An Alternative Market Framework for Water Transfers When Third Party Externalities Dominate

Abstract

Economic studies have argued that transaction costs and third-party impact of water transfers can reduce the potential of water markets in allocating water efficiently across users. The main objective of this study is to design and empirically simulate a market structure, which can overcome the transaction costs and some of the third-party externalities in surface water trading. An important characteristic of this market is trading conducted within a centralized framework by a market manager. Once the bidding rounds are closed, the market manager formulates the market model as a linear programming problem to find the market equilibrium for the bids submitted. The market manager then determines net trades on the basis of each participant’s initial permit allocation. Empirical simulations of the above market design demonstrate that the marginal cost price paid by each participant internalizes the third party impacts of water transfers. Prices are recalculated based upon binding flow constraints in each round of trade and hence additional transaction costs are avoided.