Technische Universität München

Economics of Water Use, Regulation and

Markets

Urban Water Pricing

Dr. Maria Vrachioli

maria.vrachioli@tum.de

May 28th, 2020

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Outline
• Decision making:
– Consumer surplus
– Producer surplus

• Pricing schemes for urban water:

– Average Cost Pricing
– Two-part pricing
– Increasing Block Pricing

• Welfare loss

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Opportunity costs and net benefits

• Efficient allocation of resources when the net benefits from the use of
those resources is maximized.

• Net benefits are the excess of benefits over costs.

• Opportunity costs are:

– the costs associated with (environmental services and good) even when
they are produced without human input.
– the net benefits foregone because resources providing services can
no longer be used in the next most beneficial use.

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Opportunity costs and net benefits

Example: rafting and hydroelectric power production.

• Constructing a dam for the purpose of power production would flood

rapids that are used for the purpose of rafting.
• The opportunity cost of saving the river for rafting is the net benefit of
the power production that is foregone.
• The marginal opportunity cost curve is the supply curve for a good in a
competitive market.
• The total cost equals the area under the marginal cost curve.
• The net-benefits are the area under the demand curve above the supply
(marginal cost) curve.
• The net-benefits will be maximized when the output level and price are
set at the point where the marginal benefit and marginal cost curves
intersect.

How do we measure benefits and costs?

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Net-benefits for a linear demand function

• The demand curve and the total utility derived by consumers in the
consumption of quantity x0.

• The negative slope of the demand curve and states that for any good
that can be purchased in a market, the quantity demanded in a given
period of time varies inversely with the price, other things equal.
• Total utility is the integral represented by the area under the demand
curve.

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Net-benefits for a linear demand function

• The area under the demand curve [Op1Ax0] represents the maximum
amount consumers would be willing to pay for the consumption of x0
units of the commodity rather than go without it.
• This maximum willingness to pay reflects the total utility or benefit to
the consumer.

• However, resources were expended to produce that output and the

value of those expended resources must be deducted from the total
benefit to determine the net benefit.

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Marginal Opportunity Cost Curve (MC=const)

• The supply curve represents the marginal cost associated with
producing each increment of commodity x.

• The area under the supply curve [Op2Ax0] is the total value of the
resources required to produce x0.
• This cost represents the minimum amount that the producer will accept
for x0 units and, therefore, the minimum amount that the consumer
must pay.

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Maximum net-benefits (MC=const)

• The total utility or benefit minus the total cost yields the total surplus
net of resource costs delineated by [p2p1A] – Total Surplus:
– represents the difference between the maximum the consumer
would be willing to pay and the minimum he/she must pay to cover
costs of production.
– It can also be viewed as the total net benefit to society.

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Maximum net-benefits (MC=const)

The crucial issue: How this Total Surplus or Net-benefit is shared between
producers and consumers?
• This is determined by the interaction of supply and demand in the
market to determine the market price. (red line)

• The area [Op0Ax0] represents the amount that the consumer actually
pays and, also, the amount that the producer actually receives.
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Maximum net-benefits (MC=const)

The price line p0A, divides the total surplus into:
1. the amount the consumer would have been willing to pay, but did not
have to - consumers' surplus. Blue area [p0p1A]
2. the amount in excess of what the producer would have been willing to
accept, but was able to realize more - producers' surplus. Yellow
area [p2p0A]

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Maximum net-benefits (MC=const)

• Total costs shared in proportion to producers' and consumers' surpluses
will be shared in proportion to benefits received, which satisfies the
economic equity criterion.

• For most commodities in an open competitive market, this would be

automatically taken care.

• However, water and the necessary infrastructure to control it tend to

exhibit some common property inflexibility and irreversibility
characteristics that hinder a purely competitive market reallocation of
water.

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Externalities
• Consider an example where a factory is producing a product and
discharging waste to a nearby river. A hotel downstream of the factory
uses the river for recreation.

• If there are different owners for the factory and the hotel, then an
efficient use of the water in the river is not likely to occur.

• An externality exists whenever the welfare of some agent (firm or

consumer) depends on its own activities and the activities of some
other (external) agent as well.

• In the above example, the additional cost to the hotel as a result of the
factory discharge is an externality.

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Externalities

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Pricing Schemes for Urban Water

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Average Cost Pricing

1. What does “average cost pricing" mean?
Average cost pricing is characterized by an equilibrium quantity (q*) set
by the intersection between the demand curve and the water utility's
average cost curve (D=AC).

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Average Cost Pricing

2. What are the two (2) optimal conditions associated with AC pricing?

• the water utility needs to

cover its (total) costs.
(This includes both fixed
and variable costs.)
On the graph, this means
that the equilibrium point
needs to be on the average
cost curve.

• consumers need to be on
their demand curve.
On the graph, this means
that the equilibrium point
needs to be on the water
demand curve.

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Average Cost Pricing

3. We say that average cost pricing is inefficient. How do we know that
this is the case?

– We know that average cost pricing is inefficient because in an

average cost pricing equilibrium, the price of water is not equal to
the marginal cost of water. (p ≠ MC)

4. One of the problems with average cost pricing is that we are “trying
to achieve two objectives using a single price.“
What are these two objectives?

– 1st objective: The utility covers its costs. Average cost pricing does
achieve this objective.
– 2nd objective: “economic efficiency”. However, economic
efficiency is characterized by a price equal to marginal cost (p =
MC).

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Two-Part Pricing
1. What are the two “parts" in two-part pricing?

– 1st part: A volumetric rate for water that equals the marginal cost of
providing the water.
– 2nd part: A fixed fee, often called a “connection charge" that a
household pays regardless of how much water it consumes.

2. Why do we want two parts?

What are the objectives that each price is trying to achieve?

– 1st part objective: the utility covers its costs.

– 2nd part objective: allocation is economically efficient.

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Increasing Block Pricing

1. What component of increasing block pricing is similar to two-part
pricing?

– Under increasing block pricing, the top volumetric rate should

equal the water utility's marginal cost of providing water.

2. What is the marginal rate charged for the first few units of water
provided?

– The lowest marginal rate is at or near zero dollars per unit of water.

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Increasing Block Pricing

3. Why is this potentially desirable from a social/philosophical
perspective?

– Society generally likes providing a “lifeline rate" for “necessary"

water use.
– In other words, society doesn't want basic-use water to be
prohibitively expensive for very low-income households. (This is
not an explicitly economic justification.)

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