20 July 2008

More Supply versus Higher Prices

Many people think that "shortages" can be solved by "making" water with desalination. I don't like that idea, and neither do these Australian economists:
They argue the most efficient way to regulate water usage would be to price water according to supply and demand so that householders pay more in times of drought and less during times of heavy rainfall. "Just like we do for bananas, we should pay more when less is available," they write.

Professor Crawford said higher prices during drought would provide a better incentive for people to curb their use, and those who used large quantities of water would have to pay for it.

"If we had flexible water pricing people could choose how much water they wanted to use and where they use it," he said.
More supply (via desalination) will not fix a shortage because demand will expand to absorb new supply.

Bottom Line: We should price water like bananas.

hattip to TS

18 comments:

  1. Don't prices help on both sides of the equation, by both curbing demand and increasing supply?

    For example, I oppose "price gouging" laws after a natural disaster, because (a) they encourage people to clean out the store of canned goods, bottled water, gasoline, generators, etc. right away, but also (b) they discourage outsiders from shipping in more supplies.

    In your example, maybe desalination plants are efficient for some regions of the world, and if so the way to pay for them is to charge people more.

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  2. Douglas Knight20 July, 2008 08:32

    The pricing you proposed in Forbes is way above the price of desal, so you ought to favor desal as a way of lowering that price.

    Can you put a price tag on the politics of changing the system? Is desal really more expensive than making it possible for farmers to sell water? Again, don't let the perfect be the enemy of the good.

    And how expensive is desal, anyway? In your post on desal, you claim it's about the same as (but added to) the distribution cost of urban water, but I bet that distribution cost is average, not marginal.

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  3. Prices that reflect demand make good sense, I agree. Still, I live in a place that is completely reliant on outside sources for water, therefore having a desal plant as a local water source hedge has some appeal to me for security reasons.

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  4. The sweetheart deals for farmers sicken me, and allowing alienability of water rights so it gets to the most efficient places, would be an improvement, much as I hate to see these welfare babies get further enriched.

    But have you noticed the general tendency of farmers not to get a clue when market forces tell them to stop farming? How long it takes them to realize they should just sell the durn farm, as if it's some unthinkable option?

    I don't have any stats with me, but I get the feeling farmers would not take up the opportunity to sell their water rights and retire -- that the thought wouldn't even enter their heads.

    Do you have any statistics, David, from cases where farmers had tradeable water rights, and sold them when it became more profitable?

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  5. @Bob -- you're right on the S AND D response.

    @Douglas -- my plan is revenue neutral, i.e., it uses high prices to curb demand AND provide the first (75gal/cap/day) water for "free" to everyone.

    Desal will cost MORE than getting water from a river or farmers, so the same price schedule will give less free water or have even higher prices. (Desal is supply side, my prices are demand side.)

    You're right that dist cost is average. Dist cost FROM the desal will be even more expensive...

    @legalfish -- desal makes sense on islands and submarines but probably not in CA or in the middle east -- when they are using it to grow wheat!

    @Silas -- read this post. Most farmers are pretty clever, but many (as humans) go with inertia. Some do it because they like farming as a career/lifestyle/identity -- and I do not begrudge them that. It's nice to create life.

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  6. Well, *I* begrudge them that. >=-[

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  7. Desalination is a mature technology widely used throughout the world, mostly by countries that are arid. It is somewhat illogical to write it off on what appears to be ideological grounds.

    Essentially there are 4 ways to deal with situations where water supply is less than ideal (near the sea):

    1. Use less. This is the true Cinderella of the resources world. We can all use a lot less resources, including water.

    2. Build another dam

    3. Recycle

    4. Desalination

    The correct approach to solving the dilemma is to make a detailed study of each option in the market concerned.

    Dams take a lot of concrete (very CO2 intensive) and they generate significant amounts of methane (20 times stronger greenhouse gas than CO2) from anaerobic decomposition of organic matter at the bottom of the lake. They are also extremely damaging environmentally.

    Recycling can be nearly as energy intensive as desalination and it involves reverse osmosis anyway.

    The best option by far is to use less; and that is where pricing is relevant. Nevertheless making the right decision involves making informed decisions, not taking ideological stands.

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  8. Saildog -- my only ideology is that we should use the most efficient means possible to allocate our resources. I am (often) down of desal because people see it as a easy solution but fail to consider the price.

    I'd amend your statement ("The correct approach to solving the dilemma is to make a detailed study of each option in the market concerned.") to say "The correct approach to solving the dilemma is to determine the cost of each option in the market concerned."

    Dams and other infrastructure are notoriously expensive and often inappropriate when completed. I advocate market solutions because they are flexible and integrate the wisdom of crowds.

    So, yeah, ideological stands are a waste of time.

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  9. Douglas Knight22 July, 2008 10:58

    You're right that dist cost is average. Dist cost FROM the desal will be even more expensive...

    huh?? Surely you have declining marginal costs.
    Maybe desal is more expensive because of transport to the city, but that just limits which cities it's good for.

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  10. Douglas -- what I meant is that distribution costs from a desal plant will be additional (i.e., pumping from a shore-based plant). Those costs are decreasing once pump capacity is built in.

    BTW, what I meant on desal costs is that they are about double current costs, i.e., "free" water today is distributed at a cost of about $1,000/AF but desal costs about $1,000/AF just to "make" -- even before distribution.

    Desal is *still* more expensive (i.e., uneconomical) as a water source -- when compared to conservation, reclamation or buying from farmers.

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  11. Douglas Knight22 July, 2008 21:11

    Sure, arguendo, desal is twice as expensive as the current marginal urban price. So we should raise the marginal urban price. But you propose increasing it 20x !

    I said before, the political change of buying from farmers is a huge cost, and I want a price tag. It's not at all obvious that buying from farmers is cheaper than desal.

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  12. Douglas -- I don't think we are communicating.

    I advocate raising prices by 20x to curb demand. You are talking about desal as a form of supply.

    Speaking of supply, buying "water" from farmers is cheaper than making water if farmers are willing to accept $100/AF and desal costs $1,000/AF.

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  13. Douglas Knight23 July, 2008 23:04

    It makes no sense to deal with demand and supply separately.

    In particular, this is nonsense:
    More supply (via desalination) will not fix a shortage because demand will expand to absorb new supply.

    In the very short term, raising prices is reasonable, because the marginal cost is infinite. In the medium term, build desal to increase supply. By advocating 20x prices, you imply that people would use a lot of water at desal prices. Let them! In the long term, trade with farmers. If you think the long term is soon, then we shouldn't waste capital on too many short-lived desal plants, but I doubt the long term is very short.

    Buying water from farmers may have high or even infinite average cost because of the cost of political change. It certainly isn't cheap to buy from farmers today. I imagine it has increasing marginal cost today.

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  14. Douglas:

    It makes no sense to deal with demand and supply separately.

    Except that they are independent, and you can -- so I do.

    In particular, this is nonsense:
    More supply (via desalination) will not fix a shortage because demand will expand to absorb new supply.


    Nonsense? So you think that adding more lanes to a road will fix congestion?

    By advocating 20x prices, you imply that people would use a lot of water at desal prices.

    Uh, no. I imply that they will use less water out of the current supply, i.e., there's no need for desal plants.

    In the long term, trade with farmers.

    I think that trading with farmers is faster and easier than building desal -- esp. in California. Check out the trials and tribulations of Poseidon's Carlsbad plant.

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  15. Douglas Knight24 July, 2008 10:37

    The comparison with traffic is ridiculous. The main problem with traffic is that most of the marginal cost of a car is external. It's relatively easy to figure out the marginal cost of water and since it's already in monetary form, people don't feel guilty charging for it.

    But relatively easy doesn't mean I actually know the price. Maybe it's almost all political. The important question is whether many small projects are politically cheaper than a single big overhaul. You certainly have more information to assess this, but when you condemn desal by merely invoking list prices, I don't think you're trying. If your last paragraph had been your original complaint about desal, I wouldn't have objected.

    And, yes, you are implying that people would still use a lot of water at 2x prices. If you don't think they would, you should advocate 2x prices, rather than 20x. Or maybe you're puritanical: that's consistent with phrasing it in terms of need (but hard to reconcile with anything else you write).

    Implication is in the eye of the reader. Maybe I'm a crazy outlier, but you should be nervous about contradicting reader statements of implication!

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  16. Douglas -- we need to sit down and have a beer. Seriously. I think that we sit 30 degrees from each other, so it's hard to know what the other is saying sometimes..

    The comparison with traffic is ridiculous.

    Let me spell it out:
    1) There's congestion
    2) Lanes are added
    3) More cars get on the road
    4) There's congestion.

    Try the water version:
    1) There's a shortage
    2) More water is added
    3) More houses get in the system
    4) There's a water shortage.

    when you condemn desal by merely invoking list prices, I don't think you're trying.

    I am not condemning desal -- I am merely saying that it's neither a silver bullet (absolute problems) and that other stuff should be used first (relative problems).

    If you don't think they would, you should advocate 2x prices, rather than 20x.

    I don't care about the price multiplier -- all I care about is that the prices are high enough to choke demand at the margin to equal supply.

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  17. Douglas Knight24 July, 2008 22:58

    If water or highways cause a population boom, let them! As long as they're priced at marginal cost, including externalities, we should provide more.

    The difference is that no one knows the marginal cost of traffic and no one, at least in CA, prices anywhere near it. A highway priced at the marginal cost of traffic won't be (very) congested, because congestion is the primary form of the marginal cost of traffic.

    That is, most of the marginal cost of another car is in the form of inconvenience to other drivers. That externality is what makes traffic pricing so difficult. The externality is hard to price because it's diffuse and idiosyncratic. It degrades the product by slowing traffic and it causes stress. Or, maybe, the problem isn't figuring out that price, but having the political will to impose a fee for amorphous harm.

    The special word "congestion" is a warning that traffic is different from other markets. In some ways I guess it's like a market under a shortage, where arbitrary factors determine distribution. But highways have some amount of congestion from the second car. At some point, adding another car destroys value. But it's not at all clear what that point is. I doubt any highway in the world is priced at or above marginal cost. Also, the varying quality of speed and stress suggests that product differentiation / price discrimination is necessary for maximum value.

    Water is a normal good. It's relatively clear what the marginal cost of water is and we should not worry about supplying arbitrarily much water at that price. It has some externalities, but they're mainly at the river or plant, easy to see, easy to measure, if not to price.


    Here's an argument that desal is politically harder than buying water from farmers:
    Half of the political problem is getting a fair price to the owners of the plant. If they just sell to one city, it's bilateral monopoly, but if there's a market, it's straight-forward. A long distance market doesn't seem plausible without transport on rivers, which requires legalizing water trading, and that requires clarifying water rights.

    That doesn't apply if it's a public plant, but I'd rather have private industry make a risky computation of the viable price than trust the government to decide the right price, subsidize if it doesn't work out, etc. But if a city adopts 20x pricing, that part of the guessing game is cut out. It still has decide if it's pessimistic about a future market.

    (Somewhere you complained that desal owners would be a vested interest who would obstruct the creation of a market. I would guess that bilateral monopolies create corruption.)

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  18. I think that you are complicated marginal cost. If traffic is congested ALL cars are responsible and ALL cars should pay more (congestion charge) until traffic is not. (It's like saying that no one snowflake is responsible for the avalanche.)

    Water is a normal good. It's relatively clear what the marginal cost of water is and we should not worry about supplying arbitrarily much water at that price. We should if we run out of it -- esp. since the "cost" of water often does not include scarcity cost. That's why I have the "20x" water proposal (I didn't say 20x, but you keep saying I did.) If demand is greater than supply at MC, what now? Price MUST rise of you don't want a shortage.

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