Introduction to Economics of Water Resources

Public or private Excludability (E): the degree to which users can be excluded Subtractability (S): the degree to which consumption by one user reduces the possibility for consumption by others. Public goods: have a low subtractability and a low excludability Private goods: have a high market potential because of their high levels of excludability and subtractability

Basic Need, Merit, or Economic Good ? Depending on the quantities supplied to individuals, water can be a basic human need, merit good, or an ordinary economic good: –under conditions of extreme scarcity, there is only one option and only one choice to be made, which is to get the water to the thirsty, which closes all options. In this case, water is no more an economic good but a basic need for people to survive –When there is just enough for the thirsty, water also fulfils the criteria for being considered a merit good: good that has a high societal function but are generally not expressed in monetary terms, such as the importance of having clean rivers and a beautiful scenery. –It is obligation of human societies to assure reasonable levels of water to meet the basic human needs and merit goods

Basic Need, Merit, or Economic Good ?

Some Economic Indicators NPV (net present value) Internal Rate of Return (IRR) Interest Rate where NPV cost =NPV benefits Economic Efficiency Marginal Cost = Marginal Benefits

Some Economic Indicators NPV Strong: –Choosing among mutually exclusive projects –Decide if the project can be funded Weak: –Sensitive to interest rate –No information about degree of acceptability Internal Rate of Return (IRR) Strong: –Maximize the return when we have Limited fund –Used to rank projects –Decide if the project can be funded Weak: –No information on the size of the project

Costs / Benefits Direct Cost / Benefit –Easily measured, allocated to a specific production and consumption Indirect Cost / Benefit –Difficult to be measured, indirectly related to production and consumption Fixed Cost –Do not vary with the quantity of output (capital / investment costs) Variable Cost (is it same as recurrent cost ??) –Related to quantity (raw material, chemicals, labors, fuel, etc.) Incremental cost / benefit –Compare the situation with or without introducing new components to a project Opportunity Cost –The cost of foregoing the opportunity to earn a return

Some Economic Indicators B/C ratio Strong: –Rank projects according to degree of acceptability –Decide if the project can be funded Weak: –Sensitive to interest rate

Economic Efficiency P TC: Total Cost TB: Total Benefit MC: Marginal Cost AC: Average Cost MB: Marginal Benefit

ITB connection

Economic Efficiency P Rising limb = supply curve Below the falling part of AC Higher the rising part of AC Affected by variable costs = Demand Curve = Benefits associated with One Unit increase in output Optimality Condition

Definitions Total cost curve: variation in total production cost (Fixed costs + variable costs) with the level of production Total benefit curve: variation in the resulting benefits with the level of production Average cost curve : total cost divided by the level of production –U shape –Decrease first because of economies of scale Marginal cost curve: the slope of the total cost curve, represent the change in total cost associated with a unit increase in output –Supplier will not produce an extra unit unless the price exceeds the marginal cost –The rising limb represent the supply curve Marginal benefit curve: the slope of the total benefit curve, represent the change in total benefit associated with a unit increase in output –Represent the demand curve

RESULTS: M&I Demand Curve

RESULTS: M&I Supply Curve

RESULTS: 2010 Equilibrium Point

Cash Flow Example Year Investment Cost O&M Cost Cost NPVc Revenues NPVr Interest rate NPVc NPVr

IRR IRR=0.068

Free Market System Competitive system: Allocation of resources with maximum efficiency –Consumers must be consistent and independent –Producers must operate with the goal of profit maximization –No price regulations or constraints by the government, labors, business, etc –Goods, services, and resources must be mobile free to move from market to another –Buyers and sellers must be aware of the prices instantaneously –Commodities must be sufficiently divisible –All resources must be fully employed

Market Demand People will buy less at higher prices provided that income, tastes, prices of substitutes remains constant Price elasticity of the demand: Shifts in Demand: –Customer preferences –Number of customers –Customer income –Price of related goods –Availability of alternatives Q P

Market Demand Price elasticity of the demand: –More elastic at high prices –Rigid at low prices –Perfectly elastic when E=infinity, means no one will buy if the price increases Example: –Calculate E at different locations on the curve assuming a unit change in price will result in a unit change in the demand. Q P E=-5 E=-1 E=-0.2

Market Supply Market supply: the amount that producers are willing to sell/produce at different prices Shifts in supply curve: –Technological advances –Favorable production conditions –Lower input cost Q P

Market Equilibrium Market equilibrium: –the minimum that customer can pay for certain quantity and the maximum that suppliers can receive for the same quantity –Automatic way for allocation –Represent the customers willingness to pay –Economic efficiency Q P Demand supply surplus shortage

Irrigation Water Prices in Israel