And all the boards did shrink

Every now and then, some crazy economist will come along and argue that if we really want to limit water use, we should scrap quantity controls, put up the price, and compensate low-income households.

Of course, this only works if household demand responds to the water price. If what the boffins call “the price elasticity of demand” is near-zero, then raising prices will be ineffective. So it’s useful to occasionally get some new evidence on this point. In a recent paper, Robert Stavins and coauthors estimate new price elasticities of -0.3 to -0.6. Along the way, they remind us of where the literature stands.

In a meta-analysis of 124 estimates generated between 1963 and 1993, accounting for the precision of estimates, the mean price elasticity is -0.51, the short-run median is -0.38, and the long-run median is -0.64, with 90 percent of all estimates between 0 and -0.75.

In a more recent meta-analysis of almost 300 price elasticity studies, 1963-1998, the mean price elasticity is -0.41.

In other words, if you raise the price of water by 10%, most econometric studies suggest that demand will fall by between 3% and 6%. That suggests that prices can work perfectly well to reduce water use. Time to scrap those annoying water restrictions, anyone?

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13 Responses to And all the boards did shrink

  1. ChrisPer says:

    Water bills are six-monthly and appear not closely related to day-by-day usage choices. You need faster feedback on those choices.

    My family had both an award for environmental choices, and a letter about being an upper 10 percentile houshold water user. Four kids, massive laundry, nappies, garden retic , pool, it adds up fast but you don’t have good knowledge of consumption daily.

    How about an integrated utility usage meter with electricity, fuel, gas and water all presented in dollar terms, designed to encourage economy, and delivered to homes from a web site?

  2. harry clarke says:

    My guess is that urban users probably pay too much for their water now – its state governments implicitly leving taxes on their urban dwellers by overpricing urban water and underpricing water used in irrigated agriculture. The predictable response to a shortage is to say jack up price but maybe a better idea is to allow all rural water supplies to be traded with towns where this is possible – e.g. in Melbourne.

    Maybe we can dispense with the stupid restrictions, pay less for our water and farmers will enjoy better returns from selling their water than they get by using an underpriced water resource asset.

    If you can’t do this then yes we need expensive alternative sources of water from desalination plants which will double water prices.

  3. Andrew Leigh says:

    ChrisPer: The studies I’ve cited show that people can respond to price signals with semi-annual bills. The website would be handy, though — it’s a clever way of giving people more information, without adding greatly to the administrative burden.

    Harry: John Quiggin wrote a terrific CEDA paper making just this point. I agree with it, but am working on the assumption that it’s not going to happen for the time being.

  4. Yobbo says:

    Harry is right, a huge majority of water use is by agriculture and industry (especially mining in WA).

    If price signals are going to be introduced, it has to apply to everyone, especially as industry currently gets its water basically free.

  5. Rajat Sood says:

    Having consulted to a major water utility in past years, I can say that the water businesses, regulators and governments have all known or accepted as such for a long time. The key issue until now has been a lack of political will to implement higher tariffs. The lack of will has even extended to ‘declining block’ tariffs, whereby consumers only pay usage tariffs beyond a minimum threshold level of consumption. As for real-time metering, Victorian bills are quarterly and all it takes it one big bill to influence behaviour. Water bills are presently largely comprised of fixed charges and a restructuring to a greater variable component would be the first sensible step.

  6. reason says:

    I’m with you all the way BUT
    somehow that “and compensate low-income households” keeps getting forgotten!

  7. Peter Whiteford says:

    “Compensate low income households”- i.e increase churning?

  8. Kevin Cox says:

    We have been promoting the idea of charging more for water and returning the “extra” money collected to those who consume less on a per head basis. This money is Rewards for being careful with a community resource. It can be thought of as paying people not to consume. The other twist is that money people get has to be used to increase supply or save water. If you get some money (Rewards) and cannot use it yourself then you sell it to someone who can.

    When you do some simple modelling the price increase gives a reduction that is the same year after year. That is people say reduce their consumption by 10% and it remains at that level. We do not know how much people will reduce consumption in order to obtain Rewards but we assumed it would be similar to the reduction caused by the price increase.

    The interesting effect is the spending or investment of Rewards. This compounds and soon dominates the reductions. That is if you spend your Rewards on some water saving device then that continues to save water and you then add in more savings from your investment. We have some numbers on how much we can save per dollar spent on things like water harvesting and greywater recycling etc .
    After a few years the investment effect soon dominates and it takes surprisingly small increase in prices to remove the need for water restrictions.

    In operations we expect that after an initial burst of gadgets for the house and garden most money would be invested in community projects like water harvesting for golf courses and sports fields and community plantings. These projects are surprisingly efficient.

    One could argue that this can all be done by the Water Authorities increasing the price and reinvesting. Unfortunately the history of monopoly suppliers whether they are public or private is that the money does not go back to feeding the “golden goose” but is diverted to other purposes.

    There are two arguments put up by economist gatekeepers (and they are always economists) to the Reward idea. The first which I find bizarre is that it is economic vandalism to direct the expenditure of Rewards towards increasing the supply of water. That is, we have interfered in the market. My argument about that is – of course we have. That is the reason we did it.

    The second is that it is too complicated. While it might appear complicated in operations it is simple to operate because you disperse decision making and you automate almost the whole process.

    The other argument I have heard against the idea is that “sooner or later you will run out of ways to save water or increase water supply”. This again is a strange argument because when that happens you have no water restrictions and you either spend the Rewards on your neighbours water supply or better still you drop the price of water.

    The nice thing about the approach is that the authorities can adjust the size of the Rewards to match the rainfall or level in dams. When you feel a drought coming on you increase the price and give more Rewards and you can do it quickly because you do not have to go through pricing regulators who are on the watch for price gouging of monopolies.

    So the system will use prices to control demand, direct the expenditure of resources through a market in infrastructure to save water, and advantage the poor by redistributing income from the high consumers to low consumers. You would think that economists would embrace the idea?

  9. Andrew Leigh says:

    PW, that’s a pointed jab! We already have in place several social benefits, which we increase on a regular basis. As occurred with the GST introduction in 2000, one could simply raise them a little more to offset a water price rise. Since low-income households aren’t paying tax, this isn’t going to lead to churn (or at least not the tax/middleclass welfare churn I’ve been worrying about lately).

  10. Kevin Cox says:

    What does it mean to “increase churn” in this context?

  11. Christian says:

    Talking about pricing water – Is there any competitive way for doing this or would it just involve mandating a price. Would we just adopt an electricity market structure, with one company owning the infrastructure and other companies paying to use it to transport water to consumers and competing with one another on price? If so, how would we deal with the fact that consumers would probably purchase from one company over another partly on the basis of how they source their water and its quality(reservoir, recycled, desalinated) – Therefore you couldn’t just mix all the water together as it flows through the pipeline system, this would be a real problem that you don’t have with electricity (electricity can be from different sources, but its all pretty much the same quality in the end). The only way I see it working is if all water, from all sources, was required to have a minimum quality level.

  12. Kevin Cox says:

    Obviously increasing the price of water will reduce demand and remove the need for water restrictions. The other solution to removing the need for water restrictions is to increase the effective supply by investing in ways to save water and by increasing supply. Unfortunately this only happens as a result of political not economic pressure because an economic system that relies solely on prices to determine allocation of resources has little effect on investment in savings and increasing supply when there is a near monopoly supplier.

    Why would a monopoly supplier spend money reducing demand or on expensive ways of increasing supply when they have the option of increasing prices and if that fails bringing in water restrictions? They don’t. In the ACT the cost of water is up to $3.12 per kilo-litre. This is still below the cost of supply through tanks and most greywater recycling but way above the cost of supply from catchments and pumping from the Murrumbidgee.

    The problem has arisen because infrastructure (roads, rail, electricity wires, sewerage, water pipes, communications wires) that is best delivered by a monopoly has been corporatised without bringing in economic regulators such as market choices to prevent the abuse of monopoly pricing power. There are many ways of changing the economic system to eliminate the need for water restrictions but a simple raising of prices is amongst the worse from the point of view of supplying water for the least cost and in the most equitable way.

    We see the same effect but in different ways with our transport systems, with the provision of broadband, changing land use, with the provision of energy, education, health etc. Economic systems that rely solely on price to consumers as the regulating mechanism are going to be less efficient in terms of the cost of delivering goods and services than systems that include other information in the allocation and provision of goods and services.

  13. Rob Macdonald says:

    To Harry Clarke:

    Hi Harry, and how are farmers supposed to seel their water to Melbourne? Should we build a pipline from Lake Mulwala to Melbourne or should we fund capital works to capture the ample runoff from the water collected by all the bitumen and concrete every time it rains?

    You tell me which makes more sense – building infrastructure to better harvest existing rainfall, or building infrastructure to shift water from one place to another?

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