Price Fluctuations...

Jarad says:

I was wondering if you could post a blog about consumer perception of quickly and drastically fluctuating prices. It is my hypothesis that humans, as a species, prefer predictability over unpredictability. Aside from the problem of putting a price on the most essential ingredient in human life, I believe this is your major obstacle in public perception of market-based water prices. As two examples of where we run into quickly and drastically fluctuating prices, we have gasoline and the stock market. I believe that consumer reaction will be more akin to the gasoline market than it will to the stock market, but perhaps with even more public outrage.

I started thinking about this question as gas hit $4 and as it has declined, possibly even to under $1. When we skyrocketed up to $4, people were in a frenzy, selling gas-guzzlers, buying fuel efficient vehicles, driving differently to increase mpg, taking public transportation, complaining to their legislators, etc. As people reacted to this new price, there was no indication that they thought the price was elastic and that it would return back to `normal.' To their credit, it seemed as if $4/gal or higher was the new reality and they reacted accordingly. Of course, it turned out that the price did come back down and some of the actions people took seem in retrospect a bit rash. I'm sure people have already adjusted to the new reality of our current gas prices, but this adjustment is not news-worthy. My point is that people acted as if today's price was the price forever without understanding that there would be fluctuations and acting accordingly.

In an opposite vein, people who have stock, mutual funds, or even index funds deal with constant volatility in the market. The prevailing wisdom for investing in the market is to buy and hold which essentially eliminates all the fluctuations in favor of the long term trend. Although many people check their investments daily, they don't tend to act on that knowledge on a daily basis. So somehow we are insensitive to the quickly and drastically fluctuating prices in the market. Perhaps even to our detriment. I'm curious how many people move their investments from the market into guaranteed return accounts as they get closer to retirement age.

I tried to imagine what would happen if the water coming out of our faucets quadruple in price. (I understand that you propose a small quantity of free water, but I think the perception would still be that the price was quadrupling.) I doubt we would be insensitive to the price like we are in the market. More likely it would be like gas and everybody would be extremely conscious of the water they were using, i.e. taking shorter showers, running dishwashers only when they were full, not leaving the tap running as you brush your teeth, etc. But my guess is that there would be even more public outrage about these price fluctuations [1] including perhaps attacks against the water utility or breaking into water pipelines to steal water.

My question is really this: Is it in human nature to want predictability or is it just the society we are accustomed to? [2] Would we be able to deal responsibly with quickly and drastically fluctuating water prices? [3] Somebody must have done research on this and perhaps you already have the answer.

So, I basically agree with Jarad's description of how gas and stock prices move and are perceived -- including the very interesting discussion of expectations. (I discussed fluctuations of water prices -- and how to minimize them -- in section 7.2.1 of my dissertation.)

The good news is that prices need not fluctuate as Jarad assumes (see [1]) -- for a few reasons:

1. Water prices are regulated (gasoline and stock prices are not).
2. Water markets are local, so supply and demand are more likely to be balanced and less-likely to be manipulated by speculation.
3. Water supplies can be known and priced over the medium term, i.e., I suggest that urban prices be set every quarter. Wholesale all-in-auctions can set new prices daily (as I suggest that MWDSC do with its member agencies) or seasonally (as I suggest happen with agricultural auctions).

To answer Jarad's other questions, I'll say that [2] it is human nature to prefer stability -- especially with something that we "cannot live without" and [3] we can smooth prices even further by sending water users a monthly bill that averages prices across the prior three months.

As for prior research, all I can say is that economists have assumed for years (based perhaps in intuition or on psychological research) that people prefer -- holding mean constant -- to have a lower variation in outcomes, i.e., to have smaller fluctuations around a given average value.

Bottom Line: Water prices should be higher, and they should move up and down (slowly) as sustainable supplies fluctuate down and up.