Managing Water: Rights, Markets, and Welfare

Abstract

This article investigates key aspects related to managing water resources, and explores their implications for economic efficiency: incomplete property rights; overallocation of water; the divergence between water entitlements and productivity of water use. These issues are explored in a production model with a single input, water drawn from a common source, and two main insights are offered. First, a novel result relating welfare and water entitlements is established, an equivalence between the socially optimal and legal assignment of water rights, via a set of social weights implied by the rights assignment. It is also shown that, for water entitlements for which the divergence between productivity and entitlements is substantial, no set of valid social priorities can lead to the socially efficient allocation. Second, considering a hypothetical water market with an endogenous price, it is found that trade in water is unable to eliminate allocative inefficiency, and that taxes have unexpectedly moderate effects on trade and welfare, with the majority of tax shifts canceled out by changes in demand. In addition, trade is not effective at facilitating efficiency-enhancing reallocation of water under scarcity when entitlements diverge substantially from productivity. The results here highlight important new connections between welfare and water entitlements and the limitations of market-based instruments under incomplete property rights, and have implications for designing property rights regimes for managing water under scarcity.