23 May 2008

Elasticity of Demand

Anonymous asks in yesterday's post:
"Water managers need to do the same thing if they want customers to use less water."

If the extra revenue from an excess tax doesn't cover the elasticity of demand for water, should the water managers be subsidized?
How can we get people to pay more towards the full price of the resource if water managers may have an economic disincentive to do so?
I wrote a little about elasticity [wikipedia] back in the dark ages (April!), so let me add some more comments here.

I think anonymous is referring to the old problem of zero-profits in the water business, i.e., set price such that total cost = revenue = price * quantity. we know (Law of Demand) that price increases lead to a reduction in quantity demanded; the only question is by how far it will fall (a lot = elastic; a little = inelastic). If quantity demanded falls "too far" then total revenue will fall by more than total costs, negative profits result, and subsidies are necessary to cover costs.

Let me comment on this in several ways:
  1. The problem usually occurs in a drought, when people cut back use by "so much" that revenue falls faster than costs -- mainly because most costs are fixed, i.e., they do not fall when quantity does. The "solution" in those cases is to raise prices.
  2. I am suggesting going from the other direction, i.e., raising prices FIRST and then getting the reduction in quantity demanded. Given price elasticity of water is nearly zero for indoor use (and around 0.6 for outdoor use; see page 21 in my dissertation), higher prices will lead to higher revenue.
  3. My suggestions for pricing water is to move prices up by 200-500 percent. Given this HUGE jump, it's more likely that outdoor use (we are talking urban, not ag -- that would be an interesting story, since fixed costs in ag are lower, there's groundwater, etc....) will drop by, say, 50 percent. (Indoor use would drop by nothing since I would exempt "basic use"/indoor use from the price increase.) Given a 200 percent increase in price, it's feasible that this move would lead to higher revenue. (Academic but important caveat: elasticities are point estimates for small changes in price, and 200 percent is NOT a small adjustment.)
  4. Worst case scenario is that revenues would drop. I suggest covering the difference with property taxes. (This is the flip-side of my suggestion that excess revenue be distributed on a per capita basis.)
Bottom Line: Our smallest problem is how to pay for water service. Since we pretty much pay nothing (what percent of your annual income goes to water?) right now, the key idea is to raise prices so that people DO start paying attention.