11.4. Water Market-Economic Efficiency

The water “market” is not homogeneous. Different sub-sectors (agriculture, industry, power, transport, flood protection) have different characteristics (Zaag, 2006). However, this study undertakes the use of water for domestic purposes. Economic efficiency is defined as the maximization of social welfare also requires the efficient use of resources. Allocative efficiency means that resources are used for the production of goods and services most wanted by society. Productive efficiency implies that the least costly production techniques are used to produce any mix of goods and services. Allocative efficiency requires that there be productive efficiency. The principle condition for the optimum distribution of resources is to ensure MC=MB equality, because the consumer aiming to maximize the benefit will make a demand on the goods and services which ensure the most satisfaction. The producer, aiming to maximize their profit shall continue to produce until the point where the marginal cost is equal to the market price. Thus in the absence of externalities and other market failures the market demand and supply curves where the marginal benefit equals the marginal cost. This is also the point where total surplus (consumer surplus plus producer surplus) is maximized. There is no way to rearrange production or reallocate goods so that someone is made better off without making someone else worse off — a condition known as Pareto optimality. These conditions are undertaken and discussed in regard to the water market by Winpenny (2005), as can be seen in Figure 11.9.

Figure 11.9. Market Equilibrium(Winpenny, 2005)

In Figure 11.9, the demand curve relates the consumer’s willingness to pay to the amount of water consumed. This would normally be downward-sloping from left to right, reflecting the diminishing marginal valuation of successive increments of water. The supply curve slopes upwards, reflecting the fact that increments of demand can normally be met only at rising cost to the water system. From the point of view of fixing prices, the cost schedule is best interpreted in the sense of long-run marginal costs of expanding the system to meet a permanent increment of demand. These basic notions are equally applicable to water ‘mining’, such as the excessive drawdown of aquifers, where the benefit of reduced consumption is the avoided cost of alternative future supplies. As shown Figure 11.9, net benefits are maximized when OA units of water are produced with a price of OE. Net benefits, the excess of the area under the demand curve over that under the supply curve, are represented by the area CBD. If consumption is higher than this, say OH, the costs ABIH of supplying the increment AH exceed benefits ABFH by BIF. Conversely, if consumption is restricted to OK, for instance by excessive prices or over-zealous restrictions, the loss of consumer benefits KMBA exceeds the supply cost savings KLBA, and this solution is also sub-optimal (Winpenny, 2005). In fact, it is difficult to make mention of a balance regarding the water market in the traditional sense. The application of price- based instruments, once an appropriate value system has been agreed, is particularly difficult in the case of water, because the flow of water through a basin is complex, and provides wide scope for externalities, market failure, and high transaction costs (Franks at al. 1997). Nevertheless, in the market, decisions are based on the private costs and private benefits to market participants. If the consumption or production of goods and services poses an external cost or benefit on those not participating in the market, however, then the market demand and supply curves no longer reflect the true marginal social benefit and marginal social cost. Hence, the market equilibrium will no longer be the socially (Pareto) efficient outcome.

11.4.1 Externalities

Externalities are the direct benefits or costs of producers and consumers to other producers and consumers as a result of their actions. As externalities cannot be priced, the social benefit and cost of production and consumption differ from each other and this is considered by the market as failure. That is, when the pricing mechanism and the cost and benefit in question are not equal to the production and consumption amounts as desired by the individual and society, then there is a loss in social welfare/benefit. By following the argument of Hussen (2004), this situation can be explained as follows:

1. In a situation where a positive externality is present Social bene?ts = Private bene?ts + External bene?ts and External bene?ts > 0 Therefore, Social bene?ts > Private bene?ts
2. In a case where negative externality prevails Social costs = Private costs + External costs and External costs > 0 Therefore, Social costs > Private costs

11.4.2 Externalities in water market

In the water sector, positive externalities are associated with improved water and sanitation. Numerous benefits of using quality water were examined above. Use of water by one user commonly has negative effects (externalities) on other users. The most important negative externality is impairment of water body quality as a result of industrial activities in the long term. This is titles as negative externality in macro economics. There are many negative externalities in the short- to medium-term. For example, pollution from a town can mean that downstream users have to incur additional treatment costs. Similarly, drainage water from irrigation fields often carries high levels of salts, nutrients and pesticides, leading to losses of aquatic habitats (Kay at al. 2005). In recent years, the importance of externality has come again to the forefront for the water sector due to population pressure and a demand on water more than ever before. On the other hand, the construction of a new dam, the extension of a water supply network, the repairing of a water treatment plant, or the renovation of a small scale irrigation scheme all require a significant amount of investment and cost-benefit analysis. Also, the unique characteristics of water use should be taken into account. Not taking into consideration the negative externalities before taking decisions, not conducting an careful analysis or including it in cost expenditure analysis, will adversely affect the effectiveness and efficiency of these such investments. On the other hand, as aforementioned, in a competitive market, for example, the efficient allocation of goods is reached at the point where the market price balances supply against demand. At this point each water abstractor uses a level of water where the additional or marginal benefit to withdrawing an additional unit of water is equal to the cost of withdrawing it. However, unlike in the case of many goods, the use of water can have wider impacts which are not typically reflected in the costs to the user (White, 2015).

Figure 11.10. Cost of the externalities in water use (Grafton et al., 2013)

As shown in Figure 11.10, the demand curve shows the marginal benefit incurred by an individual with one unit of water production. The supply curve reflects the marginal cost for the production of the extra one unit of water. In the case where there are no externalities, the market balance is fully efficient. The marginal social cost is equal to the marginal benefit. The marginal social cost is larger than the price. Now, let’s consider that there are externalities. For example, If a user withdraws large amounts of water from the environment they are likely to have to pay for the cost of transporting the water. However, this may create costs for other water users which they do not have to pay; such as if less water is available for crop production, fisheries, recreation, or biodiversity. These external impacts of water use are not typically reflected in market prices. As a result, they are not included in the costs faced by users, so users do not take them into account when deciding how much water to withdraw. These effects are described as negative externalities and they create a ‘wedge’ between the private and social marginal cost of using a resource. In the case of actual quantity, the marginal social cost curve has surpassed the price paid by consumers (White 2015). Due to these negative externalities, water resources are often undervalued and overused relative to the efficient allocation which includes both private and external costs.

² The economic benefits of improved water and sanitation effect households, businesses and industries need piped water for many kinds of activities. Welfare impacts on countries trough decreases poor health may in part cause this cognitive dysfunction, decreases in water-related mortality rates etc.