Production choices with water markets: The role of initial allocations and forward trading

We develop a theoretical model that describes risk-averse farmers' decisions when facing production risk due to uncertain weather conditions and when irrigation water can be traded on a market. We focus on the role of initial water allocations granted to irrigated farms at the start of the season. The presence of water markets makes the future water price uncertain and hence the value of initial water allocations uncertain. We analyze the properties of this background risk and study how initial water allocations impact farmers' land allocation decisions between an irrigated crop and a non-irrigated crop, both characterized by random expected net returns. We then extend the model by permitting irrigation water to be traded ex-ante at a known price (forward market). Finally, we illustrate our main theoretical findings using simulations. Assumptions made on the distributions of the random variables were chosen to be representative of the situation of irrigated farms located in the Murray-Darling Basin in Australia, where a water market has been in place for several decades.