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Another Reason Oil Isn’t Like Water…Or Is It? (Part 1)

August 4th, 2008 · 9 Comments
Econ 101 · Environmental Econ · Policy

So I’ve decided to do a series of oil-related posts since even I, in my cave of academia, can tell that it’s a hot topic. However, I wanted to start by commenting on policy surrounding another liquid commodity that all people rely on: water.

For all practical purposes, it is a safe approximation, at least in the U.S., to say that water is free. (By free I mean that the price to the consumer is zero.) However, (clean) water is not free to produce, so the government setting the price of water at zero leads to more use of water than is economically efficient. (You would probably turn off the water while brushing your teeth if you had to internalize the cost of producing that water, for example.) To further complicate the situation, the water utilities don’t produce unlimited quantities of water- if they aren’t really getting extra revenue from doing so, why should they? It could also be the case that easily accessible water is in short supply. This leads to shortages of water. These shortages persist because the municipal control of water utilities results in the price mechanism (i.e. forces of supply and demand) being suppressed and the price set such that demand exceeds supply. Think Soviet Russia, but with water rather than bread and toilet paper…

David Zetland does a good job of describing the consequences of free water in California. When you stop to analyze the situation, it’s clear that there is an equity argument to be made for free water- everyone needs water to survive, and there would be questionable ethics involved in allowing the price mechanism to take over. (What, now you have to be rich to cook pasta or take a decent shower?) Furthermore, water is a natural resource, and it’s not entirely clear where the “ownership” rights would lie were the market to be privatized. (Just wait until my giant rain-catching funnel is positioned over your property, then see how you feel.)

That said, the current system of unlimited free use goes to an unfortunate extreme. While letting market prices prevail is not the right answer, it seems like Zetland’s suggestion of a cap on free water and a fee on excess use is pretty reasonable. The remaining difficulty in that scenario is that it is not obvious how to set such a cap. I am not saying that this is the most economically efficent outcome, but I am saying that it seems like a decent balance in the tension between efficiency and equity. (For those of you non-economists, it turns out to usually be the case that in order to increase equity in a market, one must sacrifice efficiency. Nobody ever said that free markets were fair.)

Some of you may have noticed that this sounds similar to a cap and trade system without the trade. (The difference lies in the ability to purchase extra water directly from the utility.) So why not allow the trading? The easy answer is that the ability to trade puts an opportunity cost on consumption and thus makes the system effectively the same as giving an endowment and then letting market prices prevail. It would be easier to do a helicopter drop of cash to households and let the market for water do its thing. This doesn’t quite pass the fairness sniff test (I can hear the libertarians screaming from here) since the original equity issue was that people shouldn’t have to think about whether it’s worth it to use the water for that first shower in the morning, for example. (Besides, it’s not like current water conservers reap a financial benefit from conservation anyway.)

On a side note, I like Zetland’s critique of rationing: “Low prices lead to shortages. Water managers respond to them with calls for conservation. But this often fails. Residents in San Diego County, for example, were asked in June 2007 to cut their water use by 20 gallons a day. They used more. When voluntary conservation fails, water agencies impose mandatory rationing, which is unfair and inefficient because people who have historically been water misers are cut back by the same percentage as water hogs.” Granted, this assumes that the rationing rule is a percent decrease and not a set quota, but the idea generally holds. I’m also not surprised that the voluntary conservation was ineffective, since it suffers from a serious free-rider problem. (In fact, I’m not even surprised by the increase, since telling people to ration makes water more valuable in their minds, while still having a price of zero.) I grew up in Florida, and I remember that, during extremely dry periods, volutary rationing was put in effect by asking people to limit when and how much they watered their lawns. Not surprisingly, this seemed more successful than the plan above- not obeying the rationing request was visible via active sprinklers and a green lawn, and peer pressure is quite the motivating force.

Tags: Econ 101 · Environmental Econ · Policy

9 responses so far ↓

  • 1 Professor Coldheart // Aug 4, 2008 at 3:06 pm

    “So why not allow the trading? The easy answer is that the ability to trade puts an opportunity cost on consumption and thus makes the system effectively the same as giving an endowment and then letting market prices prevail. It would be easier to do a helicopter drop of cash to households and let the market for water do its thing.”

    You lost me at about the “thus.” I think there’s a notable difference between charging someone for every gallon of water they use and charging them for all but the first hundred. Even if there’s not a mathematical difference (taking into account opportunity costs, yes, each gallon you use is worth what it could have fetched on the cap-and-trade market).

  • 2 David Zetland // Aug 4, 2008 at 4:36 pm

    Re: trading, I would also add that the opportunity costs of trade among retail consumers are high. Among wholesale users this is not the case, which is why I advocate auctions among all users at the wholesale level. See this entry:

  • 3 Jason // Aug 5, 2008 at 2:09 pm

    Are farmers the big losers under cap and trade? They lose the ability to scale operations to market conditions (increasing cost of wheat/rice) yes? Or, at least, they couldn’t maintain the same margins. Who else loses here? Would there be a special low-income tier? Just curious about some of the policy mechanics.

  • 4 judgeetox // Mar 11, 2009 at 7:37 pm

    Look up Cochabana, Peru and Bechtels rescue plan for the citys failing water purification system and you might catch a reason that this is a very tender subject and needs to be handled carefully.

    Peer pressure is a great motivator, but the only vehicle to hammer this message across is government incentive to conserve and if the subliminal whiz kids who managed to get George W. Bush elected into a leadership position need a job today …. hammering home the conservation message might change public perception.

    Cochabana’s lesson was that taxes or charges for water delivery could be easily bypassed, because anyone can dig for it, or catch it from the sky and purify it themselves. . . how could the price be controlled?

  • 5 Ben // Apr 10, 2009 at 6:22 pm

    Interesting that you know David. we’ve crossed paths before. The main problem with this argument is that the marginal cost of water is vanishingly small. They would have practically no effect on consumers.

    The only effect really would be on farmers who use acres of the stuff (literally, they measure water in terms of acres, not gallons). and farmers have political power. so no solution that uses economics alone has any chance.

    farmers are a stubborn lot. efforts to buy out their water rights at a massive premium have failed.

    As an aside, most economists (esp theorists) incidentally mnake the mistake a lot of making a theoretical point without considering magnitudes.
    Greg Mankiw makes this mistake when arguing for a higher gasoline tax (both on his blog and his op-eds and during a white house conference call, that I was part of). Theoretically he is correct, that externalities should be taxed. Empirically, the magnitudes are quite small and unlikely to matter.

  • 6 gtorell // Apr 11, 2009 at 2:36 am

    I hate how you easterners think the only water policy on earth is riparian doctrine and water markets don’t exists.

  • 7 gtorell // Apr 11, 2009 at 2:36 am

    and how I can’t spell. argh.

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