14 May 2008

Price and Efficiency

Fixed Carbon asks me to
comment on increasing efficiency of water use in both ag and the urban sector, which would (might, could?) also come with a true water market.
Economists generally say that an increase in the cost of an input will lead to innovation to reduce the quantity of that input in the productive process. For example, when water is "free", farmers use flood irrigation. When it gets more expensive, they switch to methods that use less water per unit of output (e.g, drip irrigation). Besides this increase in "intensive" technological adoption, higher prices make innovation more cost effective -- leading to adoption of "extensive" technologies invented just for the purpose of saving resources.

Technology is not the only answer, of course. When water becomes more expensive, institutions of abundance (e.g., unmetered water supply to residential and agricultural customers) are no longer cost-efficient ("too cheap to meter"), and new institutions -- paying per unit -- are necessary. I discuss these forces at length in Chapter 3 of my dissertation, where we see how MWD ran into big problems when it applied rules of abundance in situations where water supplies were tight (and they still are today, sadly).

It's also possible that efficiency can drive price, i.e., innovations can lower costs. Although we can imagine a selfless inventor pushing out innovations that lower costs, much innovation is driven by the desire to make increase profits (even holding the price of inputs constant). Back again to price driving efficiency.

Overall, I'd say that "prices" (costs, profits) drive efficiency 80 percent of the time, and that efficiency drives prices 20 percent of the time.

Bottom Line: Prices are useful as a means of indicating where to put our innovative effort. When prices are set by cost of delivery or political means (not scarcity), we have a hard time knowing where to put our scarcest resource (human innovation) and waste our natural ones.