What weird irrationality compels water authorities to price “Adam’s Ale” so cheaply, then mercilessly harangue consumers to conserve? The enforcement of sometimes crazy rationing schemes, like watering lawns only on dates ending with the last digit of one’s street address, is but a symptom of this dysfunction. If water is scarce, then it should be priced accordingly. Only then will users voluntarily limit their use to quantities they value at no less than its real resource cost. This might involve changes in agricultural and industrial practices, landscaping and lifestyles. Perhaps there would be fewer lawns and swimming pools installed where water is most scarce. But these actions should be taken voluntarily in response to market incentives.

Water prices are generally regulated and administered, and only rarely established in an actual market. Pricing is usually based on the infrastructure costs of delivering water, as well as the costs of processing required to meet various standards. Again, these prices seldom reflect the real scarcity of water. This is partly due to populist distortions of the idea that water is basic to life, the perception that water is a public good, and the related political appeal of notions like “the water belongs to everyone”. There is also the admirable objective of keeping water affordable for the poor. But unit water prices faced by different users are not uniform: agricultural users sometimes pay as little as 90% less per unit than the generally cheap prices faced by urban consumers. Industrial users are also accorded favorable rates. Needless to say, incentives are way out of line!

When a resource is priced at levels that do not reflect its scarcity, something has to give. The resource will be overused, and overuse of water inflicts severe environmental damage. With water, that can mean draining lakes and killing springs and riverbeds along with the habitat they support, not to mention lower water quality. The waste doesn’t stop there: authorities are sometimes prone to propose costly infrastructure boondoggles to address water needs, such as dams and reservoirs in arid climates from which large quantities of stored water evaporate.

This episode of Econ Talk features a discussion of water mis-pricing and its consequences. (A hat tip on this to the estimable John Crawford). It covers issues in the management of water systems in the U.S. and under-developed countries. It is a very informative discussion, but it neglects one of the most promising methods of pricing, managing and conserving water supplies: marketable permits, or a secondary market in water rights.

Marketable permits involve the assignment of base usage rights using criteria such as estimates of total supplies and the customer’s past usage levels. This base allocation of rights can be dynamic, changing over time with drought conditions or improvements in conservation technology. Usage up to the permitted quantity is priced administratively, as usual, which keeps water affordable to individuals in lower economic strata. Beyond that base level, however, users must acquire additional permits from a willing seller at a mutually agreed-upon price. Trades can take place on a centralized water “exchange” so that prices are observable to all market participants. And trades may take various forms, such as short-term or long-term contracts which may involve prices that differ from “spot”.

How does this help solve the problem of scarcity? The price of water on the secondary market will rise to the point at which users no longer perceive a benefit to marginal flows of water above cost. A higher price encourages voluntary conservation in two ways: it is a direct cash cost of use above one’s base water rights, and it is an opportunity cost of foregoing the sale of permits on water use up to the base assignment. Those best-prepared to conserve can sell excess rights to those least prepared to conserve. The price established by the trade of permits will bear a strong relationship to the actual degree of scarcity.

A hallmark of allocative efficiency is when the marginal value of the resource is equalized across different uses. This condition implies that no gains from trade are left unexploited. But in the case of water, this means that gains in efficiency will be limited unless all users face the same “spot” price. To fully exploit the market’s potential for efficient allocation, large agricultural and industrial users must face a relatively low base price that differs from residential customers only in terms of infrastructural costs. Granted, voluntary trades between users can take place under specialized contracts as long as the terms are publicly available. This allows intensive users to hedge risks to assure that their needs can be met in the future. However, those users will still have to weigh the marginal benefits of certain crops or industrial processes against prices that more accurately reflect scarcity.

This discussion has ignored certain complexities. For example, assigning rights is complicated by the fact that there are almost always multiple sources of water, such as rivers, public and private wells, lakes and runoff capture. There are sometimes different classes of rights-holders on specific sources. Rights on some sources might not be subject to base pricing by a water authority, but water permits could still be sold by these rights-holders on the secondary market, providing an incentive for them to conserve.

There have been political and legal impediments to the development of water markets in the U.S., some of which are discussed here. A recent effort to promote a water market in the western U.S. has arisen in response to drought conditions. Here is a good article from the last link above, a lengthy abstract of a research paper proposing development of a water market in the American West. Of course, there are many academic papers on this topic, but they are mostly gated. I lived in San Antonio in the 1990s when a controversial proposal to build a large reservoir was under debate. This was intended to relieve demands on the Edwards Aquifer, upon which a large area of Texas depended for water. It was voted down by a coalition that included many libertarians and environmentalists. At about that time, I met a natural resource economist from the University of Texas system who proposed the establishment of a water market in south Texas. He had trouble getting local support for the idea; it was politically taboo due to superstitions about an effort to allocate rights (marketable permits) on what is often perceived as a “public good” (despite the exclusivity of its benefits to customers). Later, in 1998, the San Antonio branch of the Federal Reserve Bank of Dallas published this interesting article on the development of a water market in south Texas. To my knowledge, there is still no water market there, but battles over water use and conservation continue.