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Key Considerations in Applying Microeconomic Theoryto Water Quality IssuesBrian Davidson a & Hector Malano aa University of Melbourne , AustraliaPublished online: 22 Jan 2009.

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International Water Resources AssociationWater International, Volume 30, Number 2, Pages 147–154, June 2005

© 2005 International Water Resources Association

147

Key Considerations in Applying MicroeconomicTheory to Water Quality Issues

Brian Davidson and Hector Malano, University of Melbourne, Australia

Abstract: Statements, such as those that suggest that all the world’s population has a right to freshpotable water supplies or that those who polluted water should be made to clean it up, are usually madewithout recourse to the costs and benefits of segregating water according to its quality. The purpose inthis paper is to demonstrate the value that economic thinking can add to issues surrounding waterquality by addressing four key questions. First, who would benefit from differentiating water quality?Second, given the multitude of quality types that exist, is it possible to specify a finite set of manageablecategories that can be assessed? Third, can the costs of treating water to change its quality be viewed ina logical manner? Finally, given that water quality changes as it is used, how can the effects of thischange on other users be viewed? This study found that an economic approach adds significantly toconceptualizing these problems, however, an analysis of them is severely hampered by the lack of infor-mation on water quality pricing that results from interventions that occur in the water market.

Keywords: water quality, marketing margins, externalities, substitutability

Introduction – Understanding QualityAlthough many economic assessments assume that

products, goods, inputs, etc. are homogeneous, some econo-mists have observed the heterogeneity that arises fromassessing different qualities of a good. So much so thatallowing for differences in quality and differentiating prod-ucts has spawned studies in monopolistic competition andmarket segmentation analysis at a macroeconomic level.However, more defining, especially from the viewpoint ofwater, is the microeconomic assessment of quality issues.In this situation, economists have attempted to define aproduct in terms of its attributes. The purpose in this paperis to detail elements of microeconomic theory that can beused to understand key issues surrounding water quality.

It should be noted from the outset that a number ofanalysts have assessed components of the economics ofwater quality issues. Pigram (1997) is a good example ofthe types of studies that have been conducted. He de-scribes the value of water to be used in competing uses,stressing the market and non-market aspects of the prob-lem in an Australian setting and notes that water quality isat the heart of the problem. In addition, in the field of envi-ronmental economics, some analysts have attempted to quan-tify water quality using contingent valuation methods. Yet fewanalysts, if any including Pigram (1977), have detailed thetheory that underlies their assessments of water quality.

In understanding quality, it is important to come toterms with some preconceptions that exist surroundingthe subject. While many commentators think and expressthe idea that the quality of a product is good, bad, inferior,superior, or some such other qualitative marker, such think-ing is of limited use. A more correct way of looking at thisis to suggest that different degrees of quality exist, thevalue of each being determined by factors of supply anddemand for each quality grade. What one user might con-sider one quality characteristic to be inferior, say becauseit is high in nitrates, another user, who values this attribute,might consider it superior. Second, many tend to think thatthe range of quality grades is limited, being those that areacceptable versus those that are not. In reality, it must beassumed that many different quality categories exist. Qual-ity attributes may be due not only to the great diversity inthe degree to which a particular pollutant might exist inany given body of water, but also from the variety of pol-lutants that do exist. Third, it is often assumed that quality,once determined, does not change. The quality of watercan change over time and over different geographic re-gions. In other words, water quality is a highly dynamicand complex problem.

It is important to come to terms with water qualityissues, because different end users are affected in differ-ent ways by changes in it. Four issues seem to predomi-nate. First, who would benefit from differentiating waterquality? In resolving this issue it is possible to come to

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terms with why segregating water into different qualityclassifications is of benefit. Second, given the multitude ofquality types that exists, is it possible to specify a manage-able finite set of categories that can be assessed and usedin the water industry? Resolving this issue allows for acontrollable assessment of questions surrounding waterquality. Third, how can the costs of treating water, thuschanging its quality, be viewed in a logical manner? If an-swered, then the costs of transforming water can be as-sessed. Finally, given that water quality changes as it isused, how can the effects of this change on other users beviewed? This leads to the resolution of questions of exter-nalities and pollution. These questions are important be-cause they address the issues, respectively, of: why watershould be segregated into quality characteristics; how itshould be done; and (with the final two questions) who isaffected by changes in it directly and indirectly. Prior to un-dertaking these tasks, an understanding of water quality at-tributes and the uses and limitations that can be placed on thistheoretical economic view of water quality issues is needed.

Indicators of Water QualityWater quality criteria are based on scientific and tech-

nical information that is used as an objective means ofassessing quality required for a particular use. Each useof water requires a certain set of quality attributes that

must be measurable and quantifiable. This implies that it ispossible to specify particular sets of indicators of qualityfor each use and that for each indicator there are particu-lar concentrations below which adverse effects will notoccur, i.e. a threshold level (ANZECC, 1992)

The key indicators used in classifying water qualityare physical (e.g. flow, temperature, etc.), chemical (e.g.nutrients, toxicants, etc.), and biological (e.g. microbes,macro invertebrates, etc.).

The value of water depends on its productive poten-tial, which, in turn, depends on its use. Water with fewerimpurities generally has a greater productive potential asit has a greater range of potential uses without incurringcosts of treatment. Water of a certain quality can have, inprinciple, a range of potential uses, e.g. agriculture, urban,industrial, etc. However, the range of uses within eachcategory can be limited by the quality of water. Details onthe maximum levels of impurities that can be tolerated inwater destined for different uses are presented in Tables1 and 2. It is apparent that the quality of water used fordrinking and food processing is much more stringent thanthat for either urban or industrial uses. It should be notedthat a great degree of disparity can exist in the range ofimpurities different end uses may require. Taking the caseof irrigation water (see Table 2) for instance, highly salinewater may often be used on salt-tolerant crops, wastewa-ter is not ideally used on raw leaf vegetables, and the use

Table 1. Water Quality Criteria for Various Uses (maximum parts per million)

General urban Food Boiler waterItem Drinking good poor processing high lowAntimony 0.05 - - 0.05 - -Arsenic 0.05 - - 0.05 - -Barium 1.00 - - 1.00 - -Bicarbonate 500 150 500 300 5 50Boron 20 0.3 3.0 - - -Cadmium 0.01 - - 0.01 - -Calcium 200 40 400 80 1 40Chloride 250 200 800 300 - -Chromium 0.05 - - 0.05 - -Copper 1.0 0.05 1.5 3.0 - -Cyanide 0.05 - - 0.02 - -Fluoride 1.7 - - 1.5 - -Hydrogen-Sul 1.0 0.95 2.0 0.5 0 5Iron 1.0 0.1 1.0 0.2 - -Lead 0.01 - - 0.05 - -Magnesium 125 30 150 40 1 20Manganese 0.05 0.05 0.5 0.01 - -Mercury 0.001 - - - - -Nitrate 25 - - 20 - -Phenol 0.001 - - 0.001 - -Selenium 0.01 - - 0.01 - -Silica - 10 50 50 1 30Silver 300 100 300 300 - 50Sulphate 250 200 400 - - -Synthetic detergents 0.5 0.2 1.0 0.5 0 0Solids 1500 300 3000 1000 100 2000Zinc 5 5 15 5 - -Source: International Land Development Consultants (1981)

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of water with high sodium content is limited by soil type.There are also specific quality requirements within eachof these uses. Irrigation water must meet specific salinity,ion, and pathological concentrations for different types ofcrops. Water for domestic and industrial use also has tomeet very specific quality criteria. In the domestic con-text, while drinking water must meet strict bacteriological,salinity, and specific ion criteria, gardens can be wateredwith grey water (e.g. water used for washing and bathing).

What needs to be understood is that a range of differ-ent qualities of water exists. Depending on the quality char-acteristics of that water, it will have different values todifferent users. Users can tolerate, up to some maximum,different qualities of water. Yet in doing so, they wouldincur increased cost from using water that was closer tothe maximum tolerance than that that was free of an im-purity. Finally, the cost of using increasingly impure watercould be measured either by the cost of treating the waterto remove the impurity or by ascertaining the costs of lostoutput from using the impure product.

The Use and Limitations of Economic TheoryEconomics is the study of rational choice. In other

words, it is the study of how consumers and firms recon-cile that they have unlimited wants and limited resources.In general, consumers attempt to maximize their utility (orthe satisfaction they derive from the consumption of a prod-uct), while producers do the same via their pursuit of profitsfrom the sale of their products and services. Both consumersand firms are limited by the resources available to them. Sothey need to make choices that result in them gaining as muchas they can, given their resource constraints.

The actions of a consumer can be characterized bythe specification of a demand schedule, which is the quantityof a product a consumer is willing and able to buy at a givenset of prices. In general as the price rises consumers demandless. Similarly, the quantity a producer is willing to sell at agiven set of prices is specified in a supply schedule. In gen-eral, as prices rise, producers supply more of the product. Amarket is a place where buyers and sellers can get together.A perfectly competitive environment, where the supply anddemand schedules intersect, is unique and results in the de-termination of the market price and quantity placed on a mar-

ket. At the market price all that is produced is consumed, sothere is no surplus or wastage of the product in question.

This, albeit simple, view of economic theory is usefulin understanding questions of water quality. It is quite ob-vious that if water is segregated into its different qualitygroupings, then individual supply and demand schedulesfor each quality group can be assessed. However, an un-derstanding the value of different water quality groups al-lows an analyst to look beyond simple questions, such asthose that suggest that all should have access to freshpotable supplies of water and that all pollution of watershould be eradicated. These come at a cost, and it is aneconomic assessment of these costs that allows policymakers to understand how their interventions might improvethe efficiency and equity of current resource allocations.

The major problem with using an economic approachto assessing issues of quality in a market such as that forwater is the reliance on prices as the purveyor of informa-tion. In economics, price is considered to be the factorthat makes suppliers and consumers react. Market pricesare generally not revealed in this market, due to the mas-sive government intervention that occurs. This, in turn, hasresulted from the great degrees of market failure that ex-ist in the market (Perry et al., 1997; Davidson, 2004,). Thewater market is characterized by monopolization, exter-nalities, inadequate property rights, and the public goodnature of water itself. All these factors affect the price. Ina market where prices cannot and are not allowed to op-erate, one could question the validity of using an economicapproach to assess questions of quality.

Yet this should not be of concern because there areimportant elements that an economic approach can add toassessing questions of quality. The logic underlying qualityissues is based on an economic problem in itself. That is,the needs and requirements of different users. Further, aneconomic approach based on free or market-determined pricescan be adjusted to assess the reality of the situation at hand.This is done by specifying a set of shadow prices, which arethose that would exist if the good was freely traded.

An economic approach can be used to address somevery important questions. In this paper the important is-sues of who benefits from introducing a grading scheme,how it could be undertaken, and the effects of changing wa-ter quality deliberately or unintentionally are addressed. Yet,this is only the start, and much more can be achieved. Theeconomic approach can be extended to account for any num-ber of static and dynamic issues over and continuum of spaceand time. Any good applied microeconomics text (such asTomek and Robinson, 1990) can be used as a basis for apply-ing economic thinking to issues surrounding water quality.

Who Would Benefit from Distinguishing DifferentWater Qualities?

Freebairn (1967) was one of the first to provide a de-tailed theoretical assessment of how consumers, with dif-

Table 2. Water Quality for IrrigationDegree of problem

Item Units none increasing severeSalinity (ECw) dS/m <0.75 0.75 – 3.0 >3.0Sodium (ECw) dS/m <3.0 3.0 – 9.0 >9.0Chloride meq/l <4.0 4.0 – 10.0 >10.0Boron mg/l <0.75 0.75 – 2.0 >2.0NO3-N mg/l <5.0 5.0 – 30 >30.0HCO3 meq/l <1.5 1.5 – 8.5 >8.5Source: FAO (1976) Water Quality for Agriculture, quoted inInternational Land Development Consultants (1981). ECw = electricalconductivity of water; dS/m = decisiemens per meter; meq/l =milliequivalent per liter.

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ferent quality requirements, may benefit from segregatinga product into quality groups. He argues that a set of dis-counts and premiums result from segregating a product.These premiums and discounts represent the amount aconsumer is willing to pay or forego for different qualities ofwhat was a homogeneous good, water. Changes in premi-ums and discounts over time and space reflect the differentdemands for the differentiated product over time and space.

If it is assumed that the costs of grading a product arezero, he concluded that all consumers would gain a Paretoimprovement from grading a previously ungraded prod-uct. In other words, all consumers are better off and nonelose if they can purchase the type of product with theirrequired characteristics, instead of not knowing what qualitydifferences exist. Consumers would pay a premium forthe product that possesses the characteristics they demand,and pay a discount for that that does not.

Alternatively, Freebairn (1967) argues that suppliersof a product may not gain a Pareto improvement fromsegregating a product. A supplier, who provides too muchof a product that is not valued by the customer may loseas their price is discounted, while others will gain from thepremium paid for the more highly regarded product. Thosesupplying water that does not suit consumers requirementswould treat water for the impurities that are not demanded,incurring the costs of treatment. If the cost of treatmentwas greater than the premium earned from treating water,then it would not be undertaken. Thus, some producersgain higher returns, while others receive lower returns. Itshould be noted that grading the product also improves theflow of information in the market, which benefits produc-ers. Overall, Freebairn (1967) argues that from a supplier’spoint of view, a potential Pareto improvement (one wheregainers could compensate losers) would exist as the gainsshould outweigh the losses. What this implies is that if thecosts of treatment are low or zero as Freebairn (1967)assumes, then premiums paid for water demanded by con-sumers would be greater than the discounts levied on wa-ter not demanded by consumers. This might still be the caseeven if treatment costs are high, as it may be possible to passa significant proportion of the treatment costs on to consum-ers as the demand for water is relatively inelastic.

Segregating Water into Different Quality GradesThe importance of the consumer in determining water

quality standards cannot be underestimated. In many cases,differing standards of a good are determined by suppliers,who have the technical and scientific skill to segregate aproduct. However, the value of the segregated product isdetermined ultimately by consumers. If, for instance, sup-pliers differentiate a product according to a set of charac-teristics that is not of interest to consumers, then nopremiums and discounts will exist in the market.

In a market like that for water, premiums and dis-counts for different quality groupings tend not to exist.

This is due to a variety of reasons, such as governmentintervention, market failures, and inadequate segregationtechniques. However, the absence of premiums and dis-counts in a market should not be indicative of the fact thatconsumers do not value the attributes of the product. Allthat is occurring is that their ability to express these de-mands is being suppressed. Analysts need to determinewhat these discounts and premiums are likely to be byusing techniques that reveal the shadow price for particu-lar grades of water. A shadow price is the price of a goodthat would result if it were determined in a free market,i.e. one that is free of taxes and subsidies and other inhib-iting factors. The shadow pricing of non-market goods likewater is a positive first step in providing policy makerswith the information they need to discriminate betweenquality differentiated products.

Even if consumers determine which quality attributesare important, the range of different quality characteris-tics can be immense. Some will be defined in an objectiveway (i.e. as parts per million, etc.), while others will besomewhat more subjectively established (i.e. tastes). Dif-ferent quality attributes can be typified not only accordingto type (i.e. taste, salt, algae, a pollutant, etc.), but alsowithin each type, by a multitude of measures. This leadsto a situation in which many quality types must exist forthe product water arising from the potential combinationof parameter levels (see Tables 1 and 2).

It must then be asked, if it is possible to group variouscategories together, while maintaining broad quality char-acteristic differences? If so, then any analysis of qualitydifferences would be significantly simplified. To do this, itshould be recognized that users can work within well-de-fined tolerances. It is only when a tolerance is exceededthat water is of no use to an individual group of users,even though it may be of value to another group of users.Also, it should be recognized that water quality is not con-stant. It can change over time and space and varied asdifferent users consume and discard water.

For purely explanatory reasons, let us assume that alla consumer of water is concerned with is a single impu-rity, say salinity. From Table 2 it should be noted that asalinity (electrical conductivity of water, ECw) of less than0.75 decisiemens per meter (dS/m) causes no problems.However, water which is graded between 0.75 dS/m and3.0 dS/m causes increasing problems, while water greaterthan 3.0 dS/m causes severe problems for irrigators. Giventhat consumers value water for its attributes, it may wellbe that by observing the range of prices over a particularquality characteristic range, like that for salinity, a groupof arcs is yielded (see Figure 1). At 2.0 dS/m, there ismore of a pollutant than at 0.75 dS/m. Thus, the priceusers will pay for water at 0.75 dS/m (P0.75 in Figure 1) ishigher than that at 2.0 dS/m (P2.0). Thus, the relationshipbetween the price and increasing amounts must be nega-tive, resulting in a downward sloping schedule. In addition,the points at 0.75 dS/m and 3.0 dS/m represent points where

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irrigators reach tolerances they cannot breach. Irrigatorswho grow salt-sensitive crops will not use water that isgreater than 0.75 dS/m, while those who grow salt-toler-ant crops can use water that is partially saline. However,beyond 3.0 dS/m, the water can only be purchased bythose who have no concerns with water that is saline. Theselevels (0.75 and 3.0 dS/m) are points of inflection, where thebehavior of buyers on each side of them is different.

If consumers can substitute water with differentamounts of the pollutant, within each tolerance point, itcould be the case that they mix water with different levelsof impurities to yield water with an average level of thepollutant. For example, if equal amounts of 3.0 dS/m and0.75 dS/m saline water are mixed, it would yield waterwith 1.875 dS/m of salinity. To calculate the outcome ofblending two different qualities of the product together,the difference between the two quantities is multiplied bythe proportions mixed, all of which is added to the qualityof the purest product (i.e. say if equal amounts of 0.75and 3.0 dS/m are mixed, then ((3.0 - 0.75)*0.5) + 0.75). Itshould be noted that the actual price of pure 1.875 dS/msalinity affected water (P1.875) is less than the price ofblended product (Pc). This arises because there is a costinvolved in blending. The difference between the two (P1.875and Pc) is the cost of blending. This leads to two importantelements. First, the price of blended water would be de-termined along a straight line between points between thetwo quality groups being blended (A and B in Figure 1).Second, as the price of unblended water is always belowthe blended product, as the tolerance points are approachedthe difference between the price paid for the blended prod-

uct and the unblended product reduces to zero. This wouldresult in the shape of the curve representing the pricespaid for the unblended product being convex to the origin,between the two tolerance points.

It should be apparent that anywhere between 0.75and 3.0 dS/m levels of the pollutant water can be com-bined into a blend and used. These two levels representthe upper and lower tolerances for a particular use. Whileit may be possible to blend beyond these tolerances, it isnot worth it as the blended price is greater than theunblended price of the product. If for example the usertries to combine equal amounts of say 2.0 and 4.0 dS/mlevels of pollutant containing water together, the averageprice (Pd) would be below the ruling market price for 2.0dS/m unblended water (P2.0). Thus, it can be asserted thatinflection points are a discontinuity that represents thebounds of tolerances which consumers will not breach.

If the arcs show the degree of substitutability within acategory and the ends of the arcs represent the tolerances,then it should be the case that the prices for water withinan arc move together. Yet, the prices of the water qualitycategories from different arcs should move independentlyof one another. This could easily be tested by regressionof the prices of pollutant-containing water against oneanother. If the intercept of this regression is not signifi-cantly different to zero and the slope coefficient is notsignificantly different to one, then the two different watercategory types must be substitutes. If this is not the case,then it must be the case that they are demanded by differentusers and their prices move independently. This is predicatedon the fact that different users have different uses for water.As a consequence, the premiums and discounts for differentquality characteristics of water will vary over time and space.

Determining whether different water qualities are sub-stitutes or not, simplifies any analysis of water quality. In-stead of assessing the impacts of all types of water quality,all that is required is an assessment of broad substitutablegroups. In other words, only one quality type within eachbroadly substitutable category needs to be assessed. Inaddition, changing supplies within a tolerance group canbe assessed, as changes in the premiums and discountsfor each group should reflect this.

Water quality standards usually involve a large num-ber of parameters. In the preceding analysis, it was as-sumed that a single parameter existed (in that case salinity)and that the remaining parameters were constant and in-significant. Expanding the analysis for more than one char-acteristic is not that difficult. With two characteristic, atwo-dimensional surface would be assessed and with morecharacteristics a multidimensional surface would result.

Once again it must be asked: What use is an assess-ment of the groupings of quality characteristics in a mar-ket where prices are constrained and premiums anddiscounts are not allowed to emerge? The answer to thisquestion lies in the logic underlying the analysis. In a wa-ter market, the tolerances of different end users are known

Figure 1. Deriving Quality Grades

P0.75

Pc P1.875

P2.0

P3.0 Pd

P4.0

0.75 1.875 2.0 3.0 4.0 dS/m

A

B

Price of water

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and usually mandated for by a government authority. Inother words, the ends of the arcs, those inflection points inFigure 1, are well defined. Water within each tolerancecan be blended and is substitutable. So in order to simplifythe analysis of water quality all that needs to be assessedis the price, albeit a shadow price, of one grade withineach tolerance grouping, not all the prices and types withineach grouping. Even if more than one set of tolerances isneeded to define a particular water use group, only oneprice within the whole grouping is needed, as long as it iswithin the tolerances demanded by water users. Why?Because of blending, one type of water is substitutablewith other types, the prices of all substitutable quality typesshould move together. From a practical point of view itshould also be asked if consumers are capable of blendingdifferent water quality types together. After all, such anactivity is usually the domain of a water supply company.While this is acknowledged, consumer blending is morecommon than most people imagine. Farmers along sew-age-polluted streams are not adverse to blending watertaken from the stream with groundwater. Farmers whohave access to more saline groundwater supplies areknown to blend it with surface irrigation supplies.

Assessing the Costs of TreatmentImproving water quality has an associated cost which

depends on the treatment process required. This can bebetter visualized in a double-entry matrix of quality andalternative uses (see Table 3). In this table, it is assumedthat each cell represents the threshold value for particularquality parameters. The cost of treatment to change thequality parameters that currently exceed the drinking wa-ter criteria (A1, A2, … An) to compliant parameters (B1,B2, ….Bn) for drinking use will entail the cost of all treat-ment processes involved. It must be noted that there aresome limitations to all the possible use-quality permuta-tions that are related to the feasibility of the physical bio-logical and chemical processes involved in modifying waterquality. For instance, it may not be possible to remove ni-trate and heavy metal pollution of groundwater such thatthe water can be used for drinking purposes. However, ingeneral water can be transformed from one quality cat-egory to another. Such water treatment processes are

something water authorities around the world have beendoing for decades. To assess the costs of treating water,changes in those costs and who pays for it involves calculat-ing the marketing margin between raw and treated water.

For the ease of explanation, it can be assumed thattwo levels exist in the market. The first is treated water,which is the transformed product and the second is forraw water, the material which needs to be treated. It canalso be assumed that the input for treated water is rawwater and that there is no market for water that is nottreated. Such a market has aknown supply schedule forraw water and a known demand scheduled for treatedwater (see Figure 2). In other words, the willingness tosupply raw water and the willingness to pay for treatedwater is measurable. Hence, they are known as “primary”curves. What is not measurable is the supply of treatedwater or the demand for raw water. These schedules areknown as “derived” curves, as they can be derived fromtheir primary equivalent supply and demand schedules. Theintersection between the primary demand and derived sup-ply schedules for treated water will determine the priceconsumers will pay the treated water (i.e. Pt). The pricefor raw water is determined by the intersection of the pri-mary supply and derived demand schedules for raw water(Pr). The difference between the two prices representsthe costs of treating water and all the activities involved in

Table 3. Cost of treatment for alternative uses of water according towater quality

Water Use

Quality Parameters

Drinking Urban Industrial Agriculture

Chemical B1 A1

Biological B2 A2

Physical B3 A3

Figure 2. The cost of treating waterQuantity of water

S derived

D primary

S primary

D derived

Price

Pt

Pr

Qw

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delivering the product to consumers. This is known as the“marketing margin” for the product.

Relaxing the assumption limiting analysis to just twomarket levels allows for an assessment of treatment costsindividually from other marketing costs. The analysis canbe extended to include not only a market for treated wa-ter, but also one for untreated water, in addition to isolatingdifferent components within each marketing margin. How-ever, it could be argued that the total cost of treating wa-ter involves the entire marketing margin, not just part of it.In other words, the costs of just treating water and theother marketing costs (such as the costs of reticulation)are one and the same thing. It should also be noted thatthere is a difference between the marketing margin andthe actual cost of providing the service, as the actual costdoes not include the profit margins and other incentivesfor treating water. The marketing margin may also includea number of price manipulation techniques, such as priceaveraging and price leveling (see below).

Understanding the marketing margins approach allowsanalysts to assess the effects of changes in treatment costson consumers and producers individually. For instance, ifmore water treatment is required, the increase in costsand its effects on producers and consumers can be mea-sured. This analysis can also be used to assess the effects ofprice leveling and price averaging (first expressed by Parish[1967] and later estimated by Griffith [1974]). Price levelingreveals the effects of keeping prices constant at one marketlevel, while allowing them to fluctuate in other market levels.Price averaging is the practice of subsidizing the sale of onetype of the product from another (say untreated water usersfrom higher prices charged on treated water users). Boththese cases are not unique in the market for water.

Even in a market where institutions set prices, themagnitude and distribution of potable and wastewater treat-ment costs can be measured. The issue of who pays ifwater is graded and then priced more efficiently accord-ing to the costs of treatment depends on the price andincome elasticities of demand implicit in the market.

Changing Qualities that Result from Use - theCase of Externalities

The very act of using water, even collecting it andtransporting it, changes the quality of the product. Manyof these changes have an impact on other users, many ofwhom are not compensated for these alterations in theproduct. This is the case of externalities, which, it shouldbe noted in the case of water, could be either positive ornegative. Negative externalities occur when one user putsa pollutant into the water that has an adverse impact onanother user who receives no compensation for it. Posi-tive externalities occur when a user adds a constituent tothe product water that has a positive impact on other us-ers and yet that user pays nothing for the privilege. Forinstance, if effluent runs off from one farm and into a

river, this could adversely affect downstream users whodesire clean fresh water. This case is typified by salinereturn flows from irrigation in the upper and middle reachesof a river basin impacting on users in the lower basin.Such a case is a negative production-induced externality,if the polluter does not compensate downstream users.However, if the effluent was a nitrogen-enriched fertilizerand the downstream users did not compensate the polluterand gained from it, then it would be a case of a positiveproduction induced externality. It should be noted that con-sumption-induced externalities, which can also be bothpositive and negative, also exist. For instance, nutrient ladendrainage water creates a positive externality if used oncrops by downstream farmers, but can also produce anegative-induced externality by creating an algal bloom inwater courses. But they are of less importance in this case.

To take the case of a negative production-inducedexternality, the most common case in water, a differenceexists between the private cost of producing a productfrom water, and the actual (or public) cost of that product(see Figure 3). The private supply curve accounts for allthe marketable marginal costs involved in producing theproduct in question. The public supply curve includes allthe costs involved in the private supply curve and addi-tionally the costs associated with the water pollutant. Thedifference between the two curves is often called the “ex-ternal cost” of the externality. The result of negative pro-duction-induced externalities is that the product producedtends to be under-priced and over-supplied. The oppositetends to occur with a positive production induced exter-

Figure 3. Externalities

External cost

S public

S private

D

Ppublic Pmarket

Qpublic Qmarket

Price of a good that produces pollution

Quantity of a good that produces pollution

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154 B. Davidson and H. Malano

IWRA, Water International, Volume 30, Number 2, June 2005

nality. The public supply curve is below the private curveand the product is undersupplied and over priced.

While the analysis can be altered to assess consump-tion-induced externalities, what is arguably more interest-ing is an assessment of the measures that can be used toameliorate the effects of this market failure. The aim is, inthe case of a negative production induced externality, totax either the water itself, the pollutant or the product pro-duced from the water to an extent that is equivalent to theexternal cost. This is known as internalizing an external-ity. Alternatively, Coase (1960) incorporated property rightsinto the analysis of externalities. He argued that externali-ties were nothing more than a transaction cost that re-sulted from governments failing to protect private propertyrights and that government should facilitate their unfet-tered exchange in markets. Both approaches, it should benoted, do not eliminate the effects of the externalities, al-though they would reduce it. Rather, both approaches ad-dress the concerns economists mostly have regardingexternalities. That is the fact that such effects are uncom-pensated in the market.

SummaryThe aim in this paper was to highlight the theoretical

thinking economists could employ to assess issues of wa-ter quality. An issues approach was employed to highlighthow some economic thinking can shed light on the com-plex questions associated with assessing water quality. Theissues surrounding who benefits from defining differentwater quality standards was identified, along with the speci-fication of how the multitude of different quality standardscould be aggregated into a few manageable categoriesand how the two important questions of assessing treat-ment costs and the effects of externalities were viewed.Thus these issues, important in themselves, serve also toreveal the benefits society can potentially gain by havingeconomic analysts gain a better understanding of how in-cremental changes in the water industry could result in amore equitable and efficient allocation of resources.

It could be argued that in a market with corruptedprices, what good is an economic approach to the problemof water quality? The point is that economics is but one ofmany approaches that could be employed. It provides asuccinct approach to getting at the heart of the problem.For instance, the importance of consumers in the processof determining water quality standard is most evident fromthis analysis. It provides the basis upon which all analysiscan be undertaken. Finally, it provides solutions to the myriadof problems that arise once one looks at the quality of water.

About the AuthorsBrian Davidson is a Senior Lecturer in the School of

Resource Management at the University of Melbourne.He has over 20 years experience teaching and research-

ing many different issues in agricultural and resource eco-nomics. Currently his research interests are in understand-ing and measuring how water markets deliver services tousers and how water can be shared between governments.Email: b.davidson@unimelb.edu.au

Hector M. Malano is an Associate Professor in theDepartment of Civil and Environmental Engineering at theUniversity of Melbourne. He has over 30 years of teach-ing, research, and consulting experience in irrigation andwater resources management. Prof. Malano’s primaryresearch interest focuses on water resource systems mod-eling and the integration of hydrologic and economic wa-ter allocation modeling. He has published over 100 refereedpapers international journals and conferences. Email:h.malano@civenv.unimelb.edu.au.

Discussions open until November 1, 2005.

ReferencesAustralian and New Zealand Environment and Conservation

Council (ANZECC).1992. Australian Water Quality Guide-lines for Fresh and Marine Waters. Canberra, Australia:ANZECC.

Coase, R. 1960. “The problem of social cost.” Reprinted in W. Brietand H. Hochman, eds. 1971. Readings in Microeconomics. 2nd

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Freebairn, J. 1967. “Grading as a market innovation.” Review ofMarketing and Agricultural Economics 35, No. 3: 147-62.

Griffith, G.R. 1974. “Sydney meat marketing margins – an econo-metric analysis.” Review of Marketing and Agricultural Eco-nomics 42, No. 4: 223-39.

International Land Development Consultants. 1981. Agricul-tural Compendium for Rural Development in the Tropicsand Subtropics. Amsterdam: Elsevier Scientific PublishingCompany.

Parish, R.M. 1967. “Price levelling and averaging.” The FarmEconomist 11, No. 5:187-98.

Perry, C., M. Rock, and D. Seckler. 1997. “Water as an economicgood: a solution or a problem.” In M. Kay, T. Franks, and L.Smith, eds. Water: Economics, Management and Demand.London: Chapman and Hall.

Pigram, J. 1997. “The value of water in competing uses.” In M.Kay, T. Franks, and L. Smith, eds. Water: Economics, Man-agement and Demand. London: Chapman and Hall.

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