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The Illiquidity of Water Markets: Efficient Institutions for Water Allocation in Southeastern Spain

Donna, Javier and Espin-Sanchez, Jose (2016): The Illiquidity of Water Markets: Efficient Institutions for Water Allocation in Southeastern Spain.

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Abstract

Water is an essential good for human life but there is controversy over whether it should be allocated using markets. In 1966, the irrigation community in Mula (Murcia, Spain) switched from a market institution, a 700 year old auction, to a system of fixed quotas with a ban on trading to allocate water from the town’s river. We present a dynamic demand model in which farmers face liquidity constraints (LC) to explain why the new, non-market institution is more efficient. We show that ignoring the presence of LC biases the estimated (inverse) demand and demand elasticity downwards. We use the dynamic demand model and data from the auction period to estimate both farmers’ demand for water and their financial constraints, thus obtaining unbiased estimates. In our model, markets achieve the first-best allocation only in the absence of LC. By contrast, quotas achieve the first-best allocation only if farmers are homogeneous in productivity. We compute welfare under both types of institutions using the estimated parameters. We find that the quota is more efficient than the market.

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