Misconceptions About Water Pricing

Throughout the United States, water management has been approached primarily as an engineering problem, rather than an economic one. Water supply managers are reluctant to use price increases as water conservation tools, instead relying on non-price demand management techniques, such as requirements for the adoption of specific technologies and restrictions on particular uses. In my March 3rd post, “As Reservoirs Fall, Prices Should Rise,” I wrote about how — in principle — price can be used by water managers as an effective and efficient instrument to manage this scarce resource.

In a white paper, “Managing Water Demand: Price vs. Non-Price Conservation Programs,” published by the Pioneer Institute for Public Policy Research, Professor Sheila Olmstead of Yale University and I analyzed the relative merits of price and non-price approaches to water conservation. We reviewed well over a hundred studies, and found strong and consistent empirical evidence that using prices to manage water demand is more cost-effective than implementing non-price conservation programs.

Despite such empirical evidence regarding the higher costs of non-price approaches to water conservation, many constituencies continue to prefer them. Professor Olmstead and I believe that this reliance on inefficient command-and-control approaches to water management may be due — in part — to several common and influential misconceptions regarding the use of water pricing.

One misconception is that “because water prices are low, price cannot be used to manage demand.” This misconception that low prices somehow obviate the use of price as an incentive for water conservation may stem from economists’ definition of a price response in the range observed for water demand as “inelastic.” There is a critical distinction between the technical term “inelastic demand” and the phrase “unresponsive to price”. Inelastic demand will decrease by less than one percent for every one percent increase in price. In contrast, if demand is truly unresponsive to price, the same quantity of water will be demanded at any price. This may be true in theory for a subsistence quantity of drinking water, but it has not been observed for water demand in general in 50 years of published empirical analysis.

A second misconception is that “water customers are unaware of prices, and therefore price cannot be used to manage demand.” If this were true, the hundreds of statistical studies estimating the price elasticity of water demand would have found that effect to be zero. But this is not the case. Instead, consumers behave as if they are aware of water prices. The hundreds of studies we reviewed cover many decades of water demand research in cities that bill water customers monthly, every two months, quarterly, or annually; and in which bills provide everything from no information about prices, to very detailed information. Our conclusion is that water suppliers need not change billing frequency or format to achieve water demand reductions from price increases, but providing more information may boost the impact of price changes.

A third misconception is that “increasing-block pricing provides an incentive for water conservation.” Under increasing-block prices (IBPs), the price of a unit of water increases with the quantity consumed, based on a quantity threshold or set of thresholds. Many water utilities that have implemented IBPs consider them part of their approach to water conservation; and many state agencies and other entities recommend them as water conservation tools. But analysis indicates that increasing-block prices, per se, have no impact on the quantity of water demanded, controlling for price levels.

A fourth and final misconception is that “where water price increases are implemented, water demand will always fall.” Price elasticity estimates measure the reduction in demand to be expected from a one percent increase in the marginal price of water, all else constant. Individual water utilities may increase prices and see demand rise subsequently due to population growth, changes in weather or climate, increases in average household income, or other factors. In these cases, a price increase can reduce the rate of growth in water demand to a level below what would have been observed if prices had remained constant.

Raising water prices (as with the elimination of any subsidy) can be politically difficult. This is probably one of the primary reasons why water demand management through non-price techniques is the overwhelmingly dominant approach in the United States. But the cost-effectiveness advantages of price-based approaches are clear, and there may be some political advantage to be gained by demonstrating these potential cost savings.

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The Myth of the Universal Market

Communication among economists, other social scientists, natural scientists, and lawyers is far from perfect. When the topic is the environment, discourse across disciplines is both important and difficult. Economists themselves have likely contributed to some misunderstandings about how they think about the environment, perhaps through enthusiasm for market solutions, perhaps by neglecting to make explicit all of the necessary qualifications, and perhaps simply by the use of technical jargon.

So it shouldn’t come as a surprise that there are several prevalent and very striking myths about how economists think about the environment. Because of this, my colleague Don Fullerton, a professor of economics at the University of Illinois, and I posed the following question in an article in Nature:  how do economists really think about the environment? In this and several succeeding postings, I’m going to answer this question, by examining — in turn — several of the most prevalent myths.

One myth is that economists believe that the market solves all problems. Indeed, the “first theorem of welfare economics” states that private markets are perfectly efficient on their own, with no interference from government, so long as certain conditions are met. This theorem, easily proven, is exceptionally powerful, because it means that no one needs to tell producers of goods and services what to sell to which consumers. Instead, self-interested producers and self-interested consumers meet in the market place, engage in trade, and thereby achieve the greatest good for the greatest number, as if “guided by an invisible hand,” as Adam Smith wrote in 1776 in The Wealth of Nations. This notion of maximum general welfare is what economists mean by the “efficiency” of competitive markets.

Economists in business schools may be particularly fond of identifying markets where the necessary conditions are met, where many buyers and many sellers operate with very good information and very low transactions costs to trade well-defined commodities with enforced rights of ownership. These economists regularly produce studies demonstrating the efficiency of such markets (although even in this sphere, problems can obviously arise).

For other economists, especially those in public policy schools, the whole point of the first welfare theorem is very different. By clarifying the conditions under which markets are efficient, the theorem also identifies the conditions under which they are not. Private markets are perfectly efficient only if there are no public goods, no externalities, no monopoly buyers or sellers, no increasing returns to scale, no information problems, no transactions costs, no taxes, no common property, and no other distortions that come between the costs paid by buyers and the benefits received by sellers.

Those conditions are obviously very restrictive, and they are usually not all satisfied simultaneously. When a market thus “fails,” this same theorem offers us guidance on how to “round up the usual suspects.” For any particular market, the interesting questions are whether the number of sellers is sufficiently small to warrant antitrust action, whether the returns to scale are great enough to justify tolerating a single producer in a regulated market, or whether the benefits from the good are “public” in a way that might justify outright government provision of it. A public good, like the light from a light house, is one that can benefit additional users at no cost to society, or that benefits those who “free ride” without paying for it.

Environmental economists, of course, are interested in pollution and other externalities, where some consequences of producing or consuming a good or service are external to the market, that is, not considered by producers or consumers. With a negative externality, such as environmental pollution, the total social cost of production may thus exceed the value to consumers. If the market is left to itself, too many pollution-generating products get produced. There’s too much pollution, and not enough clean air, for example, to provide maximum general welfare. In this case, laissez-faire markets — because of the market failure, the externalities — are not efficient.

Similarly, natural resource economists are particularly interested in common property, or open-access resources, where anyone can extract or harvest the resource freely. In this case, no one recognizes the full cost of using the resource; extractors consider only their own direct and immediate costs, not the costs to others of increased scarcity (called “user cost” or “scarcity rent” by economists). The result, of course, is that the resource is depleted too quickly. These markets are also inefficient.

So, the market by itself demonstrably does not solve all problems. Indeed, in the environmental domain, perfectly functioning markets are the exception, rather than the rule. Governments can try to correct these market failures, for example by restricting pollutant emissions or limiting access to open-access resources. Such government interventions will not necessarily make the world better off; that is, not all public policies will pass an efficiency test. But if undertaken wisely, government interventions can improve welfare, that is, lead to greater efficiency. I will turn to such interventions in a subsequent posting.

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