Water scarcity is a constraint on economic activity in many regions, and improving the allocation of water is an important part of the process of economic development. Economists have advocated water markets as a way to increase efficiency and to cope with environmental problems. Unfortunately, actual water markets, including those in developed countries, usually fall far short of this ideal. The paper considers the allocation of water by markets that are only imperfectly developed, in which prices are not publicly known and in which there is no centralized trading location. These limitations impose transaction costs on buyers and sellers, that is costs associated with completing a transaction. A conceptual model of the effect of transaction costs on trading patterns is developed. Stylized results are tested using data from an informal water market in California. The paper concludes with a description of the importance of transaction costs, comments on the transition to more formal water markets, and policy recommendations.
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