26 August 2010

This kinda BS stops water markets

In this paper [pdf] two academics claim that farmers cannot afford to use markets for water because the price required to balance supply and demand would be too high for the farmers to make money.

Besides the basic flaw in this logic (shortages are good for farmers?), there is the other flaw -- that prices would rise to the VALUE of water before quantity demanded fell to equal supply -- so that farmers "lose money."

This is just wrong.

All that's required is that prices rise high enough to choke demand. It's nearly certain that the price will be below value.

In fact, this figure from paper illustrates where price has to go, both to end shortage and cover system costs: somewhere above O&M costs and below value. Yes, the price is way above what they are paying, but that price is WAY too low.

How would they set the price to balance supply and demand? How about All-in-Auctions?

Bottom Line: All academics have biases; some have biases that defy common sense.


Johannes said...

Hi David,

But what I understand from the paper is that they don't say that prices would rise to the value of the water, but they would just need to rise considerably: something you agree with I think. Then, what they state is that farmers' welfare would decline. Isn't that likely to happen? They would have to sell the food for higher prices, and won't be able to compete with other regions/countries, where costs are lower.

Thnx again for sharing your thoughts on this great blog, btw, Joh.

David Zetland said...

@Johannes -- from the paper [p 83]: "the value of irrigation water is taken as the net income received by the farmer per unit of water applied....Given the big gap between the price and value of irrigation water, a considerable increase in the price of water would be needed to balance supply and demand, which seems socially undesirable as it imposes a substantial burden on farm economic welfare." From this excerpt, you see that the author's imply that the "clearing price" will have to rise to value.

If they said what we are saying (merely higher prices), then the welfare impact would be "tolerable," since the farmers would still be making a profit.

RE: higher prices being uncompetitive, I'd say that (1) maybe the farmers would switch crops, (2) they would at least NOT be overusing their water and (3) higher prices reflect true cost. In no case is there a sound defense for selling food below cost.

jbaby said...

Someone needs to explain to me how higher costs lead to higher prices. Shouldn't farmers already be selling at the profit-maximizing price?

If they could raise their price because costs go up then they should just raise the price and say that their costs have gone up.

It seems to me that the argument makes sense if keeping current farmers cash-flow positive is some sort of societal goal. Obviously, applied across industries, this would lead to societal breakdown.

A market would lead to the end of a subsidy... that shouldn't be worthy of publication -- that's obvious. Dog bites man.

David Zetland said...

@jbaby -- beside agreeing with your other points, I'd say that higher costs would lead to higher prices IF those cost increases hit enough producers (or mattered on the margin). There's an economic literature on the amount of pass-thru of costs to consumers, and it varies from 0 to 100%, depending on elasticity, which is another way of saying market power...

Francis said...

Hadn't seen your AiA paper before. It's interesting. A few thoughts:

1. The likely sellers are public agencies. Profit is not a motive, although keeping taxes and rates low is. But while GMs get yelled at plenty for high rates, they get fired over having to declare water shortages. You have a huge institutional bias to not letting water go, unless it's truly surplus.

2. Adding in farmers who hold water rights in their own name will bring to the table people motivated by profit at the cost of adding in an enormous layer of complexity.

3. You weren't clear whether the AiA was for a single year of water or for longer-term leases. It's likely that there would be little public agency interest in auctioning multi-year rights (who knows when the next drought is coming). But telling water agencies that they are going to go through this process every year will make persuading them of the merits of the idea that much harder.

4. The other problem with year-to-year sales is that a large portion of the annual allocation is determined only when the year is half over. California farmers have for years lived with the uncertainty of the size of the snowpack. But water managers are already saying that they are seeing signs of AGW in the increased variability of snowpack size and melt dates. Casting the AiA as a way to increase certainty in any one year could be a strong selling point.

5. California has strong environmental protection laws (CEQA) as well as laws protecting legal users of water in a streamcourse, in-stream flows for fish and protection of area of origin. Laws can be changed, of course. But any law weakening CEQA will face significant political opposition from the environmental movement. And, as someone who has done CEQA compliance for 15 years or so, I can assure you that CEQA compliance for water transfers presents serious challenges. (Ask the GM of Castaic Lake Water Agency, for example, about his agency's experience with environmental compliance for a transfer of SWP water.) While CEQA has an exception for 1-year water transfers, I'd expect that the AiA process as a whole would trigger CEQA. And since CEQA compliance documents take about a year to prepare (and frequently many more years to defend in court), you may quickly find yourself in a legal quagmire where each year's AiA gets tied up in court.

6. You state that implementing the AiA requires that the underlying water right be quantified. That may be very difficult to do in California. While simplifying California's water rights system by requiring that all rights be quantified and registered with the SWRCB may be a good idea, you will face very substantial opposition. Senator Sheila Kuehl tried to take some small steps in that direction and was beaten back.

7. Maybe it's because I'm not an economist, but I found your modeling of the AiA using movie tickets and undergrads unpersuasive. But since the odds of actually getting the GMs of MWD, IID, KCWA, CLWA and Westlands to participate in a modeling exercise are zero, I think you need to revisit how to model accurately a California water AiA.

All the best,


David Zetland said...

@Francis -- Thanks for your comments!

1) Public agencies can use sales to produce revenue from excess water, as determined by their users. Sales would could be seasonal, of course. The AiA is designed to run INSIDE an irrigation district (or MWDSC), not so much to get water to outsiders, but outsiders (e.g., WWD) could be allowed to bid for upto 10% of the total.

2) Farmers SHOULD be bidding against each other, to see who gets scarce water INSIDE a district, e.g., IID.

3) Short term is better than long term, but AiA could be used for both.

4) Run the AiA twice in the season?

5) Nothing here to nullify CEQA. In fact, AiA is meant to reduce the impact of enviro constraints.

6) No need to go for the whole state. Start small -- within an ID, or even within the SWP or CAP.

7) Lab experiments always face this criticism, but it's the best I could do for comparison testing. Obviously, the big goal is to do a trial with a water agency.

I'd be happy to work with anyone you suggest :)

Johannes said...

Thanks David for reply.
About the "lab-experiment", couldn't you do a model simulation experiment to test the AiA-concept a little more robustly? I guess that could be a next step before really trying to convince a water agency for a trial. Similar f.e. to what they seem to have done in this article in WRR: http://www.agu.org/pubs/crossref/2008/2006WR005708.shtml

David Zetland said...

@Johannes -- models just spit out results based on input parameters. Humans are different, and the trust for models has certainly plummeted since the financial crash (NOT predicted by public models, but perhaps profited upon by private models)

Mister Kurtz said...

jbaby, the profit maximizing price for farmers is infinity. In a commodity market, farmers are price takers, not price makers. In a very general sense, markets have to "buy acres" each year by offering a price that might convince to farmers all over the world grow more of one crop than another, but individuals do not figure in this except in very localized situations. Further, subsidized farmers (and airlines, and steel mills, and...) typically are oblivious to their costs, since they just whine for more handouts when they need them, and politicians oblige.
Unfortunately, one of the obstacles to AiA or other auction mechanisms is that so many farmers have not a clue about their actual costs, weighted average cost of capital, or other measurements that might help them make an informed decision on whether to buy or sell water, and at what price. Many are damned good at growing crops, are fine hardworking human beings, but lousy businessmen. When a hard working entertainer or sports figure turns out to be a lousy businessperson, they get little sympathy. When a farmer does the same, he gets a handout. Go figure.