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Last modified:14/4/07
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John Quiggin

Water rules won't wash

John Quiggin Australian Financial Review

20 April 2006

As water supplies continue to fall short of demand in many Australian cities, governments have imposed a range of restrictions on water use, while exploring a variety of options for additional supply, ranging from the traditional response of new dams to desalination in Perth and, most controversially, the recycling of effluent in Toowoomba. These measures are focused on the quantities demanded and supplied. By contrast, economists have generally stressed the role of prices in matching supply to demand.

Debates over the relative merits of price-based and quantity-based measures have been going on so long as to suggest that they are unlikely to be resolved any time soon, and also long enough to suggest that neither side is completely in the right or in the wrong. The problem is to determine when to work through prices and when to control usage directly.

One important feature of price-based policies is that they work better the longer they are in place. In the short run, there may be a few easy adjustments to higher prices, but achieving substantial reductions is more difficult. Watering gardens less often, or taking shorter showers may lead to a significant loss of amenity or comfort. But if prices are permanently higher, it becomes worthwhile to invest in a wide range of water-saving technologies, or to reorganise activities in ways that use less water.

The same is true on the supply side. In the short run, changes in prices make little difference to supply. In the long run, however, higher prices will be needed if new supply options such as recycling are to be economically feasible.

What all this means is that a relatively modest, but sustained increase in prices can be effective in matching long-term supply and demand. On the other hand

Suggestions that prices should be used to match supply and demand are frequently opposed on equity grounds, with the argument that restrictions affect rich and poor alike.

These arguments don’t stand up well to scrutiny. While water for drinking and washing is a necessity, the total cost of water for these purposes is only a few dollars a week for a typical household. The largest area of demand for residential water users is for gardening and, since wealthier households tend to own larger blocks, the amount of water used rises with income, so an increase in price means that, on average, wealthier users pay more.

Since most water suppliers are regulated monopolists, any increase in usage charges will be balanced by a reduction in access charges. Since these charges are the same for all households, regardless of income, they are, in general more regressive than access charges.

By contrast with prices, directly imposed restrictions on quantities used, including prohibitions of various uses regarded as wasteful, tend to work well in the short term, and poorly in the long term. particularly in the emergency context of a drought, people are generally happy to comply with restrictions, and substantial reductions in usage can be achieved. But the longer restrictions are maintained, the less effective they are likely to be. Voluntary compliance tends to decline as emergency fades into normality, and people find new ways to use water which satisfy the letter, if not the spirit, of restrictions.

This pattern is one reason why it is a mistake to impose permanent restrictions on water use, as has been done in Melbourne and other cities. But there is a more important reason. If prices are allowed to do the job of matching long-run supply and demand, restrictions are still available as an option to manage short-run shocks, such as droughts.

By contrast, if permanent restrictions are used to hold down long-run demand, there is little flexibility left to handle unexpected shocks like droughts, or climate change. The only options are large price increases or more draconian restrictions on water use, neither of which are likely to be very cost-effective.

The failure to allow the price mechanism to work has negative consequences beyond urban areas. Expensive measures are being pursued to reduce urban water consumption when much cheaper options could be used to save water in irrigation, with the resulting extra supplies being used to meet urban needs or to allow for enhanced environmental flows.

Restrictions on urban water use are an essential tool for managing droughts and other temporary disruptions to water supply. But they should be reserved for that purpose. In the long run, prices should be allowed to work.

John Quiggin is an ARC Federation Fellow in Economics and Political Science at the University of Queensland.

John Quiggin is an Australian Research Council Federation Fellow in Economics and Political Science at the University of Queensland.

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