Allocation of a Paramount Resource — Water
How are water resources allocated to different users and economic activities?
In our previous consumer corner letter, we introduced a nuanced effort to provide the necessary commodity of water. In addition to sustaining life, water is an essential input for agriculture, manufacturing, transportation, energy production and recreation. How we efficiently allocate water resources among these competing uses is a pressing issue in many regions, especially in water-limited areas.
In economic theory, efficient allocation of water occurs when the value attributed to the marginal benefit of consumption (the benefit obtained by consuming one additional unit of water) equals the marginal cost of water provision (the cost of supplying one additional unit of water). In other words, people only pay what water is worth to them. Water flows to high-value uses in society and away from low-value uses, thereby maximizing society’s welfare. Ideally, markets function to achieve this win-win outcome. However, efficient allocation of water resources is difficult to achieve in most situations. Different legal and institutional frameworks govern water resources rather than through markets. In practice, most water is allocated through water rights. Selling and purchasing water though markets is not the norm.
In the United States, there are riparian rights and prior appropriation doctrine. Riparian rights allocate the right to use water to landowners adjacent to the waterways, streams and rivers. The rights to access water are attached to land property rights. This approach is mainly adopted in the Eastern United States where water is a relatively abundant resource. The prior appropriation doctrine is also known as “first in time, first in right”, often accompanied by a ‘use it or lose it’ component. Under the prior appropriation doctrine, if landowners obtained senior water rights, they have precedence when river and stream flows are insufficient to meet all users’ demands. If the water has not been used for a certain period of time, the user may lose the rights. Various states and federal laws are in place to regulate the transfer of water between users, which for some communities has led to inefficient water allocation. The ‘use it or lose it’ component could also discourage water conservation as the owner is afraid of losing the right to use the water.
Water trading through a well-established market can reduce water allocation inefficiency. When limited water resources do not meet all users’ demands given their willingness to pay and established water rights, purchasing or selling temporary (or seasonal) water use rights could be an effective method to transfer water from low-value to high-value uses. Recent research has shown that well-functioning market institutions and low transaction costs are key drivers to increase participation in water trading markets (Wheeler and Garrick, 2020).
Sarah Ann Wheeler, Dustin E Garrick, A tale of two water markets in Australia: lessons for understanding participation in formal water markets, Oxford Review of Economic Policy, Volume 36, Issue 1, Spring 2020, Pages 132–153, https://doi.org/10.1093/oxrep/grz032