Saturday, December 15, 2012

Don't "Plan" The Colorado River or Why Property Still Works

Bound For Los Angeles? 

Had a Better Idea

Yesterday's Los Angeles Times reported that "[w]ater demand in the Colorado River Basin will greatly outstrip supply in coming decades as a result of drought, climate change and population growth."  The story is based on a recent study by the U.S. Department of the Interior, which concludes that demand for the river's water will exceed supply by 3.2 million acre-feet per year in 2060.  According to the story, 3.2 million acre-feet is more than five times the current annual consumption of water by Los Angeles and its citizens.  The story concludes by discussing various possible responses to such a shortage.  Such responses include conservation, recycling, desalinization, building a pipeline from the Missouri River to Southern California, or towing icebergs from the Arctic Ocean to Southern California.  Interior Secretary Ken Salazar admonished all those who rely on water from the Colorado to "plan for this together."  

With due respect to Secretary Salazar, little or no planning is necessary.   Such a "shortage" is the natural and predictable result of the failure to establish property rights in a resource, a failure that results in below-market prices and thus artificially high demand and overuse by those, including agribusinesses, who do not internalize the full social cost of using the resource.  As one leading scholar has explained: "[w]ell-defined and defended property rights encourage greater resources stewardship and sustainable utilization."  See Jonathan Adler, Water Rights, Markets and Changing Ecological Conditions, 42 Environmental Law Review 93 (2012).  Thus, a well-functioning market for water from the Colorado River and elsewhere would result in prices that reflect the actual social cost of that water and thus a more efficient allocation of this precious resource.

At first glance it seems more difficult to establish property rights in water than in other items such as automobiles, I-Phones or candy bars.  After all, it's one thing to own a pickup truck; quite another to own a river.  And yet, auctioning off the Colorado River might be just the solution to this purported "shortage."  Such an auction would create a single owner of all the water in the river, and this owner would then charge a market price for the water in question, a price that would bring demand and supply into equilibrium and thus eliminate any artificial shortage.  In such a market, consumers would only purchase water when their personal value for the water equaled its true social cost.  Moreover, such consumers would have incentives to conserve water in any number of ways.  For instance, farmers might choose to plant crops that are less water-intensive, even if such crops are slightly less valuable.  Fewer citizens would purchase swimming pools, and some would forgo grass lawns for the sort of faux desert landscapes, complete with rocks, cacti and palm trees, already popular in the Southwest.

Without any planning whatsoever, then, the creation of property rights in the Colorado's water would encourage conservation and result in a more efficient allocation of this scarce resource.  As F.A. Hayek explained more than six decades ago, the price system is a "marvel" that transmits information about the value of competing uses of particular resources to various market participants.  Thus, different possible purchasers of water need know nothing about how or why other purchasers might use water, as the market price will reflect values that other market participants place on that use.  See F.A. Hayek, The Use of Knowledge in Society, 35 American Econ. Rev. 519 (1945).   Moreover, as Hayek explained in subsequent work, the creation and enforcement of well-defined property rights is a necessary condition for a well-functioning price system.   See F.A. Hayek, Free Enterprise and Competitive Order in Individualism and Economic Order, 110-16 (1948) (explaining that well-functioning competitive order depends upon properly-designed “legal framework” of contract, property, tort, and business law).  Thus, granting the Colorado's water to a single owner would facilitate the operation of a well-functioning price system and thus help optimize the allocation of water resources. 
Some might object that this hypothetical single owner of the Colorado River would reduce output below the socially optimal level and charge monopoly prices for the river's water.  There are, however, there distinct reasons that this possibility is less problematic than it might first seem.

First, even if such a single owner did reduce water output below the socially optimal level, such a (negative) deviation from the optimal output of water may do less social harm than the current regime, under which firms and individuals consume too much water, thereby resulting in artificial shortages.  All institutions are imperfect; as Ronald Coase explained over two decades ago, society must choose between various imperfect institutional arrangements.  Perhaps granting a monopoly over the Colorado's water would be the least imperfect means of allocating this resource.

Second, any claim that a monopolist will produce well below the optimal level of output assumes that the river's single owner will change the same price per gallon to all purchasers, that is, will not engage in price discrimination.  If, however, the firm does engage in price discrimination, albeit imperfect discrimination, it will be able to set output closer to the socially optimal level.  While such a firm would earn excessive profits, a properly-run and competitive auction would force the firm to pay the expected value of such profits to the national government, which could use these proceeds to reduce taxes or take other steps that would mitigate the distributional consequences of such monopoly pricing.

Third and finally, any claim of monopoly is likely overstated.  After all, the Colorado river is not the only source of water for many of the firms and individuals that currently draw water from it.  Indeed, one suspects that the current and artificially low price for the Colorado's water has discouraged firms and individuals from seeking out alternate sources.  Thus, creation of a single owner of the Colorado's water, by increasing prices closer to market levels, may actually spur users to identify competing sources of water.  If a single owner really did end up with meaningful monopoly power, the national government could consider allocating particular shares of the river's output to several sellers, who could then compete to sell the water to purchasers.

Don't look for the national government to sell off the Colorado River any time soon.  The proposal may have additional downsides not discussed here.  Moreover, the national government may have to pay just compensation to individuals who currently possess property rights to particular amounts of water under state law, for instance.  Finally, political pressure from those who benefit from the current system would prevent the sort of major reform suggested here.  Still, imagining such a radical, property-based solution could be the first step toward meaningful reform that would eliminate artificial shortages and thus obviate the need for schemes like towing icebergs to Los Angeles.