The Illiquidity of Water Markets

Traditional theory suggests that markets increase efficiency by coordinating trade and specialization among buyers and sellers. Gains are especially large when the demand is heterogeneous; these are the instances in which a water market works well. For example, farmers often demand different quantities of water because they have systematically different crops or because their farms are located in areas with different seasonal outcomes (e.g., rainfall and precipitation). Johansson (2002) outlines the basic controversy of water markets: the presence of externalities can undermine incentive for each market participant to align social and private3 outcomes. Since underground water is a common pool resource, and thus neighboring farmers pump water from the same water pool, farmers may realize the full benefits of pumping water (i.e., irrigating only their land), but pay only a fraction of the true costs (i.e., the increased probability of exhausting the source). Importantly, these costs affect all neighboring farmers not just the one extracting the water. The traditional notion of market with water rights will lead to overuse and exhaustion.