Oil and Water: A Guest Post


David Zetland, the S.V. Ciriacy-Wantrup Postdoctoral Fellow in Natural Resource Economics and Political Economy at U.C. Berkeley, blogged here earlier this week about the economics of water. This is his second of two posts on the subject.

Oil and Water
By David Zetland
A Guest Post

Over the past few months, newspapers, blogs, and television screens have been filled with stories of two precious liquids — oil and water. Although the stories seem similar (demand outstripping supply), they report fundamentally different means and success in coping with “shortage.”

Ironically, we are coping better with scarce oil — nearly 60 percent of which we buy from abroad — than scarce water, which falls from the sky.

Why such a contrast? Because oil is bought, sold, and marketed as a commodity. Water, in contrast, is treated as a “human right” that should not be allocated by price. Because scarcer oil costs more, quantity demanded falls to equal supply. Because scarcer water does not cost more, demand exceeds supply and rationing, misallocation, and hardship result.

Put differently, we would not have water shortages if water prices rose and fell with supply and demand. But prices do not change that way.

Most water users in the U.S. pay a price for water that reflects the cost of delivery. The price of water is actually zero.

Although the fixed costs of dams, pipes, etc. and the variable costs of pumping (20 percent of California’s energy is used for “moving water”) are large in aggregate, those costs are spread across many units of water. In southern California, for example, urban water customers pay about $3 for 750 gallons of tap water, most of which is imported from hundreds of miles away.

When demand exceeds supply, water managers do not raise prices; instead, they ask customers to use less. When “voluntary” conservation fails (often), managers send water cops out to ticket those who water their lawns on the wrong day, impose mandatory rationing of 20 percent, stop issuing building permits, etc. Although such methods do have some impact, their blunt nature affects people in odd, often unfair, ways.

Mandatory rationing, for example, is based on household use in prior years, which fails to reward those water misers who used less in the past and fails to recognize that the number of people in a household can change. It is also rather ineffective: Anyone who goes over quota pays an extra $1 per 750 gallons. That’s not much.

Students of bureaucracy and monopoly will note that water managers have little incentive to manage water efficiently. They can “declare” a 20 percent reduction in demand (nice round number) without worrying about the most efficient way to achieve it. They keep their jobs no matter the cost (e.g., business closures) or ineffectiveness of rationing.

Why haven’t water managers turned to higher prices?

First, because they are used to prices that reflect costs; second, because higher prices are politically difficult to impose; third, because their “public service” mandate tends to require that prices be set as low as possible and result in zero profits; and fourth, because many in the water business think that people will not respond to higher prices.

If water managers wanted to implement conservation prices that were, say, 200 percent higher than current prices, they would need political support (most urban water is supplied by public utilities; investor-owned utilities are regulated). Politicians would be able to support higher prices if the poor were protected (e.g., by giving everyone some water for free and charging more for additional water), if “excess” revenue was rebated (per capita rebates would be progressive), and if higher prices ended shortages and rationing.

Can higher prices reduce the quantity of water demanded? Yes — just as higher prices reduced the demand for oil.

When oil (gas) was “cheap,” we didn’t pay attention to how much we used. Instead, we paid attention to how fast our cars went, how long we’d be willing to drive from an affordable home to work, where to shop for cheaper stuff, etc. When prices rose (most notably when crossing the $4-per-gallon barrier), we changed our behaviors: S.U.V. sales plummeted, total driving fell, and people moved closer to work.

If water prices were raised to levels worthy of attention, we’d see the same reactions: people would reduce water consumption in the short run (not watering the sidewalk) and long-run (installing high-efficiency appliances, ripping out lawns, moving from drier places, etc.).

Let me repeat one caveat and add another: Higher prices need not harm the poor. If everyone got x gallons of water at a low price, only those who used more would pay higher prices. Second, these price-reform suggestions are relevant to urban water management, not water users everywhere. As many readers will know, agriculture consumes 70 to 80 percent of the water in the United States, and I have addressed agricultural/urban/environmental consumption elsewhere.

Bottom Line: We don’t have a gas shortage because gas is expensive; we will have a water shortage until water is expensive. Want more water? Pay for it.

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  1. Eric says:

    The economic argument on water breaks down for me because while I can live without oil/gasoline for days or even weeks at a time, it would be really hard for me to do the same with water.

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  2. CMSmaxi says:

    The issue with pricing water is that most individuals believe water should be a free resource, seeing as it is necessary for the most basic activities such as bathing. Society would view rising the prices on water as simply a way for companies to earn greater profits. They would not realize that the increase in price had the vital purpose of keeping the demand of water intact with the actual supply. If governments were to fund advertisements that educated people on the declining water supply, communities would be more willing to spend a bit more cash. Moreover, in order to encourage large firms and businesses to utilize lower amounts of water, the government could provide subsidies to those who used more efficient water installations. Like the author suggested, there should be an amount of water that is provided at a relatively low price and when people pass this amount, there should be a kind of tax on each additional 5 gallons or so. This would discourage people from using excess amounts.

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  3. Imad Qureshi says:

    Nice piece. In fact everything is plane common sense but only if common sense was so common.

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  4. Imad Qureshi says:

    I think first couple of thousand gallons can be supplied free of charge and then a dollar for every 20 to 50 gallons. I also think that poor countries that have real scarcity of water should charge their citizens under a similar mechanism.

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  5. Matthew says:

    The economic arguement breaks down because any change of the consunption pattern of the users of 20 percent of the water will not be as effective as changes to the users of 80 percent. And the industial/agricultural uses have all the political clout.

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  6. jim says:

    Our municipality just instituted demand-based water pricing, in which usage above a previously-established, household calculated “winter average” is billed at a progressively higher rate — usage over 25% of the winter average is billed at $8.55 per 1000 gal, while usage below the winter average is billed at $3.42 per 1000 gal.

    This is a massive improvement on low unit pricing and will likely be very effective at constraining water use in a drought-stricken area. However, the method for calculation penalizes residents with efficient winter use (i.e. water-saving devices in the house, front-loading washing machines, etc.) who also wish to water their lawns. They pay a higher marginal cost per gallon of irrigation water than those who run water like crazy all winter.

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  7. Nick says:

    Eric (#1) says, “The economic argument on water breaks down for me because while I can live without oil/gasoline for days or even weeks at a time, it would be really hard for me to do the same with water. ”

    That is why Zetland says, “Let me repeat one caveat and add another: Higher prices need not harm the poor. If everyone got x gallons of water at a low price, only those who used more would pay higher prices.”

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  8. Ben says:

    I agree mostly, and I think supplying cheap water for a set amount of gallons solves the fact that to a certain point there is a highly inelastic curve for water, but people will curb usage for frivelous water usage that has a more elastic demand curve.

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