Introduction to Economics of Water

Resources

Public or private• Excludability (E): the degree to which users can be excluded• Subtractability (S): the degree to which consumption by one user

reduces the possibility for consumption by others.• Public goods: have a low subtractability and a low excludability• Private goods: have a high market potential because of their high

levels of excludability and subtractability

Basic Need, Merit, or Economic Good ?• Depending on the quantities supplied to individuals, water

can be a basic human need, merit good, or an ordinary economic good:– under conditions of extreme scarcity, there is only one option and

only one choice to be made, which is to get the water to the thirsty, which closes all options. In this case, water is no more an economic good but a basic need for people to survive

– When there is just enough for the thirsty, water also fulfils the criteria for being considered a merit good: good that has a high societal function but are generally not expressed in monetary terms, such as the importance of having clean rivers and a beautiful scenery.

– It is obligation of human societies to assure reasonable levels of water to meet the basic human needs and merit goods

Basic Need, Merit, or Economic Good ?

Some Economic Indicators

• NPV (net present value)

• Internal Rate of Return (IRR)Interest Rate where NPVcost=NPV benefits

• Economic EfficiencyMarginal Cost = Marginal Benefits

Some Economic Indicators• NPV

Strong:– Choosing among mutually exclusive projects– Decide if the project can be fundedWeak:– Sensitive to interest rate– No information about degree of acceptability

• Internal Rate of Return (IRR)Strong:– Maximize the return when we have Limited

fund – Used to rank projects– Decide if the project can be fundedWeak:– No information on the size of the project

tt

r

CBNPV

)1(

)(

)0)1(

)(@(

t

t

r

CBr

Costs / Benefits• Direct Cost / Benefit

– Easily measured, allocated to a specific production and consumption • Indirect Cost / Benefit

– Difficult to be measured, indirectly related to production and consumption

• Fixed Cost– Do not vary with the quantity of output (capital / investment costs)

• Variable Cost (is it same as recurrent cost ??)– Related to quantity (raw material, chemicals, labors, fuel, etc.)

• Incremental cost / benefit – Compare the situation with or without introducing new components to

a project

• Opportunity Cost– The cost of foregoing the opportunity to earn a return

Some Economic Indicators• B/C ratio

Strong:– Rank projects according to degree of

acceptability– Decide if the project can be fundedWeak:– Sensitive to interest rate

t

t

tt

ratio

r

Cr

B

BC

)1(

)1(

Economic EfficiencyTC

Q*

TB

MC

AC

MB

max

Quantity

TC

Q*

TB

MC

AC

MB

max

Quantity

PTC: Total Cost TB: Total Benefit MC: Marginal CostAC: Average Cost MB: Marginal Benefit

ITB connection

Economic Efficiency

TC

Q*

TB

MC

AC

MB

max

Quantity

TC

Q*

TB

MC

AC

MB

max

Quantity

P

Rising limb = supply curveBelow the falling part of ACHigher the rising part of ACAffected by variable costs

= Demand Curve= Benefits associated with One Unit increase in output

Optimality Condition

Definitions • Total cost curve: variation in total production cost (Fixed costs +

variable costs) with the level of production• Total benefit curve: variation in the resulting benefits with the

level of production• Average cost curve : total cost divided by the level of production

– U shape– Decrease first because of economies of scale

• Marginal cost curve: the slope of the total cost curve, represent the change in total cost associated with a unit increase in output– Supplier will not produce an extra unit unless the price exceeds the

marginal cost– The rising limb represent the supply curve

• Marginal benefit curve: the slope of the total benefit curve, represent the change in total benefit associated with a unit increase in output– Represent the demand curve

RESULTS: M&I Demand Curve

GAZA DOMESTIC & INDUSTRIAL WATER DEMAND CURVE

0.5

0.6

0.7

0.8

0.9

1

1.1

1.2

1.3

1.4

7 7.5 8 8.5 9

Monthly Demand (Mm3)

Un

it P

rice

($/m

3)

0

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6

2 3 4 5 6 7 8 9 10 11 12

monthly supply (Mm3)

mar

gin

al c

ost

($/m

3)

import 1

brackish water treatment 1

import 2

brackish water treatment 2

seawater desalination 1

seawater desalination 2

RESULTS: M&I Supply Curve

RESULTS: 2010 Equilibrium Point

0.5

0.6

0.7

0.8

0.9

1

1.1

1.2

1.3

1.4

2 3 4 5 6 7 8 9 10 11

monthly supply / demand (Mm3)

mar

gin

al c

ost

/ p

rice

($/

m3)

supply

2010 demand

Cash Flow ExampleYear 1 2 3 4 5 6 7 8 9 10  

Investment Cost 100000 50000 50000                

O&M Cost       10000 10000 10000 10000 10000 10000 10000  

Cost 100000 50000 50000 10000 10000 10000 10000 10000 10000 10000  

NPVc 100000 45455 41322 7513 6830 6209 5645 5132 4665 4241 227012

Revenues       50000 50000 50000 50000 50000 50000 50000  

NPVr 0 0 0 37566 34151 31046 28224 25658 23325 21205 201174

                       

                       

Interest rate 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.1  

NPVc 264476 259285 254400 249797 245455 241353 237473 233799 230317 227012  

NPVr 329781 311034 293632 277462 262421 248415 235361 223181 211807 201174  

IRR

150000

175000

200000

225000

250000

275000

300000

325000

3500000

0.01

0.02

0.03

0.04

0.05

0.06

0.07

0.08

0.09 0.1

0.11

Interest Rate

NP

V NPVc

NPVr

IRR=0.068

Free Market System• Competitive system: Allocation of resources

with maximum efficiency– Consumers must be consistent and independent– Producers must operate with the goal of profit

maximization– No price regulations or constraints by the

government, labors, business, etc– Goods, services, and resources must be mobile

free to move from market to another– Buyers and sellers must be aware of the prices

instantaneously– Commodities must be sufficiently divisible – All resources must be fully employed

Market Demand• People will buy less at higher prices provided that

income, tastes, prices of substitutes remains constant• Price elasticity of the demand:

• Shifts in Demand:– Customer preferences– Number of customers– Customer income– Price of related goods– Availability of alternatives

Q

P

Market Demand• Price elasticity of the

demand:– More elastic at high prices– Rigid at low prices– Perfectly elastic when

E=infinity, means no one will buy if the price increases

• Example:– Calculate E at different

locations on the curve assuming a unit change in price will result in a unit change in the demand.

Q

P

1

531

5

3

E=-5

E=-1

E=-0.2

Market Supply• Market supply: the amount

that producers are willing to sell/produce at different prices

• Shifts in supply curve:– Technological advances– Favorable production

conditions– Lower input cost

Q

P

Market Equilibrium• Market equilibrium:

– the minimum that customer can pay for certain quantity and the maximum that suppliers can receive for the same quantity

– Automatic way for allocation

– Represent the customers willingness to pay

– Economic efficiency

Q

P Demandsupply

surplus

shortage

Irrigation Water Prices in Israel