Chapter B) Market-failure, efficiency, and government intervention

Text: Reader, based on Griffin 2.7-2.10 + 4.1-4.6 + 5.1-5.7 + 8.1-8.6 and two journal articles

This chapter is organized as:

Lesson 1: Efficiency in the presence of water’s characteristics

Lesson 2: Institutions and property rights

Lesson 3: Market failure and property rights

Lesson 4: Policies and their effects on consumer and producer surplus

Lesson 5: Water pricing

Lesson 6: Privitization of water supply

Lesson 7: Payment for watershed services

Objectives of this chapter are:

1) To understand the effects of property rights on achieving efficiency.

2) Explain how institutions can promote efficiency and how market failure can cause inefficiency.

3) Elucidate the major reasons for inefficient allocation of water resources.

4) Describe the categories of policies to make the allocation of water more efficient and explain
how they work, including advantages and disadvantages.

5) Understand the different types of water pricing, the reasons why suppliers use them, and their
effects on efficient water supply and use.

6) Apply water allocation policies, including water pricing, to simple cases.

7) Apply an economic perspective on the discussion on water supply privitization and payment for
watershed services.

Introduction:

This chapter covers four related topics in water resource economics. They are fundamental to the
understanding of water as an economic good. In chapter A we have been looking at demand and supply
of water, and how water can be allocated efficiently. In this chapter B we go a step further by analyzing
first how efficiency applies to water with its special characteristics of reuse and non-rivalness.
Subsequently we focus on market failures in terms of public goods aspects of water and externalities,
and on various ways to regulate the water sector given these market failures. Again, the focus is on
water quantity rather than water quality.

Summary:

Efficiency and equity

First, we cover efficiency in the context of reuse and nonrivalness. For many uses of water, the water is
usually not destroyed or consumed in its use, so the water is available for reuse. Normally this is only
possible within the same region and season. An example is hydropower where water is used to generate
electricity, but subsequently, it can be used for irrigation or some other use. In general, we can
formulate the efficient allocation of water for two uses (w1 and w2) by denoting return flow R(w1) such
that 0<dR/dw1<1, so that we maximize B1(w1)+B2(w2) subject to w1+w2=W+R(w1). That is, the
additional water available from return flow can be reused by water user 2. This implies a decrease in the
marginal value of water compared with a situation without return flow. Consider the extreme case
where all water from user 1 becomes return flow available to user 2, so that R(w1)=w1. Then this water
is considered non-rival. Non-rival water use implies that water use by one user does not impede water
use by another user, i.e. there is no competition over scarce water resources. An example is the
recreational use of water for swimming (as long as the beach is not too crowded). Non-rivalness implies
that the individual demand curves for water should be summed up vertically rather than horizontally,
because each unit of water can be used as many times as there are users. Hence, unlike rival water use,
the value of non-rival water uses increases in the number of users.

Efficiency of water use directly impacts the equity of water use. When applying the efficiency criterion
to determine the allocation of water, some users may lose while others gain (although the overall
benefits of water use will be maximized). This is fine when efficiency is the only criterion that is desirable
to guide water allocation. There are other issues, however, that a society may find important, including
equity. One possible approach is to implement the efficient allocation of water but compensate those
that lose water as a result. Another, related, approach is to apply the so-called neutral efficiency
criterion, which says that the benefits of water use should be maximized subject to no water user being
worse off (that is, moving along the Pareto frontier). Also, sectoral policies might play a role. Although it
may be more efficient to increase water allocation to industry, this may weaken the position and
productivity of the agricultural sector, which may be considered undesirable.

Public goods and externalities

The allocation of a resource over people or firms is determined by the choice or natural emergence of a
particular institution (or institutional setting). The institution in place determines amongst others who
owns the property rights of the resource. By resources, we may refer to quantity or quality of water or
water infrastructure in various forms and locations. There are different types of property settings,
including open access resources (no use rights have been determined, e.g. some fisheries), common
property resources (open access resources with embedded conditions for use), state property resources
(government owns property rights, e.g. municipal sewage system), and private property resources (an
individual or firm owns the property rights, e.g. bottled water). Private property has the benefit that
property rights to the resource can be transferred from one individual (with low marginal benefits of
resource use) to another (with higher marginal benefits). Such a transfer, or trade, is beneficial to both if
sufficient compensation is made, and it moves the allocation of the resource closer to the efficient
allocation. This is a large advantage of the private property rights system.

For this reason, economists would advocate the private property rights system for as many goods as
possible, including many aspects of water quality and quantity. Efficiency-enhancing trades will then
take place in water markets, as discussed in detail in chapter C. In equilibrium these trades lead to the
neutrally (or Pareto) efficient allocation of the resource. This equivalence is described by the first
fundamental theorem of welfare economics and is a powerful argument to advocate trade to increase
welfare. There are some assumptions, however, for the theorem to work as intended. When one or
more of these assumptions are violated, the theorem does not apply and we say that a market failure
occurs. There are four main market failures in the context of water resources: (i) many water resources
are public goods or have public goods aspects, (ii) water use induces externalities, (iii) transaction costs,
and (iv) many water services are served by natural monopolies.

(i) Public goods are characterized by non-rivalness (consumption by one user does not diminish the
availability of the good to others, as discussed above) and non-exclusiveness (it is prohibitively
expensive to exclude someone from consuming the good). Rival, non-exclusive goods are called open-
access goods (e.g. a pond used for watering of livestock), while non-rival, exclusive goods are called club
goods (e.g. a recreational fishery club). Finally, private goods are both rival and exclusive. Many water
uses are immediately rival and most, but not all, are excludable. An important exception is e.g. the value
of instream flow in a river. It provides river ecosystem quality and biodiversity, and its “use” is both non-
rival and non-excludable. As a result, this service cannot be traded and the first welfare theorem does
not apply. As a second result, nobody is interested in providing this service so that ultimately, increased
water use may diminish instream flows and destroy valuable habitat.

(ii) Externalities, the second market failure discussed here, occur when the use of water by one user
affects some other agent without compensation being paid. A standard example is a factory that
pollutes a river such that downstream fishermen are faced with diminishing fish stocks. Note that
externalities can be both good and bad. Externalities need to be internalized before the first welfare
theorem applies again. This implies that the externality needs to be priced. In the example above, this
would imply that the factory compensates the fishermen depending on the impact of its pollution on the
fish catch.

(iii) Transaction costs are those costs that are related to the use of a certain policy, including costs of
information gathering, negotiation, implementation, and monitoring and enforcement. When
sufficiently high, it may not be efficient to e.g. implement a policy in order to internalize an externality.
(iv) Natural monopolies, the third market failure, occurs when production of a good is characterized by
declining average (and marginal) costs of production. It is therefore most efficient to have only one
producer for the particular good, as he can supply the good cheaper than two or more producers jointly.
Example of natural monopolies are public utilities like municipal water supply. Because of the large
investments needed to construct a city-wide water supply and sewage infrastructure, there is usually no
competition from other utilities. Hence, the water utility may act as to increase the price of its services
without fear that its customers will switch to another utility. Usually, water utilities are either public
operations or they are price-regulated firms, each of which brings about particular difficulties.

In order to enjoy the advantages of the private property rights system, while preventing the
disadvantages of the above market failures, governments often decide for mixed systems, using market-
oriented institutions to harness private incentives, but leaning on nonmarket institutions where market
failures are looming. An example of a mixed system are the water markets in the western US and
Australia, where an encompassing combination of trading conditions and constraints assures that
market failures do not prevent a proper functioning of these markets.

Efficient allocations are more easily obtainable under a private rights property system. But does it
matter who owns these rights. According to the Coase theorem, the allocation of private property rights
do not matter for the final, efficient, allocation of the resource. The only effect of the initial distribution
of rights is that the initial owner will earn a rent as he or she can sell the resource to other agents.
Hence, there is no effect of the distribution of property rights on efficiency. There is, of course, an effect
on the final distribution of wealth in the society. Again, there are caveats. One is that for the Coase
theorem to work, transaction costs should be negligible or sufficiently low. Another caveat is that
property rights to water are often hard to define, given its public goods characteristics. This makes
trading of water or its related services more complicated than for many other goods.

Policy instruments

A good policy is one that creates more benefits, due to increased efficiency of resource use, than costs,
including transaction costs. Not everyone necessarily gains from a policy. When there are both gainers
and losers, the hypothetical compensation criterion assesses whether the gainers of a prospective policy
can potentially compensate the losers (i.e. aggregate efficiency rather than Pareto efficiency). When
considering policy changes, gains and losses are often denoted in terms of changes in consumer surplus
and producer surplus. Using municipal water supply as the leading example, consumer surplus is equal
to the net benefits of water consumption to consumers after they have paid for the water. Producer
surplus is equal to profits; in this case profits of the water supply utility. Whichever form they have,
policy changes affect individuals and firms through (i) price rationing, (ii) quantity rationing, (iii) demand
shifting, or (iv) supply shifting. (i)-(ii) Price rationing implies that the water price receives a (artificial)
mark-up such that the amount of water demanded will decrease. This may be an effective policy in
response to temporary water shortfalls or to boost the utility profits. Quantity rationing implies that the
quantity of water demanded is capped below real demand in order to reduce water consumption. Both
price and quantity rationing may be effective to reduce any externalities due to high levels of municipal
water use. If properly designed, they may have a similar impact. (iii)-(iv) Demand-shifting policies aim to
shift or rotate individuals’ water demand curve, rather than causing movements along the demand
curve induced by rationing. They include policies like education and information provision, and the
promotion of alternative water use technologies. Supply-shifting policies aim to either lower the
marginal cost of delivered water or to alleviate any supply constraints. Such policies move the water
supply curve downward or extend it in case of alleviating constraints. The impact of each of these policy
changes on consumer and producer surplus can be easily evaluated graphically, using a diagram that
displays water supply and demand curves, in combination with water prices and quantity demanded.

Water pricing

Water pricing deserves a separate treatment as it is the most widely-used tool to affect water use both
in municipal water supply and in other settings. Note that the use of water pricing as a policy instrument
goes beyond the simple price-rationing described above. Much more sophisticated policy instruments
for water pricing can be designed. Recall that, in general, efficient pricing is equivalent to marginal-cost
pricing (MC=MB=water price). Water prices (or rates, charges, or tariffs) normally include a fixed and a
variable component, the variable component being dependent on actual water consumption by the
customer, possibly adjusted for time of use and type of use. The fixed component normally includes a
meter charge and a connection charge, both of which cover capital costs to the supplier and are
justifiable in terms of economic efficiency.

Three structures for water rates are quite common, depending on the change of per-unit price with the
amount of water consumed: decreasing block rate, increasing block rate, and uniform rate structure.
Decreases and increases in the per-unit price are step-wise; within one “block” the per unit-price is
constant. Hence, the water bill for w units of water equals p1(w2-w1)+p2(w3-w2)+… . The difference (if
any) between p1 and p2 determines whether the rate structure is increasing or decreasing. Historically,
decreasing block rates were popular, offering many advantages to suppliers. Nowadays, increasing block
rates have gained popularity. They are perceived as more fair and promote water conservation.
Theoretically, the uniform rate structure is optimal as it allows to equate the marginal benefit (the water
price) with the marginal cost of supply. This is hampered by a.o. lack of information due to imperfect
measurement of water use.

There is wide evidence that water is systematically underpriced by suppliers. An important answer is
that suppliers have multiple objectives, including (i) revenue sufficiency, (ii) economic efficiency, (iii)
equity and fairness, (iv) simplicity, and (v) legality, all of which have implications for the water rate
structure to be selected. Objective (i), for instance, is largely responsible for the widespread use of
average-cost pricing rather than (the normally higher) marginal-cost pricing. The economic perspective
on water pricing is can be summarized as: charging marginal costs for new connections and meters, and
including marginal costs in the water rate structure, irrespective of block or uniform pricing. These
marginal costs should include all costs through the complete supply chain that are necessary to supply
the water (i.e. including social and natural values, externalities, opportunity costs, etc). For most real-
world cases, this economic perspective implies a substantial increase of the variable (volumetric) water
price, which is compensated by a substantial decrease in connection and meter charges. Overall, this
assures revenue sufficiency, just like average-cost pricing, but efficiency will be enhanced.
Special case: Privatization of water supply

Privatization of water supply has been promoted in developing countries since the 1990s by
international NGOs and donor agencies. The main goal of privatization was to increase the efficiency,
investments, and coverage of water supply compared to the poor results offered by public utilities.
These goals were found difficult to achieve. Privatization in water supply was taken up at a slower rate
than other sectors. The article in the reader (Kirkpatrick et al., The World Bank Economic Review, 2006)
evaluates differences between privatized and public water supply utilities in Africa. The authors use a
database that covers 110 utilities across Africa, covering 13 countries, 14 of which were privatized. Using
several econometric techniques, the authors find as a main result that there are no significant
differences in performance.

Special case: Payments for watershed services

Payments for ecosystem services (PES) is a recent and popular mechanism to create markets for the
goods and services provided by nature that would otherwise have no price. The mechanism also applies
to water resources. Users of the services from watersheds such as governments, NGOs, companies, or
individuals pay land-owners to conserve the water on their land, so that they enjoy the continued
provision of services like clean water, hydro-ecosystem protection, stable water supply, etc. The article
in the reader (Turpie et al., Ecological Economics, 2008) describes one such PES system: the South-
African “Working for Water” program. This program was established in 1995 with the main goal of
restoring hydrological functioning (mainly water supply) of mountain catchments by clearing these
zones of invasive plants. The authors describe the scope of the program and how it fits into the PES
system.