Income Distributional Effects of Using Market-Based Instruments for Managing Common Property Resources

In the face of growing management problems and conflicts over increasing demands and dwindling or increasingly variable supplies of surface and groundwater, the need for revising the conventional water resource allocation methods has been increasingly felt among natural resource managers and policy makers. For the past 30 years economists have advocated for the application of various types of market-based instruments (MBIs) as an efficient means of effecting the re-allocation water resources among competing uses. While MBIs have been implemented in several countries, they have continued to encounter strong socio-political opposition, due to the impacts imposed on third-parties during transfers and re-allocations, as well as the distributional effects across different types of water users. Despite the demonstrable efficiency gains of MBIs, the resulting equity or distributional effects of MBI-driven re-allocations can be of equal or greater importance to policy-makers and the constituents that they serve. At the same time, the realized gains in economic efficiency from the application of MBIs depend heavily on the heterogeneity of the agents they are targeted towards, as well as the degree of information asymmetry that the regulator faces. In this paper, we use a simple theoretical framework to show the trade-offs between efficiency and equity that might arise from the application of MBIs to a heterogenous population of agents drawing non-cooperatively from a natural resource pool. Using the idealized centralized planner as a benchmark of dynamic, allocative efficiency, we compare the realized efficiency gains that can be realized by alternative policy instruments and the resulting impacts on distributional equity, in terms of the cumulative net benefits over time. Using the specific example of groundwater and the empirical setting of Southern California, we are able to highlight the trade-offs between efficiency and equity that might exist among alternative policy instruments, and how MBIs perform with respect to those dual criteria. We find that under agent heterogeneity, there are asymmetric gains in efficiency when the centralized planner allocations are constrained by equity considerations. Through such results, this paper demonstrates the importance of considering both efficiency gains and the minimization of disparities in distributional inequity, when designing policy instruments that create winners and losers with potentially serious socio-political ramifications.