How probability weighting affects participation in water markets

Abstract

The behavioral tendency to overestimate probabilities of loss can affect a farmer's participation in water markets. We examine this issue with a theoretical model of a nonexpected utility maximizing farmer who places subjective weights on the actual probabilities of loss of water rights due to market transactions. The farmer bargains over sharing of surpluses with the buyer of water. The farmer then incorporates the bargaining outcome in his intertemporal expected benefit maximization problem that accounts for the possible loss of water rights due to its sale out of agriculture. Three key results emerge. First, subjective weighting of probabilities leads to discounting of resources when farmers overestimate probabilities of loss. Second, if farmers have idiosyncratic time preferences, total water supply in the market would depend on the level of heterogeneity in the population. Third, considering the case of two farmers, we find that the farmer with lower endowments bears the burden of risk reduction, whereas the one with higher endowments sells more water for profits. As the level of risk increases, however, the relative difference in risk sharing declines.