California Water Pricing - Essay Example

California Water Pricing Introduction The water allocation in California is done not by market mechanism but by legal rules based on prevalent water laws. Owners of agricultural lands are allowed significant subsidies, on account of which they are charged lower than the marginal cost of supplying the water. But the costs of water provision are high and therefore the subsidized price at which water is being purchased is of significant economic value to the users. There are three alternative policies that are considered below: Policy Alternatives Marginal cost pricing: Under marginal cost pricing, subsidies are withdrawn and the cost of supply of water is raised to match its full marginal cost. This will cause the demand for water among the farmers and other selected sectors to reduce considerably. This in turn creates an excess supply of water that the district supplier can distribute. Multiple water users are likely to pay a higher price for the extra water than the marginal cost, reflecting scarcity conditions in a relatively supply constrained water market. Thus there will be excess demand as the market price will be much higher than the marginal cost at which it is being priced. There is better efficiency in allocation as the supply is routed to users whose value of the resource matches the marginal costs incurred in its supply. The question of distribution of the excess supply of water is to be debated next. Marginal cost pricing plus auctioning excess demand: One method of distribution would be auctioning of the excess supply of water. In this scenario, farmers buy their existing allocation of water at the marginal cost and are allowed an option of buying extra water, which is beyond their original allocation, in a competitive bid. The excess water, in this case, will be redistributed to the highest bidder. Full water marketing: The other option available is full water marketing. In this case water will be traded freely in the market and price will be determined by the forces of demand and supply. Water as a resource is scarce in its existing quantity and hence supply will remain inelastic. Therefore the price of water will be higher than the marginal cost, the demand will drop and this will lead to more excess water supply for redistribution than the previous scenario. Full marketing will thus yield greater efficiency gains than the options discussed above. The excess water can to be redistributed either by auctioning rights or by granting rights by charging the users the marginal cost and allowing for resale of these rights in the open market. Analysis of Policy Alternatives While considering the above policies of water marketing, there are certain issues that crop up. First of all, it is a wrong conception that water subsidies make the agricultural industry more profitable. Applying the theory of capitalization to the agricultural land, we see that subsidies which would have benefited the initial owners of the land need not necessarily remain a benefit. As the ownership changes hands, the new owner pays the price for the subsidy benefit while purchasing the land and thereby forgoes the profits that arise from that extra benefit. Therefore, withdrawing subsidies from the existing farmers would affect them as they would suffer financially. The sale price that the farmers could receive without the water subsidy would be far less than what they actually paid for the land. Assuming that costs within basins are uniform, agricultural water prices are closer to marginal costs in some regions as the true marginal costs are lower in those regions than others. Since different regions produce varied crops, a shift to marginal cost pricing would affect some crops more than the others. The factor share of water, i.e., the percentage of total costs accounted for by water, ranges from 1 percent for celery to 35.8 percent for grain hay (Exhibit 6). Also, farmers in different regions use different amounts of water to produce a given crop. Exhibit 7 describes the inefficiencies in the allocation of water among the Californian crops. Holding the supply side constant, the marginal value of water would be the same for all crops if the water market was economically efficient. For example, given the relative values of crops in the exhibit, it would seem rational to shift water out of growing rice and lettuce and into growing lemon and cotton. Comparing exhibits 6 & 8 we see that, holding the demand side constant, when water input increases, water marketing or marginal cost pricing will shift the supply curve upwards, making it costly to produce at the same level. Taking exhibits 7 & 8, we can deduce that the additional value created by marginal applications of water is far lesser in the case of some crops than some others. This is also because the input variability is low in some crops and a change in the cost of one input in such crops will not affect the price drastically. Marginal costs will also differ depending on the fertility of the land on which crops are cultivated. All this considered, the greater the supply shock to the sector, the more that sectors costs go up as a function of increasing water prices, thus impacting that sector immensely. How much of this supply shock can be translated into higher prices to the consumers will depend on the demand side of the market of that sector. The geographic extent of water marketing is another issue to be considered. Water trading could be instituted within basins, among agricultural basins, or allowed across all basins. The larger the geographic range for trading the more scope for efficiency gains. But of course, there may be more transactions costs, political issues, or other constraints when the trading area is expanded. Conclusion All things considered, it can be fairly assumed that while the adoption of a marginal cost pricing system would bring enormous efficiency gains, it would inevitably create losers as well as winners. Withdrawing subsidies will affect the farmers to the extent of the loss they will incur from the fall in the value of their land. Rise in the price of water to match its marginal cost will affect some crops much more than the others. However, I would recommend full water marketing in California. Water is a scarce resource and efficient use of this resource is warranted. We have already seen that allocation and distribution efficiency improves when the trade of water is price rationed. When the economic forces of demand and supply determine the price and quantity of water supply, there is better demand and higher efficiency in the distribution and usage of this scarce resource. The net efficiency gains are also highest for this option. Even though the withdrawal of subsidies affect the farmers as they would have to pay higher prices to obtain the same quantity of water as before, this will lead to more efficient use of the resource, thereby, increasing its value to these farmers. If the farmers are then allowed to trade the excess water they are allocated in the competitive market, this will help them earn extra profits. Read More