Supply-Based Dynamic Ramsey Pricing with Two Sectors: Avoiding Water Shortages

In many countries current water-pricing policies are dictated by the sole objective of breaking-even in each period. This results in large withdrawals which are not sustainable in the long-run hence not optimal. In this paper I derive the optimal dynamic water resource management policy of a benevolent government which supplies water to households and agriculture. I compare the efficiency implications of the current and the optimal pricing policies using simulations. I endogenize crop-choice decisions and estimate the changes in the crop composition with the generalized method of moments. Using data from Turkey I find that under the policy of break-even prices the average number of years before the government runs into the water shortage when it cannot meet the sectoral demands is eight years. In contrast if the government were to choose water prices optimally then water shortages would be practically nonexistent over the next century.