Newsletter No 4 December2011

Market power in water markets


Erik Ansink

waterMarket power is an important source of friction in water markets. Owners of a water supply project have an incentive to reduce deliveries in order to increase the water price at the destination market. In this study we provide an economic model to assess the effects of market power in water markets.

Model set-up


One important effect of market power in water markets is that water users pay higher water prices than they would in absence of market power. The reason is that water suppliers reduce their water deliveries in order to increase their profits. Examples of such price mark-ups have been observed in many countries and in many types of water markets (e.g. Jacoby et al., 2004). These price mark-ups are undesirable because they reduce overall welfare. Up to now, there have only been empirical studies of the effects of market power in water markets, but an underlying model was lacking. In this study (Ansink & Houba, 2012) we fill this gap by providing a model that is particularly suited to analyse the frictions caused by market power in water markets.

Water markets are a special type of market because of the characteristics of water as an economic good. For instance, water that is not extracted upstream, may flow downstream and can be extracted by another supplier. This characteristic, together with many others, imply that standard economic models used to study market power cannot be directly applied to water markets. Therefore, we developed a new model that is tailored to the characteristics of water.

Specifically, we analyze market power in water markets in a setting where agents can extract, sell, and purchase water. We distinguish between suppliers and users of water. Suppliers are located along a river so that water extraction is constrained by the unidirectional river flow. They are connected  through an infrastructure consisting of direct links between individual suppliers and users. Suppliers are also connected to each other through water balances. This set-up creates a system of multiple markets for water. The delivery infrastructure determines the number of potential suppliers to each water market, while strategic considerations on extraction and supply determine which water markets are actually served.

This model set-up is general enough to cover a wide range of actual water market structures. It relates to two types of markets that have been analysed in the literature before. One is multi-market oligopoly (Bulow et al., 1985), the other is Cournot-Walras competition (Gabszewicz & Vial, 1972). Our model also extends an earlier paper on water markets which was limited to settings with only one supplier (Chakravorty et al., 2009).

Results

One immediate result is an existence result. This is a rather technical result which states that in the setting of our model there exists an equilibrium vector of water prices such that the market for water is cleared (i.e. supply equals demand for each water user). This result allows us to analyse this equilibrium in more detail.

A more practical result is the following. We find that upstream extraction affects water suppliers in three ways: (i) by the reduced physical availability of water through a reduced inflow; (ii) by an increase in the extraction costs due to reduced inflow; and (iii) by the effect on the marginal willingness to pay through upstream suppliers' deliveries. Effect (iii) describes the externality due to competition. This is a standard effect that is also present in other models of market power. Effects (i) and (ii), however, are special for market power in water markets and they are novel to the literature on multi-market oligopolies. These two effects create interdependencies between suppliers, caused by their connection through water balances.

Based on this result, we can further identify the effects of market power. We find that the standard price mark-ups due to market power are also present in water markets. There are, however, two novelties. One is that the two effects (i) and (ii), introduced above, mitigate the extent of price mark-ups. Depending on the specific type of water market, this mitigating effect implies that the effects of market power in water markets may be less severe than for conventional economic goods. The other novelty is that, compared to the competitive equilibrium, market power results in the strategic redistribution of water supply over the suppliers' markets. To assess how the combination of these effects plays out, we analyzed four specific water market structures.

Four specific water market structures

The four water market structures that we analysed are (i) monopoly, (ii) local monopolies, (iii) duopoly, and (iv) gravity-driven water trade. In all four structures we find that water resources are under-developed compared to the competitive equilibrium, which implies price mark-ups due to market power. Further, water market structures (ii), (iii), and (iv) provide results that are different from standard models of market power, due to the novel effects described above. It is therefore not obvious that all suppliers benefit from market power and all users are harmed, as one would expect. To illustrate this counter-intuitive result, we implemented a numerical illustration for the market structure with gravity-driven water trade. Our example shows that some suppliers may be harmed by market power, while some water users may benefit. Nevertheless, overall welfare is reduced by the effects of market power in water markets.

Policy implications

Our model gives rise to two specific policy implications.  One implication is that regulation of water markets may involve financial compensation schemes for those users that would be harmed by regulation. This is common practice in General Equilibrium models but novel in a setting of market power. A second implication applies to restrictions on water trade, which is a standard feature of water markets in e.g., the US and Australia. Trade restrictions are usually in place whenever the governing structure precludes water from being traded from one district into the other or whenever the system of water rights does not allow such trades. Economic intuition would suggest that trade restrictions decrease the efficiency of water allocation and are therefore undesirable. The four cases analyzed in this study, however, indicate that it is not obvious ex ante how the removal of trade restrictions affects the welfare of both suppliers and water users.

More information

Erik Ansink, tel +31-20-5981214, erik.ansink@ivm.vu.nl

References

Ansink, E. & Houba, H. (2012). Market power in water markets. Journal of Environmental Economics and Management. [Forthcoming]

Bulow, J., Geanakoplos, J. & Klemperer, P. (1985). Multimarket oligopoly: strategic substitutes and complements. Journal of Political Economy 93 (3), 488-511.

Chakravorty, U., Hochman, E., Umetsu, C. & Zilberman, D. (2009). Water allocation under distribution losses: comparing alternative institutions. Journal of Economic Dynamics and Control 33 (2), 463-476.

Gabszewicz, J. & Vial, J. (1972). Oligopoly a la Cournot in a general equilibrium analysis. Journal of Economic Theory 4 (3), 381-400.

Jacoby, H., Murgai, R. & Rehman, S. (2004). Monopoly power and distribution in fragmented markets: the case of groundwater. Review of Economic Studies 71 (3), 783-808.