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Berkeley ENVECON 162 - THE VALUE OF WATER

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12/15/05 THE VALUE OF WATER Michael Hanemann University of California, Berkeley 1. Introduction 2. What is Economic Value? How is it Measured? 2.1 The Meaning of Economic Value 2.2 Non-market Valuation and Water 3. Is Water Different? 3.1 Water as a Private Good, Water as a Public Good 3.2 The Mobility of Water 3.3 The Variability of Water 3.4 The Cost of Water 3.5 The Price of Water 3.6 The Essentialness of Water 3.7 The Heterogeneity of Water 3.8 The “Average instead of Marginal” Fallacy 3.9 The Benefits of Water 4. The Problem of Water References21. Introduction There is a widespread perception among water professionals today of a crisis in water resources management. Water resources are poorly managed in many parts of the world, and many people – especially the poor – lack access to adequate water supply and sanitation. Moreover, this is not a new problem – it has been recognized for a long time, yet the efforts to solve it over the past three or four decades have been disappointing, accomplishing far less than had been expected. In addition, in some circles there is a feeling that economics may be part of the problem. There is a sense that economic concepts are inadequate to the task at hand, a feeling that water has value in ways that economics fails to account for, and a concern that this could impede the formulation of effective approaches for solving the water crisis. My own personal assessment is that the situation is somewhat more complex than critics suggest. On the one hand, as environmental economics has evolved over the past forty years, it has developed a conceptual toolkit that I think is well suited for dealing with many of the issues of water supply and water resource management. On the other had, economists sometimes slip into older ways of thinking and characterize economic value in terms that are inadequate or misleading. Moreover, even among economists there is an inadequate appreciation of the complexities of water as an economic commodity; these render it distinctive from other commodities and they contribute to the explanation of the current crisis in water. This paper examines the economic concept of value and some related notions as they apply to water, at least partly in light of these concerns. It consists of two main sections. Section 2 reviews the economic concept of value, explains how it is measured, and discusses how this has been applied to water in various ways. Section 3 takes on the debate regarding whether or not water can or should be treated as an economic commodity, and discusses the ways in which water is the same or different as other commodities. The paper ends with a few concluding observations in Section 4.32. What is Economic Value? How is it Measured? Is economic value measured by market price? If an item has a price of $x, is this also the amount of its economic value? Most people assume the answer is yes, and economists sometimes also make this statement. For example, the following passage equates the economic value of water with its market price: “Water has economic value only when its supply is scarce relative to demand. Whenever water is available in unlimited supply, it is free in the economic sense. Scarce water takes on economic value because many users compete for its use. In a market system, economic values of water, defined by its price, serve as a guide to allocate water among alternative uses, potentially directing water and its complementary resources into uses in which they yield the greatest total economic return.”1 If it were true that economic value is measured by market price, this would imply that only marketed commodities can have an economic value. Items that are not sold in a market – including the natural environment, and public goods generally – would have no economic value. If this were so, economic value would indeed be a narrow concept and at variance with many people’s intuitive sense of what is valuable. In fact, however, economic value is different than price. Price does not in general measure economic value, and items with no market price can still have a positive economic value. This was first pointed out by Dupuit (1844) and Marshall (1879). But, as explained below, it took until the 1970s for this to become well accepted within modern economics. It was around this time that operational procedures became available to measure economic value separately from price; and it was around this time that non-market valuation emerged as a field in economics. It so happens that water as a commodity played a role in these developments, both clarifying the economic concept of value and developing operational procedures for measuring it. 2.1 The Meaning of Economic Value The distinction between market price and economic value was famously noted by Adam Smith in a passage in the Wealth of Nations describing the paradox of water and diamonds: The word Value, it is to be observed, has two different meanings, and sometimes expresses the utility of some particular object, and sometimes the power of purchasing other goods which the possession of that object conveys. The one may be called ‘value in use’; the other, ‘value in exchange’. The things which have the greatest value in use have frequently little or no value in exchange; and, on the 1 Ward and Michelsen (2002)4contrary, those which have the greatest value in exchange have frequently little or no value in use. Nothing is more useful than water; but it will purchase scarce anything; scarce anything can be had in exchange for it. A diamond, on the contrary, has scarce any value in use; but a very great quantity of other goods may frequently be had in exchange for it. (Book I, chapter IV). Smith was using the comparison between water and diamonds to illustrate a distinction between two different meanings of “value”. In fact, neither the distinction between the definitions of value nor the use of water to illustrate it was original with Smith.2 Two thousand years before Smith, Plato had observed that: “Only what is rare is valuable, and water, which is the best of all things ... is also the cheapest.”3 In fact, Plato and Smith were both expressing a thought that had occurred to many other people over the ages, namely that the market price of an item need not reflect its true value. Market price reflects the fluctuating circumstance of daily life, whether the vagaries of supply (sudden scarcity,


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