking things and measuring them. This delayed advances for half a century or so while they figured out that they were actually the same thing, but eventually this led to some genuinely useful insights into how to measure the economic value of things that don’t have a market price. Like national parks, the atmosphere, water and intangible assets.

The idea is that anything people derive utility from – where utility can be considered as ‘happiness’ or ‘satisfaction’ or pretty much any damn thing you like as long as it leaves you with a nice warm fuzzy feeling in a good place (Hawaii always seems popular amongst academics on junkets) – can be considered as having economic value. Economists being economists, they measure this in monetary terms – basically your willingness to pay for the thing that you can’t pay for. Economists are often clever, but nobody said they were always entirely logical.

Fish v People

Not unnaturally this brings us back to water, which is a much more complex subject than its molecular structure would suggest. Consider the issue of Mono Lake in California which an administrator cleverly framed as “300 fish versus 28,000 people”. As John B. Loomis remarks:
“The implication was that providing water for fish in the tributary streams flowing into Lake Mono deprived people of benefits. Besides being an unproductive way to view the resource allocation of issue, surveys of the California citizenry showed this was a false dichotomy. People cared about the fish, and the birds and the Lake Mono ecosystem … the dollar sacrifice these people would make to provide water for fish could be quantified”.
Fish 1, People 0.

Non-market Valuations

The idea is that the non-market value of stuff like water rights can be measured – in monetary terms – by figuring out how much people would be theoretically prepared to sacrifice in order to maintain the water resources. There are a number of ways of making this type of valuation, with the usual approach being attempts to find some market-priced good that works as a proxy for the non-economic good under consideration. So, for instance, there’ve been studies done on house prices around airports and locations of known paedophiles, which use the difference in house prices to measure the economic impact. The value of natural resources like national parks has been measured by looking at the travel costs of people visiting them and so on and so forth.

Of course, these approaches have problems because you’re not actually measuring the value of the item of interest but the value of an item you think might be correlated. An alternative approach is the rather obvious one of asking people what they think. These so-called contingent valuation methods can work quite well in some circumstances but need to be applied carefully. As we’ve seen in the past people don’t usually know what they think at the best of times but if you couple such a survey with the implication that there may be some money attached – say as compensation for noise levels in the vicinity of an airport – your results rapidly become unreliable.

Liquid Inequality

Whatever method’s used the need to measure the value of water is likely to increase as the world becomes hotter and water shortages increase. As the BBC link at the head of this article shows, this is likely to be a widespread problem. Even having enough water to support everyone it isn’t necessarily good enough because freshwater isn’t equally available to everyone. As Postel and Vickers point out in Boosting Water Productivity:
“6 six countries – Brazil, Russia, Canada, Indonesia, China and Colombia – account for half Earth's freshwater supply”
Even worse, as people grow wealthier they tend to use more water. Diet changes alone have a massive impact - a meat intensive diet, for instance, requires between ten and a hundred times more water to produce than a vegetarian one. And rich people eat more meat than poor ones. This study showed that Chinese meat consumption doubled between 1995 and 2007: the concern here is a global food shortage, but water’s not far behind as this World Bank report indicates:
“Due to excessive withdrawals, even a minimum of environmental and ecological flows cannot ensured for some rivers in North China. To compensate for the deficit of surface water, North China has increasingly relied on groundwater withdrawals, often in excess of sustainable levels. Such overexploitation has resulted in the rapid depletion of groundwater reservoirs, leading to the lowering of water tables, the drying up of lakes and wetlands, and land subsidence in many cities.”
More investment opportunities in Chinese water resource management, then?

Water Futures

Looking forward one of the problems is that us humans aren’t very good at giving up things we like doing regardless of the economic value implicitly destroyed by doing so. Persuading people to stop driving big cars or shooting passenger pigeons isn’t simple right up until there’s no gas or pigeons left. Then it gets really easy although alternatives, like driving nuclear powered trucks and shooting bison, are always preferable to giving up entirely.

With populations and economies continuing to grow the demand for water will also rise, while available water seems set to decline. Figuring out how to balance these demands is going to be one of the major challenges and investment opportunities of the twenty-first century. However, at the margin the true value of water is going to be determined by human lives and ecological survivability. Figuring out how to measure that is going to be a true test of economics.

Related articles: Peak Oil, the Revenge of Planet Earth?, The Malthusian Prophesy, Copper at Morewellham Quay

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