EEP100 - Lecture 2 - Claire Tompkins

Uploaded by calcommunitycontent on 18.09.2009

Sorry about the technical difficulties and the late start. It turns out that there's
no Internet connectivity in here. I guess we
have a little over an hour for the class, and
my understanding is that this is the very first class other than some administrative
meeting that you had earlier. And that you guys are going basically going to be
studying (I think) microeconomic theory as it applies to resource markets and
environmental economics. So the style of this lecture will (I hope) be somewhat
interactive. You can stop me at any point and ask me any
questions I'll give you a little bit about my background
personally, so that you know what sorts of questions I might be helpful in terms of
answering. I am actually assuming everybody hereÉthis
is a graduate class? Is that right? Or this is an undergraduate class?
It's an undergraduate class! Okay! I'm really glad that you guys told me that.
Because I was thinkingÉI wonder if you're about to
all get ready to write a thesis, or if you're just sort of starting to get situated
in economics. So, I'll tell you my background isÉwhen I
was your age, I was in a similar class. I studied resource economics, did an engineering
degree at University of Arizona, and then I recently completed a PhD at Stanford
in the Management Science and Engineering Department. And all of my thesis
work was related to resource management. I was in an economic and finance
group there. And what I ended up writing for my dissertation
was a series of new pricing models for water. So turns out that you probably
know a little bit more about water resources, and it's an area that has been
very slow to reform. And there's a lot of complicated economic questions to do withÉhow
we should manage and price water. So that's the area of expertise that
I have. So if you questions, at some point, about water resources or the economics of
water then hopefully we'll touch on that during the lectureÉbut you can kind ofÉfeel
free to jump in if you have specific questions.
It's okay if we go a little bit off track, because my objective for the lecture is to
give you a sense of research level questions and
how economics plays into making decision in real resource markets.
And then to give you kind of an opportunity to ask things that are on your mind.
David is going to actually take you into the microeconomic theory, so you learn
some of the foundational stuff you need for working in this area.
Just really quicklyÉwhat sort of majors are you guys? How many of you are
engineering majors? Earth sciences? Biology? Okay, what are some of the other
majors that I'm missing? [Environmental economics and policy]
Economics and policy is a majorÉso econ/policy. Okay, I thinkÉso maybe there's a
lot of undeclared people who are in the room. This isn't the exact lecture I'm going to
give you, but I'll start with a more general view of what we think about when we think
about resource markets So one of the things that you're going to
be studying a lot of over the next couple of
months is the idea of the market. What comprises a market and why we have to
care about markets. Why markets exist and why they don't exist.
So I guess the first concept is the idea of trade. So, what does it mean to have trade?
And here there's basically a set of economic principles that determine when you get
trade. You need two things for trade. This actually is important; I'll quiz you on it
at the end. No, I won't quiz you. I'll ask you
at the end. So, which one of these can you see best? This
one or this one? Or are they equally as bad for some people?
You guys can see this one really well. It's opposite. Okay, well bear with me, I'll tell
you what I'm writing. And I'll probably erase things as I go along. Is there an eraser
maybe? So the first concept is definitely trade.
This like the foundation of, the economic foundationÉwhat we care about in resource
markets and all markets. And turns out there's two conditions that are well established
in economic literature that determine when you get trade.
The first one is that you have to have property rights.
The second oneÉdoes anybody know the second one? The second condition? You
guys can participate if you want. If you're really shy, that's okay.
[Legal system] Legal System? UmmÉthink about just between
two peopleÉwhether or not there's a legal system. But, yeah, I'd say property
rights come out of a legal system. You don't have one without the other usually.
So that's true. You know, that's the reason trade breaks down and society and corruption
and so forth. So those are very tightly coupled principles.
The second one that I'm thinking about is actually kind of the obvious one, which is
you have to have a difference in value. So you might call it a delta. Two things, right?
So, I have a very large store of Easter candy, and you don't have any candy. So
you're willing to trade me something for candy. There's a difference in value. Sort
ofÉ I want something that you have. And those two things are actually the tenants
of trade. If anybody asks you in sort of and Econ 101 class what do I need for trade,
they'll be looking for these two things. And that all comes from what we would call
the Coasian Doctrine, which was of course Ronald Coase.
Okay, so now, that's already just one complete concept, which is sort of foundational
to what we're going to study: trade. So that all seems pretty clear; I'm sure you've
probably heard something about that before.
Now here's another conceptual question that moves into the discussion about
markets. Can you ever have 1 and 2, and still not get
trade? Is there anything that might prevent trade? If I have a property right
(so it's mine to sell) and you want it more than I want it so you're willing to pay me
something for it. Is there a reason why trade might break down?
[Tariffs, or government interference?] Yeah, that's excellent, that's brilliant.
So everybody's got this right? Sorry, guys in
the back: can you kind of see this? I need like a foil to do the opposite note
taking. I feelÉokay how bout this. I'llÉ really you just need to knowÉyou need to
have written down these two things hereÉproperty rights and then a difference
in value. And then just to be fair, I'll switch boards at some point.
So now we've got trade. Now when does trade break down? This is what gets to
markets. And that's what you just said. This is the formal economic term: it's when
we have transaction costs. Just a show of handsÉI'm trying to gauge
how familiar you are with these concepts. Is transaction costs something that people
talk about a lot? That you are very aware of? Or is this new jargon for you?
Okay, if you're really aware of it. Okay...kind ofÉokay so maybe this is a new
concept. Okay so transaction costs; let's try to list
a few things that are transaction costs, because these are really important.
One of them is tariffs. That's an excellent one. So basically some sort of tax. You can
think of it as a sales tax, any sort of tax. What else? Give me another example.
[Quotas] Quotas. what are you thinking there?
You're saying that there's a regulation that sort of saysÉyeah that's
true. Let's put that into a slightly separate categoryÉwell no. Let's put it here. Regulation.
A good example of a regulation might be: I want to trade some water. And if I want
to trade water with you, it turns out that the government says: "you've got to do a
full environmental review before you give water to her."
And the transaction cost is high because you're going to have to pay for an expensive
environmental review. So that's a really good example to have regulation.
Okay, anything else come to mind? [The physical cost of moving it?]
Yes. Perfect. That's great. Transport. And let's say transport and delivery, maybe.
Sometimes there's a delivery cost. Anything else anybody's thinking about? I'll
just keep going till we run out of ideas. [Communication barriers?]
Yes, now say more. [A language barrier perhapsÉexpensive communications,
like if you're in a remote village somewhere, you can't exactly sell
your homemade baskets on the world market] Yeah. So that hasÉperfect. Now we've hitÉyou're
going to get a lot jargon today. Sort of likeÉfirst year med-students. They
increase their vocabulary by some 12000 words.
Here's another piece of jargon, which is what we call, in economicsÉsearch costs.
And you kind of actually hit on two things. You hit on search costs and you hit on
information costs. And they're really related. Economists use them with slightly
different ideas. But the search cost isÉyou want to sell me
your water, and I want to buy your water, but you live in Wichita, and I live
in Chicago, and we don't know each other. So how are we going to find each other? And
it turns out when you go into the market, and you start looking for someone
to trade with, it's expensive. It could take you days. Those days translate into lost wages,
etc. There's a time value of money. And so thatÉ
And the information costs areÉwhat additional information do you need to hunt for.
And that information cost might include reputation. Are you going to trade with
someone who you think might come back and say, "Oh, I still own that"? Which ties
back to the property rights issue. Is that it? Is there anything else you can
think of? [Administrative costs?]
Yeah, administrative costs. Admin costs. And I think you guys might be able to
come up with a few more good examples. The last one I have is "legal costs". That's
sometimes related. But that's exactly it. So what happens if all of those things add
up to a really large amount? Then a lot of times markets break down, and you don't get
trade. You don't get trade for really rational reasons, because if the transaction
cost is higher than the value of trading in the first place, then clearly no one wants
to trade anymore. But the point I'm trying to get at here is
that you start in this perfect environment where all you really need is the property
right and a difference in value. And then the world around you imposes a huge laundry
list of transaction costs that actually end up determining whether or not you ever
get a functioning market. So these three concepts. If you take this
away from the lecture, then I've done more than I intended. Basically: starting with
the idea of trade, understanding that there's transaction costs. And then, does everybody
kind of have this list? That will bring us to the next concept, which
is markets. And here I'm going to draw you a nice little
diagram to show you how a market works.
So this is the third concept, which is a market. So we've gone from trade, which
could literally be just two people and transaction costs, to the idea of a market. So
when I say marketsÉthere's a spectrum of markets.
You can either have a really, what we call, a liquid market, where people can trade
very easily or we can have an illiquid market, in which case it is very difficult and
there are very few transactions. So a very mundane example is the toothpaste
market. Does anybody have trouble buying toothpaste? No. I mean, you can go
ahead and buy toothpaste anywhere, anytime, and you know exactly what you're
going to pay for. On the other hand, what about resource markets,
which interests all of us? If you want to buy timber, or you want to buy water,
or you want to buy land to a degree, or some form of energyÉthose markets can
be a lot more illiquid. And I'll explain, in
part, the conceptual market behind that. So here's the foundation of the market, which
is already what we've discussed. It's basically property rights. And the assumption,
if you have a market, is that there's some value to trade. So we start with property
rights, which is what you pointed outÉit is also the legal system. So that's
what you start with. Thankfully in the US we
have a functioning legal system. Then you come up here, and you really have
two choices. I'm going to ask you for a couple examples. But you have basically, here,
what I would call, Distribution Points. And over here you have, what I would call,
basically, a clearinghouse, which is an auction, which is sometimes called a central
clearing house. Okay? And then you come up here, and you basically
need is transportation, and that's part of the cost. So, transportation and delivery.
Sorry, I don't have great handwriting, which is why I tend to do PowerPoint for you
guys. SoÉjust to read what this says. So the foundational
property rights (you know, trade).
Here, two choices of structure. One is a central clearinghouse and the other is a
distribution point. These are the two different sorts of models when you build a
market. So when I say this, I'm thinking about all of us as a government body, and
we're going to help design a market that we think should exist.
So first we're going to make sure that people can trade. Then we're going to figure
out what the mechanism is (what the physical way they connect to each other is).
And again, this is dealing with search costs, right?
And then this is going to be transportation and delivery. So then, quick question
then. What are some examples of the model, this model of the central clearinghouse
or auction model? So think about a marketplace that uses this
model. It's an auction-based model. [Would e-bay fall under that?]
Yeah, yeah. E-bay is a great example. E-bay is the best example. It's the biggest
example. And a lot of times when I think of this (central clearinghouse auctions) I
think of online auctions. But in reality there's a lot of auctions that
aren't online right? So foreclosed properties would be a good example. A bank
holds an auction, and you physically go farm auctions.
There's lots of examples where people use the auction method. It's a good way to
get people together, and they can bid the value of something.
The nice thing about online clearinghouses is that you can have sort of dual sided
biddingÉyou can have sellers and buyers placing bids, which is an efficient way to
clear a market. So e-bays a good example in the resource domain.
Yeah go ahead. [Would that be like a commodity exchange too?]
Yeah, commodity exchange is another good example of a central clearinghouse.
There's a nuance to that. That's good to discuss. That relates with transportation
and delivery. That's also a good example, yeah very good.
So we're familiar with that model. Commodities is good. Another good examples
from the resource division isÉactually, if you go Google tonight, you'll find they're
actually online market places for timber, for instance, and it'll actually show up on
Google or show up on a website, and enter into an auction to get a certain number
on a lumber delivery. Same for some other resourcesÉI guess that there areÉI'm
trying to think of some good land auctions sites. Maybe not that I'm aware of, but if
you come across them, you can let me know. The distribution point model is the one that
we're much more familiar with. Does everyone just want to give a random example
of a distribution model, I meanÉ [Retail]
Yeah, retail. It's basically everything that falls under retail. So your Safeway, your
gas stations, your Walgreens. Everything is the distribution point model.
That basically begs the question: why do you choose the clearinghouse model over a
distribution point model? And that's kind of an open question; I'm not suggesting
that there's a really firm answer. There are clearly two different ways, or at least
two different ways, to build a market. So how do you choose? If you're the government
body and you've been toldÉ"Set up a market. We really need a market to make
this area efficient", how do you choose between doing a retail model, and saying "okay
we're going to have retail points, we're going to sell this stuff." Or we're
going to do an online clearinghouse. Is thatÉ [I think if you have more instability in the
supply and demand you might [inaudible] just because that way they can be more reserved
byÉif there's less supply then you're going to have to pay more [inaudible] so it
works in both directions] Well, then, you don't have the overhead of
having to store, right? You don't have the distribution point that you can't stock, yeah
that's really good. Okay?
[Maybe the purpose would be different. For example like, if you want to create more
jobs for people perhaps? Then you would want to choose the distribution point so you
can hire more people for retail versus the online thing, where it's just a Éif you want
to buy something you just go directly to itÉthere's
no like functioning or operational cost included]
So you're saying that it might beÉyou might want to have a higher labor component
to itÉlike the labor cost is higherÉ [Like if that's your purpose, so then you
would shift more to like, retail idea] Or what if it's customÉlike a person has
to be there to show you how to use itÉokay, so certain things are fit in the labor model.
Or maybe if you want more labor, you want more of the distribution point model,
okay that makes sense. [What if? I keep thinking commoditiesÉwhat
if you're dealing on like a world scale with different currenciesÉlocationsÉwould
it make more sense to do the clearinghouse?]
To do the clearinghouse versus the distribution point? I mean well, say more
because you have like multinationals that distribute things to distribution points all
over the placeÉ [I mean, with my exhibit, you kind of need
to have one priceÉthat's my understandingÉso people need to get from
all over the world and that may set a world price]
Yeah, yeah, yeah. So having the central clearinghouse allows you, basically, to
facilitate global trade, right? As opposed to the distribution pointsÑdoesn't allow
you to have global trade. So for things that you're moving large amounts of, like
commodities, you want to be able to do the clearinghouse and have globalÉyeah
that makes perfect sense, I agree with that. [I guess for things that have set pricesÉlike
for the distribution point you have someone sets the price on something. You're
notÉyou knowÉI'm going to go to the store and bid myÉyou knowÉmy rights on it.
So if you wantÉ] Yeah, so if you're the one who wants to have
a fixed price model then you also want toÉokay, yeah. So there's a price involved,
right? [I think that it would beÉfor a lot of daily
necessities it would be very inefficient to have a central clearinghouse because it takes
a lot of time. Say, for example, for a housewife who wants to go buy toothpaste,
she doesn't want to spend ten minutes bidding with the housewife next to her for
the toothpaste, so it's easier to just say it's
fixed] Yeah, that make's a lot of sense. That's a
perfect example, right? SoÉanybody else want toÉyou can chime in late tooÉ
So, sort of characterizing what we've said so far. For certain things, it's actually
really intuitive to know which model works partly because we observe the world
around us. So, as you said, I would say distribution pointsÉyou know, basically
looking at things thatÉthe demand is somewhat more stable. Right?
Because you've got overhead wherever you have your distribution point. You've got
warehouse overhead and you've got labor overhead. When you've got pretty stable
demand, no one's going to stop buying toilet paper, no one's going to stop buying
toothpaste. You know, it seems like video games are pretty robust. You know, if you
have a really strong market then the distribution point is really appealing.
On the other hand, if you have the fluctuating demand or let's say a fluctuation
supply, then perhaps you want a clearinghouse. Now someone help me get to the
next part, I'm talking a weeklyÉanother piece of jargon that would describe why
you might want a distribution point versus a central clearinghouse?
So one of the big differences here is price stability, right? So how much does the
price of toothpaste change? It changes a little bit; it doesn't change a lot.
And so I guess my point here is that the supply and demand aspect of each of these
markets determines price and it also gives you an indicator as to which model you
think is the best fit for that market. So one thing is going to be supply/demand.
You're going to think, if I own toothpaste manufacturing facility, demand is X
thousand tubes from day one until year ten, and I have all the ingredients that I need
and you have a model that fits very nicely into some sort of distribution point.
But if you have a commodities exchange where the amount of wheat you have
available each year changes. And crop substitution happens. And you have to move
large volumes. Then you basically have to have a more clearinghouse model. It
turns out that for our purposes, in terms of thinking about environment and
resources? Clearinghouse models are dominant in that environment resources
space. And then I want to get to this last piece
of the picture which is the transportation/delivery component because
of your pointÉyou don't want to be payingÉthere's cost here. And so the method
of transportation and delivery also determinesÉthis is really two wayÉ
So the transportation and delivery also determines whether or not you want a
distribution point model over if you want a central clearinghouse model.
So I'm going to try to think of a good example here.
Well, I'll give you two different resource examples. And both of them use sort of a
clearinghouse model. At least they should be using a clearinghouse model.
So on the one hand there are central auctions for timber--online auctionsÑso in
which case if you win that option you just basically get a large semi-truck that
delivers the timber to you. And the transportation is, you know, it's
fairly routine, and so the clearinghouse model is driven a lot by not wanting toÉthe
cost of transportationÉyou don't want to pay to take timber to one destination if
there's no demand for it there. So you do a
clearinghouse model, and you ship it where it needs to go.
On the other hand water, which I'm going to talk about in more detail in the second
half of the lecture, doesn't have an easy transport mechanism. You can't sort of
truck itÉwell people do truck it but it's very, very costly. So what you end up
depending on is infrastructure that's basically state-owned or federal owned
infrastructure. In which, again, you have to use this central clearinghouse model but
you actually end up having to factor in accessibility of transport.
So if you understand these three parts of your problem. If you want to sell out of a
market of anything, if you want to sell anything whether it's some sort of basic
commodity or some sort of environmental resourceÉif you can answer these three
componentsÉ If you can say: I've got well-defined property
rights, I either want clearinghouse model or distribution model or retail model
(this is definitely retail), and I can figure out how the transportation (which is you know,
like everything else)Éit is a big component of costÉ
Then I can decide, I can basically design a market...
Okay, so that gives you different parts of a market.
So I'm going to call this market design one. So far we've done trade, and we've understood
that there's transaction costs that affect whether or not you even have trade.
And then if you have trade, the transaction costs can be somehow low enough,
perhaps, through building a market that you can get a fully-fledged operating
market. So now we're going to transition, and talk about an example that I think I know
a lot about after I spent several years studying it, which is the idea of water markets.
So I'm sure that in the course of this semester you'll actually learn a lot about
different environmental and resource markets. Water markets are an area that is
starting to develop in several parts of the worldÉin South America, Australia, and
actually here in California. We're starting to see the emergence of water markets.
So now I've given you very basic tools to think about how we could design a market
or what it takes for a market to exist. So I think, well, what would be helpful is
to do sort of maybe a case study and so I'll poseÉwe'll do it in two parts. And the first
part, we'll think about why water markets don't currently exist. So we'll do
a little bit of investigative work to seeÉokay, why don't they exist?
Then the second part we'll sort of say, okay well what would it take for a market to
exist? And the reason that this is sort of generally relevant is because when you go
out into the greater wide world, you're going to be faced with a lot of situations,
especially if you work in the environmental resource policy, there's real market
failures, and when they ask sort ofÉhey, well why is this failing more, or what could
I do to fix it, and what am I going to need to take into account if I'm going to design
a well-functioning market.
So, I call it Market Design One because the first part isÉwe've arrived on the scene
and we're all in California. And how many of you are familiar with California's water
"problems" or issues. Pretty rare? Okay, so you tell me what do you sort of think
is the problem, or what are some of the problems with water? Okay? Go ahead?
[We've been having a drought recently soÉscarcity of water right now?]
Okay, so maybeÉoh shoot I almost need two boards. Do you want to do problems
over there? I know everybody can't quite see, but we'll make sure we read.
Okay, so we'll start with the problems and and then we'll sayÉwhy isn't there a
market. Okay, so one problem is very short-term, it's the drought. So there's not
enough water. [So there's always been a shortage of water
especially since the Central Valley during the 1940s, 1920s]
Oky, shortage of water. Okay maybe, sort of, there's increasingÉthere's more
demand for water? Like there's increasing demand so thenÉyeah okay.
So I'd say demand greater than supply, maybe? [Only service water is governable and ground
water isn't] So the legal issue. It's a legal issue that
affects water resources, right? So we have really savvy stuff about what you can do with
the water that we see, and the water that we can't seeÉno one's regulating it.
Very, very important. [So in California there's a larger population,
but not a large enough natural water supply?]
Right, yeah, so there'sÉhow do we describe that. That's, there's kind of a disconnect
between where the water comes from, and where the water is needed. Correct. So
So Cal has high demand but no water. The opposite is true in Northern California.
And that has some political implications too, right?
[So we have established a baseline for how much water California has during the
extremely wet period, over it's history. So what we've considered the baseline was
actually really wet. So it's not a drought, it's more of the actual average. Over
historyÉ] So that affects people's property rights.
People thinkÉokay soÉ [We made rights for more water than what was
actually available, and then you call it a drought because it's less that what we're
having] Yeah, that's a really important one. So I
would call that over allocation in California. So, a lot of legal problems that we're touching
on together. Okay so, anything else, sort of, come to mind?
[Transportation problems arise] Yeah, so one thing we have to take into account
as a society is that we have to take the cost of transporting water. So this relates
back to your pointÑthey're really closeÑthat Southern California and Northern
California. There's also transport costs, and I think
the transport part has some other dimensions because when you transport water
there are some losses; some of it evaporates, some of it seeps out of the canals
or the piping. So the transport of water, the costs, and the actual losses in
the system are really concerning. Anything else?
[Clean water? So it's not contaminated] Yeah, pollutionÉdo you have anything specific
in mind? Like chemical pollution? [High nitrate concentration?]
Okay, so fertilizer runoff, high nitrate concentration in water. So ag-pollution is one.
What aboutÉso have you guys been reading a little bit about increases in sea levelÑ
we're getting salt water intrusion in aquifers. So places along the LA coastÑthere's
now salt-water intrusion. So if you used to have a well that you use
to pump water, now you're pumping, instead of nice, clean, portable water, you're
pumping salt water. So we should include salt-water intrusion in aquifers.
There are a few other climate change ones. I don't know if people want toÉ
[You get a lot of leakage from, say, gas stations] Yeah, so another pollution might beÉwell
it's a good point. I don't know if we should distinguish between the two, but there's
surface water pollution and then there's ground water pollution. And in general,
we're just concerned about the quality of the water instead of multiple cannons.
Okay, anybody else? [Does an interest conflict, for example between
fisheries and agricultureÉlike people who want to grow food; they'll pump water
out of the river. But then people who want to fish will want the water to stay in the
river so that the fish population stays stable?] Yeah, that's exactly right. So it's slightly
legal and sort of a competing resource maybe? We should certainly note that one.
And you're probably thinking of that oneÉit was about maybe four or five years
ago, there was a [inaudible] bayÉor [inaudible] fish disaster with the farmers
wanted to irrigate their crops. This is in [inaudible], so up in the East, sort of Washington
area. And they basically convinced the regulators to allow the water to flow
to fields. There was a massive, massive death of fish. So all of the salmon died in
that particular river. Do you remember the political coverage of about a couple years
ago? People showed up in DC and put dead fish all over the white house lawn. There
have been major, major scandalsÑ big fish kill.
So yeah, competing resources. Some dispute over who actually has right to the
water. There are a lot of legal issues that we're hitting on. Anything else you want
to add to the list? [It could be a legal issue of water subsidies
for agriculture.] Okay so, but why is that a problem? Let's
say more. [If they can pay a lot less, because they
can [inaudible] or something like that, they can
out-produce the other producers who have access to water]
Okay, yeah so you're hitting on an important issue, but I think it's sort of a pricing
issue. They're not payingÉpeople are notÉthey are getting cheap water, so they're
probably using too much of it or not using it economically. Whereas if they were
facing a real priceÉ if they were paying more for their water do you think they
might install drip irrigation and use it more efficiently maybe?
So there's some pricing issues and subsidies are definitely a problem, but they're a
problem because they distort the price of water.
Okay I think that's a really good list. I'm trying to think of whether I want to add
anymore. I mean, there's a couple of other climate change things that are going on
that people who regulate water care about, so if you look at histograms of the
probability of flow of different points in a year. You'll see that it quite a bit. So
now our snowmelt occurs is moving a couple, up
to a few weeks or a few months earlier than it used to. And you sort of think: "Oh
well, what's the big deal?" But the way we manage our reservoirs is: we usually store
that water and then we release it later in the summer. But if you get the water
a lot earlier, you can't store as much. And this is a little bit of problem, but you
can't store as much water because what if you have a big storm and there's a flood?
So you need to reserve room in your reservoir to capture extra storm water. So if
you have a snowmelt later in the season, then you can actually store more of it.
Whereas if you have it earlier, you have to worry about rain and storms, and you
actually have to let more of it go downstream. So your reservoir level gets lower,
and the cause of that is actually just climate change. It's cause of global warming
which then melts the snow earlier. So that's another climate change impact
thatÉalthough California's not getting less precipitation (we're not getting less
water) right now, we are seeing an effect of the timing of the water we receive, and
that's messing up the system slightly. [I guess another problem I can think of is
other environmental problems that you have toÉlike if you're in the waterÉif you're
dealing with the cleaning of the water and distributing it and other stuff you could
deal withÉlikeÉsomething my dad has to deal withÉlike killingÉlike infestation of mussels
and stuff like that? Like the clogging the pipes. And I guess that would increase your
transportation costs because you have to get rid of musselsÉ]
Yeah, so I think that we have a lot of stuff about the fish and farm tradeoffs. We have
to put in invasive species that are changing the natural systemÉchanges to the
natural system are problematic. And then I think we should also include endangered
species because it turns out endangered species really affect how we manage our
waterÉthat's another legal issue. So you can imagine now. I don't know if any of
you are thinking about maybeÉcareers in water management, but this is a long list
of really difficult problems that we have to solve. Okay no we have aÉI don't think
that it's exhausted but it's a pretty long list of problems.
So I'll put it back into a narrative form again. So ten years ago, when I was in
University of ArizonaÉit's a desert, so lot's of water problems. As many, if not more
problems than California has, although less people. And I was starting to think
aboutÉwhat are some of the solutions to all of those problems? And there's no one
solution, of course. But there's different things that have been proposed in terms of
ways you can help deal with the system. So here, I'll present a couple of different
positions that have been touted in the academic world as solutions to some of these
problems. You can give me a little feedback if you want to on how appealing the
different solutions are. And then there's one in particular that I like to talk
about in more depth. So the first solution is back to your point
about pricing the water. There's a group of economists that have said, "Look, all of those
things on that list over thereÉthose problems/issues? All of those are externalities.
They're all problems with using water. They're not priced."
So an externality, classicallyÉis that a familiar term, by the way? Yeah, I figured
this was a super familiar term. So all of those
things are externalitiesÑmeaning they're not priced in the current market for water.
So here's one example. Why don't we just look at the price of water and raise
it significantly, so that some of the costs are
accounted for. We can raise it in a couple of ways, but we can raise it so we can
basically decrease demand. So we use less water. We can also raise the price of
water and set aside some of the funds used to buy water to go and help some of
these problemsÑto go and help with the fish and basically do some
remediationÉdeal with the competing resource issues, etc.
So one of the views isÉraise the price, and a lot of the problems will disappear.
Second group of economists say no. The price mechanism, externalitiesÑthey're
really hard to price. We don't really exactly know how much the life of a fish is
worth. We've got some studies that say fish are worth a lot, but there's not a big
consensus. So you cannot try and raise the price of water arbitrarily etcetera. What
we should do is come up with a really complete regulatory framework. We should
get the 100 best scientists in the country, and we should come up with new laws.
We should regulate ground water. We should decide actually how much water stays
in the environment, exactly how much those two existing property rights hold is.
We should determine exactly the permissible pollution level is and we should fine
everybody who pollutes, and we should monitor much more extensively. So we
should this entire regulatory approach. We're just going to completely overhaul the
system. [Are you saying that they're rationing the
water to these persons or justÉ] Well in the regulatory framework, it depends
on how much water there is left after we impose all those restrictions, but there'd
be some rationing. Under the proposed regulatory solution we
might end up taking or you might end up confiscating water. So I don't know if
you want to think that it's necessarily for sure rationing, but one thing that's already
happened, right, is that we've taken some water from the farmers in Central Valley,
and we've put it towards environmental uses. So you can sort of think
that under the new regulatory framework, maybe the farmers get a little
less water, maybe the fish get a little more water. There's probably, any way you look
at it, going to be enough water for humans, of course. But maybe we have to pay
a little more for the water under the regulatory framework. But again, let's think
of it more as a pure regulatory framework, so taking the whole amount of water
we have at stake, and deciding scientifically what's the best way to allocate
that water. And then your eyes are supposed to be getting big because you're
thinking, "How is thatÉhow would it ever be possibleÉand that's of course one of the
problems." [Wouldn't that be really hard to do because
basically everyone exerts some sort of national security rights over water? Because
I know you have some countries, like I had to do this study for another classÉwhere
Jordan, like 70 percent of the country of Jordan's water supply goes to farming, which
is only two percent of it's actual GDP. But it's still considered vital to do that
so that they are self-sufficient.] Right, exactly. So they're food independent
right? [Yeah, so I know that they're using all their
water for farming and even though they can get that food for a lower cost outside.]
That's a really good point. And so that's something that comes up a lot when people
talk about how water should be allocated, and something actually that I changed my
opinion about, in the process of doing my research, was the value of being able to
maintain farming in California for instance, which does feed a substantial part of the
US. Anyway, with both the first solution (where
you have to price everything) and the second solution (where you develop this massive
regulatory framework), both of those are, understandably, really ambitious
and really difficult. And so a term that people often use here is they say its massive
institutional resistance, and part of the transaction costs you have in either of those
systems is very, very high because you are going to get a lot of political resistance
to do neither of those systems. And that's the political, and you're going to get a high
overhead in terms of amount of study and knowledge that you need, which we need
anyway to understand the system. But just the additional knowledge that we
need to be able to price things well makes it almost impossible to be at that level.
So one and two are both things that have been proposed, they're actually actively
discussed. But they both sort of meet with some skepticism on the part of the really
applied, really pragmatic economists or really pragmatic policy makers. They're just
inherently problematic. So then there's this third solution, which
is not a complete solution, but has really been actively discussed which is the idea
of "what about creating a market for water, so that we can just get more efficient trading
between people who want to use water without having toÉyou knowÉthe price will
be increased, but we don't have to regulate it in quite the same way. And we
don't have to confiscate property rights, which will face massive political resistance,
but we can actually start to change the way it's allocated. So I think that third
design, that third solution, seemed really appealing to a large group of ag-econ or agricultural
economists and water economists and so forth.
So it turns out about 30 years ago, there was a big drought in the state of California
and the mayor had a blue ribbon panel and they wrote the document. And they said
"Let's establish a water market in California, it'll solve a lot of our problems." And
that was 30 years ago. So no one in this room was born I'm sure. That was the
predominant idea at the time. So that leads us to the third part, which
is, or the next part, which is my question to
you. Now that we understand some the problemsÉwell now let me phrase it in two
parts. What are your reactions to the proposed solutions? Does anybody want to
have a reaction at this point? A strong reaction? At this point, a strong reaction?
[It's not a strong reaction butÉhow would you create a market for water? Would
youÉ] Well that's something we should talk about.
So the question is, well that's presented in a slightly biased way, right? Saying, pure-pricing
is very hard. Pure-regulation is very hard. And doing a water market is doing
a compromise, but it's taken 30 years and we still don't have a water market in
California so my question to you is, why don't we have a water market in California?
[I guess if we had a water market would that exclude a lot of people? Like if you were
to have a market for water wouldn't there be people that maybe couldn't afford it?]
So yeah, one of the things is definitely [inaudible]. Now to make it a little bitÉI don't
want to say simpler. But how is water distributed in California right now. Basically,
think of the snowmelt or the sources of waterÑrivers or streams. Then underneath
that, there's a band of what I would call intermediaries, and they're things like water
districts. So there's a Sacramento water district and there's a Berkeley water
district. There's the metropolitan water district, which supplies a lot of water to
Southern California. So there's the natural source, then there's intermediaries, and
then there's us, the residents. And we use water. We get the water from some
water utility, right? It's just like an electricity utility. So don't think of (at least at
this point of the discussion)Élet's not talk about a water market where you or I go
online, like the toothpaste lady, and actually try to buy water in the morning.
Think about it more as the water intermediaries being able to trade water. So think
of it more of a district in the farming community could trade water with the urban
district. So that way you can get away from the problem
of not having water, because everybody within the district is getting supplied.
And just as a benchmark, there's (last time I checked) more than 300 water
districts in California. So I'm talking about trade, but between a group ofÉit'll
be like companies being able to trade. [Just to back a little bit to get perspective.
I'm curious that you said that these are the views of two groups of economists. Are there
also free-market economists saying that we should do nothing? And where does that
fit in? Like percentage wiseÉ] Well the free-market economists would be in
favor of the market solution. I think we're going to get to that
[Well free-market meaning, let it just take care of itself. Don't create a marketÉ?]
Well the free-marketÉneoclassical free market economicsÉthey would be in favor
of establishing markets and then having to limit regulation of the markets.
[Who would be the people that would be in favor of not doing anything?]
Well, people who would be in favor of not doing anything would be like [inaudible]
I mean, as in, there's a recognized problem. So I'm not sure if I've come across that
in academic literature. There's not very much discussion of "well there's no
problem" or "this doesn't exist". [Not that I'm advocating, I'm just curious
to know] No, that's a good thing, are there people
say that this thing is fine, that there's no
problem? No, there aren't very many people who say that this thing is fine. But in
terms of market design, the free market approach, which is actually being tried out
in Chile, would be more the anti-regulation. And there'd be another branch of
economists that would say, "Let's build a market, but let's really carefully regulate
it." And they would say that all markets are subject to market failure, and so that all
markets require regulation at some point. [Who has the property rights to water in California?]
So the property rights in California are what are called applied-appropriation rights.
So there's two different doctrines of water rights or water law in the US. East coast,
they're more of what's called vicarian rights. And a vicarian right is established by
basically being in proximity to the stream and removing water from the stream. And
so once you're removing a certain amount of water and if you own land that's on the
stream, then you have the rights to that water. Does that make sense?
In the west, in California, we have applied-appropriation rights, which means
they're first come first serve rights. First in time, first in right. Some people moved
out here in the 1800s, gold-rush period, and farmers moved out hereÉthey started
using water and whoever started using it first had the right to it. So you can imagine
that the way California is structured nowÉthe water rights are held
byÉpredominately by farmers and people who started using that water for
agricultural purposes before there was LA, before there was San Diego. And the
water rights that now belong to San Diego and LA and so forth are considered junior
water rights. So everything is based in time. So if you have a drought, and you have
an 1890 water right? There's no drought. There's always enough water to fill your
right. 1910Ñalways enough water. 1960Ñalways enough water. 1980Ñyou
might get cut. So a lot of cities in the western US that have more junior water
rightsÉso what economists noticed is that a lot of cities pay a lot for water, and they
value water really highly. But they don't have rights for water, at least not older
rights for water. So that's how we get to the idea of markets, right? Because what if
you can change the allocation, or what if a city can now buy older rights?
[I just thought about a really bad situation. What if there was a drought and it was
more profitable for farmers to sell all of their water rights to Southern California
versus growing crops. Would that be a potential problem?]
To sell all their rights to Southern California? Yeah, so that would be a problem in
terms of food prices or in terms of security? So in terms of food shortages. So you had
a water shortage, and now you have a food shortage. Absolutely. It definitely could
be a problem, but bear in mind. The economist's answer to that would depend on
how well food markets work but if you're a farmer and you're going to sell your
water and it's a drought. I'm sorry is the food shortage anywhere else in the world?
Or anywhere in the US? The time that you have between when you use that water and
when you have a profit is about three months. Very short. So if the price
of rice is very high because there is a food shortage, then you're going to grow rice.
So there's already an automatic price system that's built in to your decision.
Because you know what the price of food is and you know what the price of water is.
And the economist would say the water should go wherever the value is most
highly. So if the value of water is most high for food, then the price of food should
reflect that because there's a shortage of food.
And you saw a really, really high rice prices during the food crisis in 2007. And no
one was thinking about selling their water because they were using their water to
grow rice. Which they should've been because there was a rice shortage.
On the other hand, if there's a drought in California, but there's no rice shortage
globally then the price of rice might be low so then the farmer would decide to sell
his water. But the theory of the system works. Now are there sometimes problems
where the price signal doesn't get through? Yeah. And does there have to
sometimes be intervention? Well free market economist would say no. But someone
who believes more in the regulation and corrections markets would say yes, you
might have to have some rules that say how much you can sell. Does that make
sense? So any more questions or comments? We're not going to complete this because it's
an open-ended idea and open-ended discussion. But what I want to leave with
isÉ I'll launch in to one of the solutions that have been posed recently, that I actually
contributed to with my research work and then get some of your input on what you
think it takes to design a really good water market. And we won't be able to answer
the whole thing today. So when I started studying this problem with
a lot of economists at StanfordÉwhat we noticed was the attempt in California to
start a water market, which we actually thought was a good idea, because it turns
out that the amount of water you need to trade when there's a drought, while it's significant,
is not a very large percentage of total amount of the water that moves around
the state, at least not so far. And so if you could trade water in times of
drought, you could actually alleviate shortages and avoid both environmental problems
and, also, losses due to not having enough water in urban areas. So we
kind of started to investigate the water market idea. And what we came up with as part
of the answer for why water markets don't exist, even though really forward
thinking researchers proposed them and policy makers proposed them thirty
years ago. It's really two reasons. Well, three actually.
The first is the focus so far has been on trading permanent water rights. So I was
telling you farmers had a permanent right to water, and cities have more junior
rights. So imagine that LA wants to buy a farmer's water right. If LA wants to buy a
farmer's water right (and we've seen this) a couple of things happen.
They have to go through a huge environmental review first. Because they're about
to transfer water that goes into a stream, and it has environmental impact, to a city.
And of course the state says you must review all the impacts of that. And you also
have to make sure you don't hurt your neighbors because they were usually getting
some of the runoff. So first of all, expensive environmental review.
What's the second thing that happens? The community of farmers knows that you,
farmer Bill, are going to sell your water. And the community doesn't get any of the
proceeds that you receive from your sales. So they actually start to resist. So within
farming communities if people know that there's going to be a sale of a water right,
it threatens their livelihood. It would be sort of likeÉyou work at Intel, and Intel's
going to move their corporate office overseas, you might protest because you might
be like, I'm going to lose my job if you move your facility to Indonesia. So the same
thing exists in the farming communities. So you're going to end up with very, very
high transaction costs that are associated with trading permanent water rights. And again
I want to emphasize that. It's a permanent right, so once they give it to you;
all the water from here every year is yours.
Now, turns out you don't have to trade a permanent water right. In California in
2003, the Metropolitan Water District, which is the largest water [inaudible] in the
United States, for the very first time, did something kind of innovative. And they
signed an option contract with a farmer. So they didn't actually by the permanent
water right. And no one in the community objected. And they didn't have to go
through a really, really complicated environmental review because they were just
moving the water one time. They had to go through an environmental review,
which they should have, but it wasn't a drawn out process. And there was a drought
that year, and they called their water option. And they delivered water to several of
the districts in southern California. So it turns out that by just changing the
structure of the market, from the focus that existed for about thirty years onÑalways
trading permanent water rights that were very, very hard to tradeÑto just an options
off water, they started to trade in a market that didn't exist before. And so I
would propose to you that one of the elements of design that are important for
a water market is the flexibility to do temporary transfers of water using a market
system. So I'll leave a couple of minutes open for
questions at the end, but these are kind of the ideas that we came up with for the necessary
components of a really good water market and then you can add your own ideas
if you want. But the first one was: you have to be able to do temporary transfers.
Why temporary transfers? Because that's the only way you can really lower the transaction
costs and make a viable market. And our whole thesis was the reason the markets
didn't work before was because the transaction costs were so high.
So temporary transfers equal low transaction costs. That's the first thing.
The second thing you need is (anybody remember the little model?). Property
rights? [Clearinghouse?]
Yes, the second thing you need is a central clearinghouse. So we could imagine that,
without very much difficulty, we could have an online clearinghouse for water that
would connect districts around the state, so they could essentially trade with each
other during times of drought. Do you remember that kind of top level that we need
for a market? We have property rights; we have a clearinghouse with the
distribution at the top? Exactly, transportation. So the third part we need is the transportation,
and here I'll be a little more specific. We needed tradable rights to infrastructure.
[Excuse me, for number two, why don't we just have a distribution center?]
Okay, that's a good question. Explain what you mean by that.
[Why don't we just have the government do something? Since we already have all the
infrastructures and all that ready in place? Why don't we just ask them to change up
the rules and regulations? And that'll save up a lot of costs.]
Well this is a very classic debate that you have. You guys will have to argue amongst
yourselves for years to come, which is a lot of people think that the cost of the
governmentÉyou're essentially asking for central regulation, actually. And we know
that there are centralized governments in the world, but not in the US. And the
thought with water and with other areas is thatÉgovernment often don't really
know better than companies. They don't have all the information. So a government
can't necessarily decide what the water is worth to another district because they
don't have that information. And the cost of them getting that information is high,
and they might get it wrong a lot of the time. So the idea is to give that back to the
people that actually trade because it's impacting them directly. And, in theory, that's
actually considered to be the more efficient way for people to trade. And that's sort
of the thinking behind that. Whereas if the government just decides, they have to
have perfect information to get it right, and that's hard to get.
Where as individuals know their own information so they don't have to getÉso
know one has to know it for trade to work efficiently. Does that make sense?
So, importantly, the central clearinghouse, this is where prices get set. This is
whereÉwell I have a district in San Bernardino, and I want to buy your water, how
much do I have to pay for it? And the thirdÉthe transportation, the tradable
rights to infrastructure. This is because the way water moves in California
is through a central aqua duct and a canal system. So you have to be able to, if
you're going to buy water, you have to know you can move it.
At the moment, there's a priority rights system on the infrastructure. So you need to
be able to buy accurate infrastructure. It's like being able to rent a u-haul. I mean to
me, this is like "rent u-haul" but it involves the government being able to lend you
that U-haul because the government owns the infrastructure.
It seems simpler than a 1-2-3 list, but its actually a little more complicated. But
that's the high level version of what we came up with for a water market in
California. Okay I'll stop now. Are there any questions?
I'm here if you want to stop and ask questions.