EclectEcon

The southeast of England, despite having had quite a bit of rain this past May, still faces water shortages this August.

• The water authorities tell us that the reason for the water shortages is that we have had droughts.... well, at least we have had two consecutive winters with extremely low rainfall, and the water levels in the ground are perilously low.
• The tabloids tell us that the reason for the water shortages is that the water system was privatized and the capitalist pigs won't spend the money to repair the leaks in the water system. Their evidence is that considerable amounts of water are lost every day in London due to leaks, while, at the same time, water companies are making supranormal profits.
• My neoclassical inner being tells me that the reason for the water shortages is that the price of water is too low.

My explanation is closer to the truth.

Water prices are regulated in England. The type of regulation is the standard rate-of-return regulation, in which various people argue before the regulatory body about what the appropriate price should be. The theoretical model is one of a natural monopoly (a firm which has high fixed costs and low marginal costs and hence a noticeably downward-sloping average cost curve relative to the demand curve), and the theoretical goal of the regulators is to set price equal to average total costs (i.e. where the demand curve intersects the long-run average total cost curve).

• The water companies argue that their costs are high, that their capital stock is such and such, and that a reasonable rate of return on their capital, given the risk, is so-and-so. Their approach is to determine what they refer to as their "revenue requirements" by looking first at all their costs, including the opportunity costs of capital.
• Consumer advocates argue that people cannot afford the water they "need" if prices are too high; these folks argue that the price of water should be low and that alternative forms of rationing (other than the price system) should be implemented.
• In contrast, environmentalists argue that the price of water should be raised to discourage what they consider profligate uses of water, e.g. big lawns, car washes, etc.
• Of course what bothers all of the above is that if the price system is used to ration water (i.e., if prices were raised until the water shortage disappeared) is that the water companies would get the profits. There are several ways to deal with this concern though.
  
  First, so what? If you think water companies are going to get rich off water, buy some stock in them. (It would be a better investment than lottery tickets). If you think that's despicable, then buy the stock and donate it to a charitable organization.
  
  Second, a different way to raise the price of water, without having the water companies profit from the higher prices, is to tax the use of water. One might hope that the tax would be revenue neutral, and that there would be off-setting tax reductions elsewhere, but taxing something that is underpriced in the market makes pretty good sense in this scenario.
  
  
• Sadly, most people argue that the price of water shouldn't be raised because then the poor would suffer. I am skeptical of this argument. I doubt that water is an inferior good (but I don't know): I expect that if the price of water were raised, it would affect higher income groups proportionally more than it would affect lower income groups.

When I discussed this last point with an executive of SouthEast Water (the local water company), he offered the suggestion that about 80% of water usage is deemed by the regulators to be essential. This was during a field trip with my students where I am teaching this summer.

My response was to bristle. I suggested that they consider how much water people use today relative to how much water people used 50 years ago (about half) and then tell me again how much of today's water usage is essential and for what.

But here's the kicker: 70% of the households in this area are not on water meters and have the right to refuse water meters. The company might be able to vary the price of water from month-to-month, charging more in July and August, but they cannot vary the charges according to how much water these people use. Raising the monthly price for these customers will have no impact on the marginal cost of using another litre of water. In fact some have argued that if the price were raised to these customers, they would feel entitled to use more water.

In other words, using the price system ration water when there are no meters is probably out of the question, at least until the houses change hands, at which time water meters can be installed.

As a footnote, though, let me add that the representative of SouthEast Water gave an excellent presentation to my students on our field trip last month. I was delighted and pleased with the time SouthEast Water took and with the quality and depth of their work.