ILLINOIS AGRICULTURAL ECONOMICS STAFF PAPER Serie E, Agricultural Economic STRUCTURE, CONDUCT, AND PERFORMANCE IN A WATER RIGHTS MARKE by April 1983 Jan P. Crouter and John B. Braden No. 83 E-252 _Jblpartment of Agricultural Economic 1 l Y.niYerity of Illinoi at Urbana-Champaign. 305 Mumford Hall, 1301 Wet Gregory Drive, Urbana, IL 61801
STRUCTURE, CONDUCT, AND PERFORMANCE IN A WATER RIGHTS MARKET Introduction Much of the economic literature on wetern water right to urface tream flow ugget that tranferability within a water right market would reult in a more efficient allocation of water right and ue of water (Burne and Quirk; Frederick and Hanon; Hirhleifer, De Haven and Milliman). The actual performance of uch a market in achieving efficiency would depend on it tructure and the reulting conduct of the market agent. Thi paper examine a hypothetical water right market within the tructure-conduct-performance framework of the indutrial organization literature (Bain). Element of market tructure inherent in the nature of water right a a market good are dicued and ued to develop willingne to ell and willingne to pay function which decribe the conduct of the eller and buyer. Market tructure and conduct are then hown to influence the volume and direction of water right tranaction, two indicator of market performance. The Legal and Economic Setting The influence of law on wetern water tranferability and economic efficiency ha frequently been an object of economic analyi. Among other iue, economit have addreed the effect of the appropriation doctrine of wetern water law, the definition of water right in term of diverion, beneficial ue requirement, involuntary tranfer and tranferability retriction. Under the appropriation doctrine, the mot enior right holder
are thoe who were the firt to take a claim for water right. In each period, the claim of enior right holder are honored in full before 2 the junior right holder may receive any water. If water right are not tranferable under the appropriation doctrine, not only are water and water right not moved to their highet value ue, but the differential rik faced by junior and enior right holder reult in a miallocation of invetment in diverion capacity (Burne and Quirk). The practice of defining water ue in tenn of unit diverted, rather than unit conumed, may give rie to return flow externalitie when a tranfer involve a change in ue or diverion point. Given there are no binding contraint on tream flow, defining water ue in term of unit conumed would eliminate potential return flow externalitie (Johnon, Gier and Werner). The requirement that water be put to beneficial ue in order to retain the right to it erve to make right to currently unued water le ecure. Further, the current notion of beneficial ue dicourage conervation of carce water reource (Tregarthen). Legal intrument that provide for involuntary tranfer of water, epecially without compenation, reduce the ecurity and hence, the marketability of water right. Example of involuntary tranfer include ue-prioritie in drought period, precription of water right by municipalitie, and reervation of water for cenic, recreational or Indian ue (Ciriacy-Wantrup). Finally, wetern tate maintain variou legal impediment to the tranfer of water right, including area of origin, export, ue and appurtenancy retriction (Treleae, pp. 80-9 and 206-17). Thee
retriction prevent water from flowing freely to the highet bidder and thi i particularly troubleome a regional economic activity change 3 over time. Water i retained in location which are water rich when other are water poor, and by uer who are le productive than ome other who eek water. Modifying the legal rule to allow a water right market to facilitate the exchange of water right i expected to reult in ~fficiency gain. The market price of a water right would reflect the underlying upply and demand for it attribute. Some important characteritic of a water right are the amount of water the right holder may divert, the eniority of the right, and locational factor. The eniority of the right detennine the expected value and variability of allowable diverion over time. Locational factor determine the proximity of the diverion point to the propective holder' location Jf water ue, and the potential for return flow externalitie if the iiverion point i changed. Preumably, a water right i more valuable md it market price i higher the larger the quantity of water to which ':he right entitle the holder, the more enior the right, the longer the older may hold the right, and the IOC>re convenient the location of the iverion point (in term of proximity to the location of the water ue nd in the avoidance of external effect). A market in water right would encompa outright ale, hort term ale of pecified quantitie of water, and temporary leae. Outright ale and leae pa onto the purchaer any uncertainty aociated with.:1e juniority of the right. Contract for pecific quantitie of water reumably cover water known to be in the eller' poeion or pecify
4 how rik of hortfall are to be hared. Structure-Conduct-Performance in a Water Right Market A typical indutry tudy uing the tructure-conduct-performance framework f~cue on the degree of eller concentration in the indutry a the tructural variable and the profit margin a the indicator of indutry perfonnance. other tructure-conduct-performance relationhip are more relevent to a water right market. Thi ection direct attention to three tructural element inherent in the nature of water right a a market good. Thee influence buyer' willingne to pay and eller' willingne to ell. Buyer and eller cond~~t then bear upon the volume and direction of market tranaction. In the implet cae, the water right market i een to have achieved allocative efficiency when the value of the incremental unit of a water right in the eller' production i equal to it marginal value in the buyer' production. The direction of water right trade i aumed to be from lower valued eller ue toward higher valued buyer ue. Attention will be focued on the tructural element of the market which affect the volume of water right trade and the propenity of the market to achieve allocative efficiency a regard the productive value of water. Structure An exchange of a water right entail a tranfer of a pecific bwldle of attribute relating to location, quantity, and eniority. Typically, a water right i a unique good for which there are no perfect ubtitute. Thi heterogeneity create two problem. Firt, the
5 market for water right will be complex. Intead of ignalling one price a that value which equate upply and demand for a tandardized product, the market will provide a et of price that differ according to the pecific upply and demand for the characteritic of each right. Thi i not unlike the market for other cotly heterogeneou good uch a houing or land. Market complexity exact high infonnation and contracting tranaction cot for the buyer and the eller. Thee cot divorce willingne to ell (WTS) and willingne to pay (WTP) from the ue-value of a water right. The econd problem created by heterogeneity i the cope for monopolitic behavior. Since each water right i unique, each water right eller ha at leat ome degree of monopoly power. The fewer cloe ubtitute there are available, the higher the degree of monopoly power and the more cope for non-competitive, "hold-out" behavior. In term of the tructure-conduct-performance framework, thi feature of a water right market i analogou to the conventional concentrationprofit relationhip. However, "exce" profit from the ale bf right would be rent due to location and the natural carcity of water right, rather than economie of cale or colluion. The econd tructural element regarding water right i the jointne of water with other input in production. Tranferring water right (and water) from a eller to a buyer may releae other input ued jointly with water {land, labor and ome capital tructure) from the eller' production and employ other input in the buyer' production. unchanged. If thee other input are mobile, WTS and WTP will remain Thi i not the ituation if thee newly releaed
6 jointly-ued input are inunobile. One example of thi cae i land. Land and water right often are old together (even in the abence of appurtenancy retriction) becaue the ue value of land depend heavily but not entirely upon the aociated water right (Treleae, p. 5). For a water right trade to occur, the eller will require a price that include the foregone profit of the old water right and the foregone land value. Similarly, the buyer will be willing to pay a price that include the increae in hi land value from holding the right. The effect will be to increae both the WTS and WTP for the right, epecially for outright ale and long term leae. It will alo be the cae that lhe eller, the current water uer, will have other durable and pecific input (Cave and Porter) ued jointly with water uch a irrigation equipment if the eller i a farmer, machinery, building, and o forth. To part with the water right, the eller will require a price that cover the lot income to thee fixed factor (Hartman and Seatone). The lot factor income will be the internal opportunity cot minu the alvage value of the newly unemployed factor (Edward). ue value. Thi alo increae the upply price of a right above it It i unlikely that the buyer would be imilarly burdened with non-land inunobile aet whoe preence would alter willingne to pay. Finally, the nature of water right affect the tructure of the market becaue tranfer of water right entailing a change in ue or location may alter the pattern of return flow to a tream. Thi i due to the fact that the water right i defined in term of unit diverted in thi hypothetical water right market. The burden of proof to how a
7 water right tranaction will not affect other etablihed claim i an additional tranaction cot to the buyer (Brown, Sawyer and Khohaklagh, p. 646) and will reduce the buyer' willingne to pay for right to water. Conduct The conduct of the market' buyer and eller can be decribed by willingne to pay (WTP) and willingne to ell (WTS) function. In the abence of the tructural influence dicued in the preceding ection, WTP, and WTS are imply the ue value of a unit of right to water in the buyer' and eller' productive activitie, repectively. A etablihed above, the market agent mut alo conider tranaction cot, lot income to immobile factor, and potential profit in their market deciion. Thee conideration will alter WTS and WTP which will in turn influence the volume of tranaction and the market allocation of water right. we firt examine eller conduct in the abence of tranaction cot and fixed factor, deriving WTS in thi imple cae. Additional unit of water in the eller' productive activity within the period. are i.umed to yield declining marginal value product, MVP Thi i the. addition to the right holder' profit, revenue le cot, of uing an additional amount of water. Some locational factor influencing the value of the aociated water right are included in the MVP through their effect on cot. The MVP repreent the holder' derived demand for water. At high water price, le water i held than at low water price. A eniority ranking determine the probability the uer will
8 receive hi appropriation in a future period which in turn determine the expected marginal value product (EMVP ) of water obtained from the water right in a future period. The more enior the water right, the cloer the EMVP approache the MVP Noting that each incremental unit of water to which the right entitle the holder yield a tream of (dicounted) future expected profit, we take the um of the dicounted EMVP curve to derive the preent value of the um of expected future marginal value product. Thi i the capital~zed ue value to the eller (CV ) of unit of right to water, and repreent the holder' demand curve for water right. It i hown in figure 1. Thi curve i ufficiently general to repreent all type of water right trade. If for example, the tranaction involve the outright ale of an entire water right, the CV i the preent value of an infinite um of future EMVP If the water right i leaed, CV i the preent value of a finite um of future EMVP If water i old in the current period, CV i imply MVP. r p r (w) r Po..l I w w WO 0 WO w Figure 1. Demand- and Supply of Water Right
9 Suppoe the holder' water right entail diverion quantity w in figure 1. At a water right price p~, the uer would retain right to w 0 unit of water and would be willing to ell right tow~= w- w 0 unit of water. The uer maximize hi income where the lat unit of right to water, w 0, ha a value in hi production, CV 5 (w), jut equal to it value on the market, p~. By finding all uch (pr, w) pair, the upply curve, r(w), can be derived. Thi curve repreent the uer' willingne to ell a portion of hi right to unit of water in the abence of tranaction cot or immobile aet. It i olely a function of CVS, and it i analogou to a competitive firm' upply curve in a conventional indutry. The uer can never ell more than hi appropriation, and at price le than pr, he will enter the market to buy additional right to water. Turning to the buyer, dr(w) repreent the ue-value of the right to unit of water in the buyer' productive activity. Thi i identically equal to the capitalized value of right to water, cvb, analogou to the CV curve derived for the eller. The marginal value product of water to the buyer will include the cot of tranporting water from the eller to the buyer' location of ue. The introduction of tranaction cot, immobile aet and potential profit will alter the WTS and WTP function, driving a wedge between r(w) = f(cv 8 ) and dr(w) = CVb at the margin. For the buyer, market complexity due to water right heterogeneity will increae tranaction cot, and reduce the amount the buyer ip willing to pay the eller for right to water. Jointne of water and land in production will increae the buyer' land value, making the buyer
.. :
10 willing to pay an additional price for water right. The burden of proof to how that other tream uer will not be affected by the water right tranfer impoe an additional tranaction cot on the buyer, reducing WTP. Increae (decreae) in WTP, given WTS, will increae (decreae) the market price and the volume of market tranaction relative to market volume in the abence of tructural factor. A a reult of thee tructural feature, willingne to pay for right to water at the margin may be decribed a: WTP = dr(w) +additional income to fixed factor (land only) - tranaction cot (due to market complexity and the poibility of return flow externalitie). For the eller, water right heterogeneity exact infonnation and contracting cot due to market complexity., but provide the opportunity to extract upernormal rent from a water right ale. The jointne of water and other immobile factor owned by the eller require that the price of the water right cover the lot income to thee fixed factor. Increae (decreae) in WTS, given WTP, will increae (decreae) the market price and decreae (increae) the volume of market tranaction relative to price and volume in the abence of tructural factor. Willingne to ell i: WTS = r(w) +additional income to fixed factor (land, labor, and capital owned by the eller) - tranaction cot due to market complexity}. ImJ;?li~,!:ion_ for ~~ ~!.. ~.~~~!1'.-~ E'.:'.:d S:::-?i:iclu:o2:?2.:~:. The preceding ection ha hown that in a hypothetical water right
11 market, certain tructural factor inherent in the nature of water right a a market good affect the WTP and WTS function. Shift in WTP and WTS influence the volume of tranaction and the market allocation of water right. Thee tructural factor are preent in every market, and they are of pecial note in the context of a water right market becaue of the high cot of actually changing the location of ue of large quantitie of water, and the jointne of water with other input, epecially land. High tranaction cot and monopoly pricing opportunitie for current water right holder will contrict the volume of tranaction and the efficiency of the market. Jointne alo raie barrier to releaing water from exiting ue. A market work bet where commoditie are cloely ubtitutable, exchange i eay and inexpenive, and fixed factor income effect of exchange are negligible. Few good are a uniform a water. However, location, return flow and the appropriation doctrine create heterogeneity in water right. Tranacting over water, epecially very major exchange involving different location and potentially ignificant change in return flow, i far from cotle. Income effect can be large due to jointne with land and other aet. Thee factor will caue the perfonnance of market for water to diverge ignificantly from reult expected if only ue value are conidered. Fewer exchange and le pronounced aggregate change in end ue clae are among the qualitative conequence of thee tranaction cot, income effect and potential rent.
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