Blog 44: Diamond and Water Paradox by Xavier Lo, FIA, FRM, MBA

Have you ever thought about how certain things are priced [定價] in your everyday life? Could it be linked to the amount of value [價值] that it brings to you? In that case, how come water, which is so important for survival, is so much cheaper than diamonds, which actually doesn’t do much besides making things look nicer? This is a very famous diamond and water paradox [鑽石同水悖論].

Give yourself maybe a minute to think about this. Can you explain the reason for this difference? The key to solving this paradox is to understand that there’s a difference between the inherent value [核心價值] of the item, versus the value of getting one additional unit of that item. This concept of the value of one additional unit is called the marginal utility [邊緣用處]. The fact that there is so much water in the world means that the marginal utility of water is very low – you can easily get it. However, it is much more difficult to go out in the market and get yourself a diamond. There are many other examples of this paradox, like bread versus gold, or a teacher versus a professional athlete [職業運動員] (some might argue that teachers bring more value to the world).

Still a bit confusing? Water is quite cheap. However, imagine this: you have been in a desert [沙漠] for two days, and you haven’t had any water to drink. How much would you pay just to get a bottle of water? Quite a lot I would think! Although this concept is quite a simple one, I think we can often forget this when we are in the work place. As actuaries, we always calculate the value of an insurance policy. But we need to bear in mind that the price of the policy is not necessarily only dependent on the inherent value, but the marginal value.

I think a lot of people wonder why companies are so willing to let junior staff go, but try hard to keep senior executives [高層員工], even though it’s the juniors who do most of the churning and hard labour. Maybe the paradox helps explain this!

About the Author

Xavier Lo, FIA, FRM, MBA

Qualified fellow actuary (in UK and Hong Kong), Financial Risk Manager, and MBA graduate (listed on the Dean's List) with a passion for insurance, data science, and analytics. Experienced in a broad range of insurance roles (pricing, capital modelling, reserving, ERM), along with a touch of knowledge in banking. Member of the General Insurance Committee (2021), Actuarial Innovation Committee (2019 - 2021) in ASHK.

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