J. Alfred Broaddus, Jr.

English

Research Papers in Economics

Spring 2003 • Region Focus 1
I
n the early chapters of an
introductory economics
textbook, one is likely to
find a reference to something
called the “diamond-water
paradox,” meant to demon-
strate the difference between
economic value and other
notions we might have of the
relative importance of dif-
ferent commodities. Can the
price of something be a good
measure of its inherent worth
if water, something essential
to life, bears a miniscule price
compared to diamonds, some-
thing with merely ornamental
uses? A moment’s reflection,
however, reveals that there is
no real paradox here. The
difference derives from the
abundance of water and the
scarcity of diamonds. In fact,
water historically has been so
plentiful that it typically has
not been treated as an eco-
nomic commodity subject to
the laws of supply and demand.
Surely, if there were rivers and
lakes of diamonds, they would
be just as cheap—and engage-
ments might be marked in a
very different way. 
What happens when
water’s abundance begins to
recede? This issue of Region
Focus features a story on the
growing challenges facing
Fifth District communities
and public utilities as expand-
ing populations squeeze the
ability of ground and surface
water resources to quench
the growing thirst. Latent
problems with traditional
approaches to water alloca-
tion have risen to the surface
during the recent drought.
Frequent readers of this
column will not be surprised if
I suggest that market-based
approaches to water allocation
problems deserve serious con-
sideration. At one level, water
seems very much like a stan-
dard economic commodity
suitable for allocation guided
by market prices. Measuring
an individual’s or a business’
use of water does not pose sig-
nificant difficulties. Why then
shouldn’t users pay a price that
reflects the full social costs of
their use? Usage may not be
very sensitive to price in the
short run, but higher prices
would surely make individuals
more willing to consider
longer-term changes in behav-
ior or the purchase of water-
saving devices.
Of course, the technology
of water delivery may make
this a market that is not well
suited to competition. A sys-
tem for carrying water has
some of the characteristics of a
natural monopoly, since a com-
peting system would have to
duplicate the costs of building
an infrastructure. Such dupli-
cation is usually wasteful from
a social point of view. Markets
with natural monopoly charac-
teristics are often subject to
government regulation to pre-
vent a monopolist provider
from extracting excess profits.
There may also be political
constraints that limit our abil-
ity to treat water as a standard
economic commodity. Pricing
water use at full social cost
may simply not be a politically
acceptable option, given that
it would represent a substan-
tial departure from the tradi-
tional approach, in which
users pay at most for the
resource costs of water treat-
ment and distribution. As
water becomes more scarce,
the opportunity cost associ-
ated with alternative uses
rises. Standard public utility
pricing of water does not take
such costs into account.
So setting prices for water
may not be an easy task. Still,
price systems can work for
more difficult allocation prob-
lems as well, including cases in
which the government seeks
to allocate some resource for
private use. In fact, the labora-
tory  experiments of Nobel
Prize economist Vernon
Smith, the subject of this
issue’s Interview, have deep-
ened our understanding of
such allocation questions. For
example, his work on the
design of institutions for the
allocation of airport landing
rights showed how the careful
design of market institutions
can align private incentives
with social objectives. Now
I’m not suggesting that
Professor Smith begin con-
ducting experiments aimed at
solving water allocation prob-
lems. His work proves, how-
ever, that the interplay
between academic research
and public policy problems
can yield creative approaches
to difficult questions concern-
ing the allocation problems
that local, state, and even
national governments some-
times face. I don’t expect this
flow of benefits to dry up any
time soon.
NOTEW ORTHY
Price systems can
work for difficult
allocation problems,
including cases in
which the government
seeks to allocate
some resource for
private use.
Water Rights
AL BROADDUS
PRESIDENT
FEDERAL RESERVE BANK OF RICHMOND

Noteworthy : Water rights

http://www.richmondfed.org/publications/research/region_focus/2003/spring/pdf/noteworthy.pdf

Noteworthy : Water rights

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