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.