Introduction
Water pricing and proper policy are thought to be the remedy of the existing unequal distribution of water and scarcity. Further with increased geographical dispersion, there are areas that naturally have scarce water resources while others like Canada have an abundance of it. So one possible option is to distribute water to areas where water is scarce through pipelines or some other means. But this leads to the need to trade water and the question of pricing water arises. Further one of the golden rules of economics is that anything that is scarce demands a price. So due to the regional scarcity of water, it must have a price for its use to become more efficient. Thus pricing will improve the allocation of water as well as improve its quality. But there arises abundant difficulty in the pricing of water as socio-economic considerations have to be kept in mind while setting a price for water (Azevedo and Baltar). For instance, a low-income household may not be able to pay the high price set for water. So the pricing of water becomes a difficult affair.
In this paper, I will assume a hypothetical situation where Canada, having abundant water resources, has made plans to export water to countries like the Arab world or Australia where water is scarce. Assuming there exists an international water policy regulatory body I will try to ascertain the best pricing theory applicable to the pricing of water. This essay will discuss various pricing theories that environmental economics has provided and determine the best possible pricing policy for Canada to adopt.
The paper is arranged to understand the above objective. First I will ascertain the right way to consider water as is: as an economic good or a social good. Then based on of the understanding of water as good I will try to present the best possible pricing policy for water.
Is water an economic or social good?
As has been stated in the Dublin Conference, 1992, “Water has an economic value in all its competing uses and should be recognized as an economic good.” (Gleick and Burns 33). Here it must be noted that an economic price has to be set on a good which was earlier not subject to economic rules and was available freely. So it is difficult to ascertain if water today should be considered as a social or economic good. Social goods may be defined as those goods which have extensive spill-over advantage or cost (Gleick and Burns). Under this definition, widespread availability of clean and free water is a social good as it spreads individual as well as social well-being. So to make the social good available efficiently, policy intervention is necessary as a complete free market will not ensure optimal use of the natural resource (Gleick and Burns).
But the inability to meet the requirements of clean water has led to the theory of considering water as an economic good. But water is not considered as all other economic goods. This is so because the most prevalent approach to water pricing is volumetric pricing wherein every unit of water is priced but not the pipeline which becomes a social good. Thus the present understanding of water as a good is that it is both an economic and social good (Gleick and Burns).
Another aspect of water that is important to consider from the international trade perspective is if it is renewable or non-renewable. As it has been identified that not all water resources are renewable and some are exhaustive are important to understand as their policy imperative, in that case, would be to keep water available for animal and plant life in the area before trading the water.
Water Pricing Theory – Economic Good
In this section, I will discuss the various economic theories that can be used to price water. First is the traditional demand-supply theory. This is one of the fundamental theories of price determination wherein an equilibrium price for the market is reached when the market downward sloping demand curve intersects the upward-sloping supply curve. So when water is considered to be an economic good, the law of downward sloping demand applies to it. So as the price of water is increased, people will lower their demand for it and so will consume less thus lowering supply.
Some economists argue that the best method of setting a price for water is to attain full efficiency. This is done through the criteria to recover the full economic cost of transferring water. In this section, I will show the pricing for water both as a non-renewable as well as a renewable resource.
For the pricing of non-renewable resource pricing, I follow Harold Hotelling who determined the efficiency criteria for the sale of an optimal unit of the natural resources. This was called dynamic efficiency. According to this theory, the resource market operates dynamically when the total sum of the surplus resources is maximized over the total life span of the non-renewable resource. Given this, I will present a model for pricing water as a non-renewable resource using this theory. To do this it is imperative to take a few assumptions. They are: (1) the market for water is a competitive market globally and (2) all market participants are well informed about the discount rate, future demand, and price etc. To make the example simple, I assume a 2-period analysis i.e. present time referred to as year 0 and year 1. To make the analysis even simpler I assume that the marginal cost of producing water is fixed at $10. As marginal cost is the basis of the competitive market supply curve, it is also constant at $10. The third assumption we take is that the market demand is the same in both periods which is assumed to be: P = 20 – 0.5Q. Here P stands for price and Q stands for quantity demanded of water in litres. I assume that there is the resource of which is fixed at 30 litres. Here I assume that there is a 20% discount rate.
I further assume that in the first year the suppliers completely ignore the consequences or demand in the second year. Then the price of water in year 0 is the competitive market equilibrium price which is determined by equalling demand and supply:
20 – 0.5Q = 10
Solving for Q I get the price for year 0 to be 20 litres. As figure 1 shows, that there is surplus revenue that was foregone and is calculated as 0.5(20 x 20). Thus, this shows that there is a surplus of $200.
Given that there is only a fixed supply of water which is 30 litres, there is only 10 litres of water left for year 1. So with demand remaining same, the price for water will become $15 in year 1. This year’s surplus I demonstrated in figure 2 which shows the surplus to be $50.
So the sum total surplus for the two years is $[200×1.2 + 50x 1.2] or $300. But this is not the dynamic equilibrium and thus the resource has not been efficiently allocated. The reason is if I know that the price of water next year will increase further next year, I will hold onto the sale of water for next year to increase revenue. Further, as we know the profit is equal to the difference between the price and marginal cost. As in our example, MC is equal to price in year 0, so profit is zero in this year. So in this year, I must hold on to the sale of water this year to increase profit next year. Here I apply Hotelling’s Rule to find the dynamic efficiency. The rule suggests that the marginal profit of the resource in year 0 must equal the present discounted value of marginal profit in year 1. This simply means that dynamic equilibrium occurs when the marginal profit of selling a good today equals that of tomorrow.
So this is the best way of allocating natural resources and determining the dynamic efficient price for non-renewable resources. Thus, I believe that the water distribution from Canada should also follow this rule as the resources of water are fixed and non-renewable when considering water for international trade is concerned. This is so because water is a scarce economic commodity that needs to be sold in fixed supply to the other countries after meeting the domestic demand for water. So a country that sells water to other nations must do it is fixed quantity and thus Hotelling’s Rule holds to determining the price of the product.
Water Pricing Theory – Social Good
Before deciding on the pricing strategy of water it is important to understand the reasons for putting a price on water (Hanemann). The first is to raise revenue. As water is a scarce commodity in other regions, Canada can export it to gain economic revenue from international trade in water. The second is to allocate the cost of water transfer among different users and uses to ensure social justness and political adequacy. The third is to provide adequate incentive to the users to make usage of water-efficient and optimum. The fourth is to promote economic efficiency. The secondary objectives are to ensure administrative problems do not arise and to prevent negative externalities.
So the reasons for administering a price are different depending on the circumstances. There are different approaches to price water that are presently in use are (Bhatia, Rogers and de Silva):
- Connection charges: this refers to the price attached to providing the water connection. Now when a country intends to sell water, it has to achieve the cost of transferring the water to other nations, assuming that it foregoes any profit on it. So the country simply charges the price which equals to its transferring the water to the consumers.
- Fixed charges: the country may change a fixed charge on the amount of water that is transferred to the other nation. Here the country does not bind the amount of water that is to be transferred to the other countries, rather sells all the units that are demanded.
- Volumetric charges: here the price s set for each unit of water consumed.
- Block charges: It refers to a certain amount of water consumed and the higher the consumption, the higher is the price. This means increasing the block tariff for specified parts and having different prices for different predetermined blocks. Here the prices are raised for each successive block. Here the decisions are to be made regarding the volume of water attached to each block.
- Minimum charges: this refers to the bare minimum price attached to the transaction.
Usually, for water trade, the amount to be traded is fixed which are referred to as tradable permits. A price is important to be set to make efficient use of water in the ace of the increasing global problem of water scarcity. There are various ways in which the water can be increased. Volumetric water charges are supposed to be the best way of pricing social goods (Bhatia, Rogers and de Silva).
Pricing of Water
The pricing for water that I suggest Canada should adopt for the pricing of water while trading it with other countries is volumetric charges which should be determined by using Hotelling’s Rule. This is so because water is both an economic and social good. Further, there is a problem of scarcity of water which has made it an economic good. So the main aim of this pricing process will be to attain revenue as well as allow efficient use of water. To project water to be scarce to the other countries, it is important to have a price that reflects its scarcity as well as ensures responsible use of water. Volumetric water charges can further be divided into three categories based on use and operations of the water. Frit charges should be based on the cost of setting up and operations of transporting the water. Then the price should also depend on the charges based on the type of crop or is it for domestic or commercial use. Further while making the price of water, elasticity must also be considered (Bhatia, Rogers and de Silva).
Conclusion
The paper discussed the various aspects of water and the issues that are arising related to water become an economic good. Even though water retains its social benefits; it must be considered as an economic good due to its increasing scarcity. The essay clearly shows why water needs to be considered as an economic good before discussing what pricing should be adopted for water. The essay also shows that if water is to be traded then its scarce nature needs to be understood and a fixed amount of water should be supplied.
It is believed that there is no best price design for natural resources, especially water (Bhatia, Rogers and de Silva). With the increasing scarcity of water in different parts of the world and to ensure efficient management of water, proper pricing is an imperative measure. So if Canada has to export water to other countries, it must do so in a fixed amount. The price which will fetch them the optimum price should be determined using Hotelling’s Rule which should be charged on volumetric terms. This process ensures the efficient utilization of water.
Reference
Azevedo, Luiz Gabriel T. de and Alexander M. Baltar. “Water Pricing Reforms: Issues and Challenges of Implementation.” Water Resources Development Vol. 21 No. 1 (2005): 19–29.
Bhatia, R., P. Rogers and R. de Silva. Water is an Economic Good: How to Use Prices to Promote Equity, Efficiency, and Sustainability. Cambridge, MA: Harvard University, 1999.
Gleick, Peter H. and William C. G. Burns. The World’s Water, 2002-2003. Washington DC: Island Press, 2002.
Hanemann, M. The role of pricing in water resources management, Special GWP Seminar in Water Pricing. Stockholm, Sweden. Berkeley, CA: Department of Agricultural and Resource Economics, University of California at Berkeley, 1999.