13 March 2012

It’s all about winners and losers

I am at the World Water Forum this week -- to give a talk (actually, reflect on an EEA report) on water value and water efficiency -- but also to listen to the "state of the art" in world water matters.

While it's definitely true that everyone here is truly interested in improving the ways we use water (for humans, the environment, and so on), I am not sure that many of them go to the FOUNDING force affecting how we allocate and use water. That foundation is the desire to maximize the benefits from water use, while minimizing the costs of acquiring and using that water.

Nothing new there, you say? Well, yes, everyone is used to weighing benefits and costs when making decisions, but the DISTRIBUTION of benefits and costs in water is what makes our activities, policies and decisions so interesting.

In the water sector -- more than any other sector I can think of (even finance!) -- it's fairly common to find one group bearing the costs for benefits that go to another group. Thus, you might find that taxpayers support irrigation infrastructure that benefits farmers, or that the environment experiences the "cost" of water withdrawals for urban consumption, and so on...

These mismatched costs and benefits are the reason why politics are so important in water, because the allocation of costs and benefits often takes place through some political mechanism.

What's troubling is that economists have often supported these mismatches, in their analyses of "net social benefits from policies."

Let's examine the range of cost-benefit distributions from most acceptable to least acceptable to clarify where things go wrong.
  1. I spend $1 to buy ice cream worth $2 for me. That 2:1 benefit cost ratio (BCR) is acceptable. This is an example of "maximizing your utility from limited resources."

  2. That $1 goes to Sue (the ice cream seller) who pays $0.50 for the ice cream. She, likewise, is happy with a 2:1 BCR. This is an example of "mutual gains from trade."

  3. Instead, I buy the ice cream for $0.50. I get a BCR of 4:1 and Sue breaks even. This example -- like the mutual gain from trade), is called a Pareto-improvement, since I am better off and she's no worse off.*

  4. Now a politician named Dick comes in. He's got an economic study that shows that I value the ice cream more than Sue does.** He knows that "society" will be better off if I have it, since I value it at $2 whereas Sue only values it at $0.50. So he takes the ice cream from Sue and give it to me, knowing -- under the Kaldor-Hicks criterion -- that Sue could THEORETICALLY be paid off, out of my surplus, so that Sue was no worse off. The problem -- to Sue -- is that the criterion says "those that benefit could in theory compensate those that have lost out... it is justifiable for society as a whole to make some worse off if this means a greater gain for others..." and stops there. Dick and I agree that society is better off and that Sue could -- theoretically -- be compensated but really does not need to be.***
Although these examples are probably pretty clear, let's use one with water.

Say that a dam will delivers $100 of benefits (irrigation, flood control, hydropower), but puts my land -- worth $20 -- underwater. Should the project go ahead? Yes. Should I get compensated? Maybe. In a country with property rights, I will get some money ("market value" may be less than the value to me), but people without property rights (China!) often get little or nothing.

What about water pollution? What if industry discharges polluted water that lowers the value of water to people downstream? A "pigouvian" tax may reduce that pollution to an "efficient" level from a SOCIAL perspective, but that tax doesn't help people downstream if the government keeps the revenue -- a policy that's normal in OECD countries.

Bottom Line: It's not enough that projects deliver a "net social benefit" -- winners need to pay for their benefits, and losers need to be compensated for their costs. Politicians who approve those projects need to match benefits and costs. Those who just help special interests are Dicks.

* It's an improvement as long as one of us is better off and the other one not worse off. Both of us better off is fine, but remember that we're not increasing TOTAL happiness with this ice cream trade -- just deciding who gets more money for the ice cream that I buy. Although economists tend to ignore who gets the money, regular folks pay CLOSE attention to it!

** I paid for the study :)

*** My jaw hit the floor when I heard that in graduate school in 2003. Professor Silvestre said (as I remember) "we do the calculations as if the other person was compensated, to find out if the BCR exceeds one. If it does, we go ahead but there's no need to pay the losers.


  1. Well put!

    Who does these distribution "studies?" What practical governance tools exist?

  2. I found for the most part that these folks at the World Water Forum are about getting someone else's money to "try" and solve their own problems without really looking at themselves first.

    "give me your money so I can solve my problem"

    But not really interested in hiring someone like me to help them. Nada

