10 April 2012

The value of water

Addendum: Consider Umwelt when you consider values (hover your mouse over the cartoon).
In my book, I mention "value" over 200 times and the "value of water" 12 times. When discussing value, I use the phrase "personal subjective value of water" to remind readers that the value of water varies among individuals, unlike the cost of providing that water or the price that's charged for it -- whether it comes in a bottle, in a cubic meter to the tap or a megaliter/acre-foot down an irrigation ditch.

These ideas -- explained in Chapter 1 [free sample chapter PDF] -- are related to the economic concept of a "demand curve" that describes how our value of water (or any other good) changes according to how much of it we have. Thus, we put the highest VALUE on the first unit of water we receive, a lower value on the next unit, and a lower value on the unit after that.

These values form a downward sloping demand curve that "exists" before we even talk about price or cost.

When a price is given for the good, then we consume as much of it as we can AS LONG AS THE VALUE TO US exceeds its price. Some people will consume more than others at the same price (liters of bottled water, length of shower, etc.)

The total SUBJECTIVE PERSONAL value of that consumption to us is then the difference between the value of what we consume and what we pay for it, or the area under the demand curve.* This figure shows value in the blue triangle:**

The most important lesson from this little example is that nobody knows how much value you get from that consumption. It's even arguable that YOU do not know the value of how much you consume, since you do not often face the choice of "how much is that first litre of water worth to me" in a true auction/market environment.

Maybe you say "a lot" and others would agree, but "a lot" means different things to different people, and THAT statement leads me to this RFQ (via KC and AL):
Value of Water to the U.S. Economy: Call for Papers and Request for Quotes
Under contract to the U.S. Environmental Protection Agency Office of Water, Industrial Economics, Inc. is seeking proposals from independent experts for the development of papers on (1) water's contribution to the U.S. economy, (2) current capabilities to analyze and estimate this contribution, and (3) the steps necessary to improve our understanding of water’s economic contributions.
Although this contract has been awarded, money will be spent, and values will be discovered estimated guesstimated made up, I'd like to point out that none of these numbers will mean anything in two ways:
  1. I may not agree with numbers that YOU give for the value of water used to grow a tomato, fabricate a silicon chip, etc.***
  2. Even if we agree on values, then those estimates will be wrong. Real values are based on personal choices, not the price paid or cost of delivery.****
I'm willing to bet that there's no policy recommendation to take, even if (1) happens, either because different values of water will not lead to reallocations (that's a political decision) or because those "values" may be wrong, which means that reallocations may lead to a LOSS in total value of water in use.

What do I recommend instead? Set up mechanisms that make it easier for us to reconcile our values of water, so that water ends up going to highest and best use. There's NO NEED to know values, just a need to reconcile them. These are scarcity-adjusted, full cost water prices (in the case of urban water service) or markets for water (in the case of irrigation or bulk municipal water). I've discussed these endlessly in this blog, but they are also discussed in Chapters 1 and 5, respectively, in my book.

For more on these issues, I suggest that you (and the EPA!) look at this report from the European Environmental Agency: "Towards efficient use of water resources in Europe," which relies on a discussion of "value" that I was very happy to criticize in Marseille. Here's the MP3 [60 min 21 MB] of the whole presentation and my slides [PDF].

My main point (see the slides) is that the EEA needs to set a minimum water flow to protect the environment, then use market mechanisms to allocate water to economic uses (urban, industrial, agricultural).

Bottom Line: The EPA should not waste its money (our money!) to "measure" water's contribution to the US economy. It should work on improving the ways we allocate water, to reconcile our PERSONAL SUBJECTIVE VALUES in a way that maximizes our water wealth.
* And above the price line, since the value under that price line is cancelled by the money we have to give up to get those units.
** If yo wonder why price/value (the independent variable and the outcome) is on the vertical axis and quantity (the dependent variable) is on the horizontal axis (the economic "norm"), then read my article [PDF] on the problems with that.
*** Note that a correct way to value water in use is NOT to divide total value by amount of water (that would make "lawyer water" far more important than "strawberry water"), but to evaluate the relative contributions of water and other inputs -- something that's very complex and not worthwhile, compared to pricing water correctly and letting people use as much as "makes sense" to them.
**** Economists agree that people buying a last unit "on the margin" pay a price that's at or just below their value for that LAST unit, but there's no way of knowing the value of earlier, "inframarginal" units.


Mr. Kurtz said...

Gosh, the Government ought to expand this project so that we can learn the correct value for everything! It would make picking stocks, buying houses, selling art, a snap, with certain profits for everyone. Once they make us all rich, tax revenues will erase the national debt, too.
Let's roll up our sleeves and hire lots more experts.

Audrey said...

You are right. The allocation of water is extremely important now more than ever before.

Governments all over the world would learn a lot from your article, especially governments in third world countries where some persons have never seen running water from their pipes.

DR said...

Pardon the econ 101 question, but didn't your last post get the causation backwards on the demand curve explanation?

You write that the demand curve concept:
"...describes how our value of water (or any other good) changes according to how much of it we have. Thus, we put the highest VALUE on the first unit of water we receive, a lower value on the next unit, and a lower value on the unit after that."

I read that to say that quantity demanded drives price. My understanding is that the algebra says unit price drives quantity demanded. While the graph is (by convention) backwards (or inverse), the explanation should be something like… the demand curve concept:
"…describes how the price of water affects how much water we buy. Namely that at higher unit prices we buy fewer units, and at lower unit prices we buy more. Presumably, the higher priced water would be devoted to higher value uses, and lower priced water would be devoted to lower value uses."

My sense is that your paper on teaching economics is an attempt to clear up the dependent-independet variable mess that leads to the above confusion.

Or perhaps not- this is your expertise, not mine. Am I just flat out wrong? Again? Is it the notion of value that makes this messy? Isn't value better capture by indifference curves, utility curves or some other game theory tool?

David Zetland said...

@Kurtz -- thanks for the short version of my spite for this idea :)

@Audrey -- agreed. And they use the vagueness of "value" to misdirect it to cronies.

@DR -- good question. The demand curve is "built" on our values per unit. Demand MANIFESTS as a response to the price on offer, in the way you described. So, I kinda merged the two directions (causality and response) into one explanation...

RD said...

One of the things we do as a matter of form is to assign $.01 to every gallon.

Not that this is the price or cost, but it does get you to understand in planning or proposals what you are actually doing in a market.

Its really made a difference in how we think about water and how our clients do too.

ron griffin said...

While aspects of the Ind. Econ. overture do seem to suggest that the goals are immature, I can't confidently know from the announcement that EPA wants total values -- yes, that's dumb -- and there may be some service to be obtained from marginal values or the stir this is creating. But even marginal values shouldn't be equated when frictions such as transportation losses and transaction costs are considered, and marginal values can have a lot of seasonality in the same use/place, so to redirect the work towards an inventory of marginal values has issues too. Otoh, I like new ideas such as gov't regs. requiring the inclusion of marginal in situ water value in finished water rates, so an inventory of regional environmental water values is not without interest to me. Plus, I don't know EPA's motivations; perhaps there's a spin we're not recognizing. And, while I'm looking for silver linings here, there are indications that the project is malleable. Perhaps not a $-efficient approach to whatever the EPA goal is however. Of course, any reason for David to flash the neon over his populist book is worthwhile isn't it?;)

Anonymous said...

I forwarded the RFQ with this...

Hello, Good Colleagues: well, here’s a challenge for you: water’s contribution to the economy. Then we can do air’s contribution, followed by soils’ contribution-a veritable wealth of work. I can’t think of a single allocation decision that would turn on these values-except for BuRec’s budget. Go get ‘em.

David Zetland said...

@ron -- although I am sure that you're not implying that I should NOT promote my book on my blog, I only did so to point out that, yes, I have thought of the issue at hand. It's a citation, even if it's a self-citation.

But what worries me is that you say the book is "populist." Do you mean promising benefits without costs (my defn) or do you mean it "popularizes" economics for non economists? Have you read my book?

ron griffin said...

Of course you can advertise. It's your ball. I didn't wish to imply otherwise.

Populist=for regular people

whereas my book (link) on Water Resource Economics is intended for people who may not be economists but didn't skip calculus 101. This is not intended as a criticism of anything;)

David Zetland said...

@ron -- Thanks for the clarification. I'll let that link slide :)

JD said...

Re: “My main point (see the slides) is that the EEA needs to set a minimum water flow to protect the environment, then use market mechanisms to allocate water to economic uses (urban, industrial, agricultural).”

Setting the minimum public trust flow that must be allowed to pass out of a basin is a clear and necessary first step to long-term management of the water quality impacts of both point and, especially, non-point waste discharges throughout the basin.

This applies to both surface and ground waters. The ability of that public trust water to carry a particular load, without unacceptable impacts to beneficial uses, defines the long-term sustainable loads that can be released to the basins waters. For non-point source dischargers, especially those who can’t practically contain their discharges, this may lead to supporting higher public trust flows than they might otherwise be inclined to advocate.

Of course, the devilish detail is how to apportion the carrying/assimilative capacity of the public trust water. Public trust loads may be first in line; but, after that, will it be transparently stipulated and assigned, and how? And, once it is assigned, can market forces be allowed to (more efficiently?) distribute that capacity?

Properly set up, even someone who owns non-public trust high quality water could be incentivized (compensated) to release that water to the public trust flow stream if that transaction results in lower water quality compliance costs to an interested discharger. In some cases the water owner and discharger may be one in the same. And, an owner may have even “come across” the high quality water they are willing to release via conservation steps they have applied to their existing use(s). I could even see where if the value of water quality management is perceived to be high enough, and the costs for other management approaches are higher or unattainable, said compensation could easily compete with other bidders who would use the conserved water. Such a system may even help fund otherwise marginal conservation effort(s).”

Bea said...

Appreciated you refer to an EEA report. And fully agreed that it all starts with setting the environmental requirements (here e.g as E-flows) May I though correct slightly. It is not EEA setting these values, but this in good old Europe is a process to be set on grounds of the regional climatic, hydrological and ecosystem specifics (might be a complex task from an economic point of view). What we need is a policy framework to require water authorities to do that. Then competing water users allocate the rest between them by price, or whatever allocation mechanism. This is by the way also pretty nicely described in this report, which I do not have to advertise ;-).
There is however also the question of restoration to the level of this environmental boundary. Which environmental status, which ecosystem do I want to have? As all in Europe is more or less anthropogenic since centuries, this is not an easy question and here the value (benefits) of an ecosystem (not just water as such) might be relevant also in comparison to the cost of measures to get there. Willingness to pay does not help here obviously either, but needs some more sophisticated approach.