Knowledge Problem

This post is the follow-up to yesterday’s post on water infrastructure ownership and management, building on Arnold Kling’s original comment. See also Robert Prather’s post from yesterday, in which he helpfully provides links to his posts on the same subject.

Water is a resource that has multiple uses – human consumption (residential, commercial, and industrial), recreation, sustenance of wildlife, generation of electricity, and so on. As water becomes increasingly scarce relative to our demands for its use, the staggering inefficiency and bureaucratic politicization of its allocation will become more and more costly. Market-based pricing of water use would enable consumers to prioritize their water use and would also promote conservation when it is most needed. It would also encourage increased supply when that supply is most needed, as well as inducing innovators to pursue technological change that would enhance our ability to meet our water needs. In the absence of market-based pricing, as is the case currently, little such activity finds actual commercial application, and does little to benefit society.

In many commercial and residential buildings, water consumers do not see a direct price per gallon of water they use. Charges for water use are frequently bundled into rent, and do not vary when the consumption of water varies. The connection between the use of water and the price the customer pays is either extremely weak or nonexistent in such cases. So we tend to leave the water running while we brush our teeth, use more water than we need to for washing dishes, and have little or no incentive to replace washing machines and dishwashers that use a lot of water with newer technologies that reduce water use.

Even in cases where consumers do pay monthly bills for water, and they do face a per-gallon price, that price usually does not vary when water is more or less scarce. Thus the standard invocation during drought periods to avoid watering your lawn or washing your car, and difficult-to-enforce restrictions on water use on alternate days, and so on.

Why go through such ineffectual and cumbersome machinations when a simpler approach can deliver more bang for the buck? Allowing market pricing of water would serve a variety of objectives. Even municipal water utilities could use dynamic pricing to signal relative scarcity and to induce conservation, so dynamic pricing is a policy that can be applied regardless of company ownership.

Pricing is the most parsimonious way to communicate information on the relative value of and scarcity of something across a large number of unconnected people. The benefits of competitive water markets start with efficient resource allocation through the use of prices to transmit information about prices, costs, and scarcity. Our choices in the face of prices reflect the real value that we place on things, by revealing our decisions in the face of tradeoffs. Price discovery through markets, and the ability to use prices to compare the value of water to other commodities, leads to dynamic efficiency. Thus consumers and producers can see the true tradeoffs among the wide range of potentially conflicting uses of water.

Most importantly, price signals provide simple, straightforward incentives to conserve when that conservation is most needed. Increased water prices would be more effective at reducing the demand for watering the lawn or washing the car than plaintive platitudes about the value of conservation. These market prices therefore provide users with a natural inducement to decrease water use when water is scarce, and therefore to conserve, when water prices rise. Currently, price signals do not exist to enable the movement of water from lower-valued uses to higher-valued uses. These value change over time, and prices allow for flexibility in water allocation that bureaucracies and nationalized industry do not possess.

Indeed, water pricing can be even less complicated than electricity or natural gas pricing, which in its simplest form would require inexpensive interval meters. I think that water does not have the diurnal consumption pattern that electricity has, and that to the extent it does, the peak/off-peak consumption ratio is not as large as you can get in electricity. Thus dynamic pricing over the course of the day may not be the most profitable way to price water, but perhaps day-to-day price changes would be sufficiently dynamic to induce conservation and signal scarcity. Even something as simple as an email saying that starting tomorrow morning at 6 AM, the price of water will increase from X/gallon to Y/gallon until you are informed otherwise would be a simple way to change consumer decisions (although we are not sure by how much, because the lack of actual price changes means that it is hard to estimate the price elasticity of demand for water). In any case, if suppliers thought more creatively about the value proposition they bring to water consumers, they would find pricing terms that would appeal to customers.

An overlooked feature of market-based pricing of water is that it would induce suppliers to make more water available when prices rise, just when the supply is most valuable. The most potent force behind that supply increase is likely to be technological change that can make more water available, such as desalinization. In the current ownership and pricing environment, little incentive exists to explore such technologies except in the most arid and populated areas of the world. Dynamic pricing of water would stir the creativity of entrepreneurs who would see an opportunity to profit from new technologies to treat wastewater and saltwater to make them potable, or at least usable in industrial and agricultural applications. Such a supply would simultaneously reduce strain on the supply of potable water.

This observation raises a related point: water can also be a differentiated product. Not all uses require the quality of water that human consumption requires, and even common infrastructure can transport water that becomes a differentiated product through filtration at the customer interface. As the economies of scale in filtration technology decrease (which has happened over the past decade, with your Brita or PUR as one manifestation), the business model in which suppliers can sell water as a differentiated product becomes even more viable and profitable.

Many barriers exist to such a forward-looking and dynamic approach; customers, both urban and agricultural, have gotten used to a century of subsidized and cheap water, and are not likely to support changes that would improve the efficiency of water allocation and use across the wide range of uses to which we can put water. The benefits of dynamic pricing of water are large but diffuse, and are likely to be sufficiently in the future that any increases in the current water expense of most customers would weigh more heavily in their decisions than would the future benefits of the sustainability of the water supply.

Market-based water pricing enables better allocation of water rights, and optimized use of water, among power generation, consumption, and in-stream flow for recreational and commercial fishing and boating. Continuing to base water policy on open access will lead to overuse, inefficient allocation among those excessive uses, and continuing threats of water scarcity that will endanger both human and aquatic life.

Arnold Kling recently commented on this Tech Central Station article on water privatization, a crucial issue. Water is one of the most inefficiently and abominably allocated resources that we have, which is appalling given its scarcity and its importance. In the American Southwest we are already starting to see some of the negative effects of the bureaucratic allocation of water and the utter lack of a price mechanism to signal to people when it is scarce. And, as Richard Tren notes in the TCS article, Africa’s economic well-being is similarly stifled by the lack of price and private ownership as investment and allocation mechanisms.

Both the TCS article and the comments that Arnold received on his post reflect the conflation of two different aspects of water: owning, building and operating the infrastructure, and pricing the flow of the commodity. These two issues are constantly conflated, to the detriment of the debate and to the detriment of good water policy. This post addresses the first of those issues, owning, building, and operating water systems.

The construction and ownership of water infrastructure and water sources first runs into an important economic issue: the potential natural monopoly characteristics of the infrastructure. Water infrastructure, like last-mile telephone and electricity wires, is a network with a characteristic feature of natural monopolies – subadditivity of costs. Subadditivity of costs means that relative to the size of the market, the profit-maximizing and cost-minimizing industry structure is to have one firm. Subadditivity suggests that if left to free entry and exit, competitive dynamics would take local water markets to the point where a municipality is served by a monopoly. So, the argument goes, we should treat it as a regulated utility, prohibit competitive entry, and regulate the rate of return it earns on its assets. That is, if we don’t have the local government itself provide the water itself.

Water is one of the most frequently municipalized of all network services, although the economic argument for it is weak. As Eric Krieg said in the comments to Arnold’s post, if cable doesn’t have to be owned municipally, why does water? In fact, the literature on municipal ownership of utilities offers a mixed bag, but generally finds that municipal utilities are more poorly managed than private utilities, and largely owe their survival to political fiat and to their tax-free status. In some cases, such as electricity, municipal utilities also benefit from getting preferential treatment in getting access to cheap federal hydropower from Bonneville and TVA. I prefer to save municipalization for a separate post, but I simply think that since the wave of municipalization in the early 20th century municipal control of utilities has become a political dynamic and not an economic one, and that the argument for preferential tax treatment of public utilities is weak when commercial incentives exist to establish such services through private markets.

I think it is true that local water infrastructure currently has subadditivity of costs, and therefore can be considered a natural monopoly. The other question, though, that we should ask is whether the ownership and management structure that we choose for the water infrastructure is adaptable to changes in economic and physical circumstances. On that count I think we have another reason to decide against municipal, and therefore politicized, ownership; we also have another reason to be very, very careful in the regulatory institutions we establish to control and manage private utilities that operate in dynamic, changing environments.

But it gets even more complicated than that. Suppose you are not persuaded by my argument that water utilities should be private companies and not municipal utilities. OK, but you could still contract out the management and operation of the water treatment and water delivery facilities to a private company that specializes in such services. Such a move could save taxpayers money and reduce operating costs, because the contractor has a comparative advantage in such services, more so than local governments. Such contracting out has delivered a lot of value in a lot of different countries over the past two decades. But wait, the skeptic says, how does the contractor have any incentives to deliver clean water to our residents? [c’mon, ask me a hard one!] Municipalities hold contractors to performance contracts, and establish independent monitoring of the quality of the water and other performance measures. Recall also that this is a repeated game, and that the contractor is likely to want its contract renewed, so it has incentives to please its customers, which will counter any incentives it has to cut costs by reducing quality. For those of you who are interested in the actual experience of water service contracting, I recommend that you check out the water privatization work of my former colleagues at Reason Public Policy Institute, who are the world’s foremost policy experts in this topic.

Another problem that arises in water is something that happens in any situation where you have multiple people extracting something from a common pool – if we don’t have well-defined property rights over specific shares of the pool of water in the aquifer, for example, each individual has an incentive to overuse the water. This is a typical manifestation of what Garrett Hardin called the “tragedy of the commons”, which I prefer to call the “tragedy of open access” for reasons that will become apparent. Treating water as a common pool, without establishing any rules to govern use of the common pool or means of excluding non-authorized users, is a recipe for overuse and exhaustion of the water source.

Note the precise way that I worded that previous thought – privatization of the ownership of the water source is one option, but there is an entire continuum of commons options between private ownership of the water source and open access, and its associated tragedy of overuse. Assigning proportionate share use rights that can adapt to changes in local population is one example of a set of rules that realistically incorporates the common pool aspect of the water source and the difficulty of defining and enforcing pure private property rights in such a context. Different communities in different contexts, different geographies, different economies will come up with innovative arrangements for governing the water commons, exploiting local knowledge. For more information on this subject I refer you to the seminal work of Elinor Ostrom, a political scientist at Indiana University who has been the pioneer in the theoretical work on governing the commons, and in publicizing the novel arrangements that people devise to manage irrigation rights and other common pool extraction issues. I also recommend the work of Gary Libecap, an economist at the University of Arizona, on the use of unitization in oil drilling to enable those with drilling rights to maintain sufficient pressure and not extract oil too quickly.

Water infrastructure and source ownership and management is obviously a very complicated topic, and it’s important to realize that alternatives exist beyond just the public/private ownership decision. Even within public ownership there are lots of ways to align the incentives of the system users with long-run interests in sustaining the availability of water. Tomorrow I’ll talk about the most potent, and least used, method of doing that – dynamic pricing.

I finally got off my lazy posterior and signed up at The Truth Laid Bear’s Ecosystem, and I am happy to report that I am an Adorable Little Rodent. Must be the pert little nose …

In any case, my recent post on spontaneous order in Hayek and its inspiration, Jonathan Wilde’s Catallarchy post on the evolution of weblog order, is making me more diligent in doing such things. Next on my list, for next week, is figuring out TrackBack. I’ve set up so I can ping sites that I link to, now I need to dig in and get the rest sorted out. After grading is done.

Is up at A Penny For …, and chock-full of interesting goodies that will keep me reading in my snippets of free time all week. Here is the direct link to the post.

Scrolling down I noticed that Todd mentions being at Lambeau Field yesterday, where the Packers scored a great comeback to beat the Bears, yay! Just ’cause I live here don’t mean I root for the Bears … and given how poorly my Steelers are doing this season (notwithstanding yesterday’s win on Jerome Bettis’s superb running), the Packers are my alternate team. Plus, how can you not like a guy like Bret Favre, and the fact that he’s undefeated when the temperature is below 34 F?

Activity here will be light over the next couple of days; I am feeling a little under the weather, and have two review sessions and a committee meeting today, and two final exams to give tomorrow. Then grading commences …

This is a nice follow-on application of the ideas just articulated … over the past couple of days, the new EPA Administrator, Mike Leavitt, has been making his first public statements about the direction he intends to take at the EPA.

The first issue he is tackling is mercury. This Chicago Tribune story (registration required) nicely summarizes the issues. In short, in the 1990s the EPA proposed to follow a mercury policy that was in keeping with their historic command-and-control techniques: mandate quantity reductions, and mandate the means by which companies achieve those reductions by mandating the types of control technologies that they install. Now Leavitt is proposing that instead of following that enforcement technique, the EPA adopt a mercury emissions cap-and-trade program, similar to the EPA’s extremely successful sulfur dioxide emissions trading program.

EPA air pollution rules generally require companies to install a “maximum achievable” pollution-control technology. But EPA is proposing a trading system, allowing plants that cannot meet tough emissions standards to pay other companies to reduce their emissions further than required so that the national goal is achieved.

EPA has implemented similar trading schemes for other pollutants, arguing that it allows the market to determine the cheapest way to achieve the desired emissions reductions.

Earlier in the same article, the authors note the environmentalist reaction to the proposal:

The proposal has infuriated environmental groups, which accuse the agency of sidestepping the Clean Air Act’s requirement that companies install the strictest controls possible on mercury pollution.

This quote, from an article in the Seattle Times, will reveal more about the mindset of the various approaches to this issue:

Last night, Leavitt confirmed the EPA might reverse the Clinton-era ruling in favor of a more flexible enforcement system.

The approach, environmentalists say, would save the utility industry hundreds of millions of dollars while ensuring a relatively high level of mercury pollution for years to come. Most utilities, they say, could achieve the reduction targets as a “co-benefit” or byproduct of reducing carbon dioxide and nitrogen oxide, without having to add special equipment to cut mercury emissions.

OK, now let’s begin. First, note how the traditional EPA command-and-control approach, mandating quantity reductions and mandating the specific technology to use, assumes away all of the knowledge problems that are inherent in human society and that were the focus of my immediately previous post. How does the EPA know what is the “right” amount of mercury reduction? By law they are requiring companies to make the maximum achievable reductions. How do we, collectively, define “maximum achievable”?

This is precisely where the so-called environmentalists have been so rhetorically successful, saying that the Clean Air Act calls for maximum reductions, and notwithstanding the fact that we currently do not have any mercury-specific reductions, any reduction plan that falls short of the most draconian interpretation of the Clean Air Act will amount to an increase in mercury emissions. Note that this is the same rhetorical bait-and-switch as the federal budget folks use when they claim that a reduction in the growth rate of their program’s budget is a reduction in their budget.

Opponents of this proposal want the maximum reduction in mercury emissions. This claim completely ignores the fact that the benefits of mercury reduction come at a cost, and that in order to make us better off, we have to evaluate those costs relative to the benefits of reduced mercury emissions.

Another thing that the old command-and-control maximum reduction approach ignores is the knowledge problem and incentives regarding emission abatement technology. When the EPA decides on our behalf what is the “best available control technology”, they stifle innovation and creativity in finding novel and cheaper ways to achieve the same emission reduction. Such a policy freezes technology at that snapshot point. Even if we make the most generous assumptions about how informed the EPA is regarding technologies, and if we assume that there is no lobbying to influence their technology choice, once they make that choice they give polluters and technology entrepreneurs no incentive to engage in further innovation. Yet the so-called environmentalists believe that this specific command, to use Hayek’s phrasing, is going to be beneficial into the future. It is precisely this logic that saddles us with smokestack scrubbers when gas flue desulfurization is actually cheaper and easier to implement in many cases.

Second, note something interesting in the Seattle Times quote:

The approach, environmentalists say, would save the utility industry hundreds of millions of dollars while ensuring a relatively high level of mercury pollution for years to come. Most utilities, they say, could achieve the reduction targets as a “co-benefit” or byproduct of reducing carbon dioxide and nitrogen oxide, without having to add special equipment to cut mercury emissions.

Put another way, these folks don’t want the utilities to be able to get a two-fer — they do not want them to be able to reduce mercury in the process of pursuing other emission reductions. They want a separate mercury redution technology.

This is absolutely ludicrous, and illustrates the utter disconnect between the control-and-manage, top-down imposition of order mindset and the dispersed knowledge, spontaneous order mindset. How can anyone logically claim that having utilities achieve multiple types of emission reduction through the same process makes us worse off? In reality, in the face of tradeoffs and budget constraints, this emission reduction twofer is called more bang for your buck, and to my mind such things are to be rewarded, not punished!

It is precisely these technological innovations and “more bang for your buck” emission reduction twofers that an emissions trading system promotes, and it does so because they are flexible and cheaper ways of meeting emissions objectives than mandating specific technologies pollutant-by-pollutant. Just because they are flexible and take the form of “we don’t care how you achieve the reduction, just do it, and here’s a permit market to make it more efficient” does not make them inferior to command-and-control maximum reduction. Indeed, markets take into account all of the dimensions that matter to people, including the tradeoffs that must be made to reduce mercury emissions, and they enable people to evaluate for themselves just how much they value mercury emission reductions.

The second Harry Potter movie is on short rotation on HBO, and I estimate that in the past week we’ve seen it about eight or so times; in fact, I had the major ephiphany in the paper I worked on over the holiday while sprawled on the floor during about the sixth viewing of it. The only other thing that is played more frequently in this house is Pride and Prejudice.

I think it’s a better movie than the first one, and the book/movie also has some themes that resonate with me. The second one has much more of an individual responsibility and thinking for yourself theme to it, which appeals to me greatly. In fact, in each of the many times that the movie has played this past week, the one thing that always strikes me is at the end, when Dumbledore is consulting with Harry about Harry’s existential queries about whether he is good or evil. In the book it goes thus (and is edited slightly in the movie):

“It [the sorting hat] only put me in Gryffindor,” said Harry in a defeated voice, “because I asked not to go in Slytherin …”

“Exactly,” said Dumbledore, beaming once more. “Which makes you very different from Tom Riddle. It is our choices, Harry, that show what we truly are, far more than our abilities.”

Apparently I’m not alone in noticing such themes; in fact, there’s even an article on libertarian themes in Harry Potter on the Libertarian Party website. The author, Eryk Boston, notes with regard to book five, The Order of the Phoenix:

I won’t include any spoilers, but I can say that kids who read the book will get a fine lesson in civil disobedience, passive resistance, occasional active resistance, and the price of seeking power by state fiat. Faced with classes designed to rob them of an education, the students organize to educate themselves in clear violation of the new decrees. State interference with the press is bypassed by utilizing an alternative method. The official effort to silence a news story results in the entire school reading it in one day.

With thanks to fellow Chicagoan Milt Rosenberg (on whose show I appeared once, to discuss Enron) for the pointer.

UPDATE: Steve at The Modulator posted his post from July on this topic, which captures a lot of the relevant links from when the book came out, in the comments below. Now that I see it, I recall the Julian Sanchez and A.S. Byatt pieces particularly, alhtough I didn’t pay much attention this summer as I am only through book 2.

While it may be unseemly to mention, it is even more unseemly to nominate oneself in the “best female authored blog” category.

But why no “best economics blog” category?