—Adam Smith, Chapter 4, Book I, Wealth of Nations (1776).
The management of fresh water resources in arid regions like central Washington can be contentious. Water is a scarce resource that is critical for municipal, industrial, and agricultural development and production. Surface water in streams and rivers provide a large amount of the region’s electricity and a number of ecosystem services, including the support of the regions highly valuable fisheries. As a result, society is faced with the difficult decision of how to best allocate scarce water resources across many potential uses. Reallocating water from one use to another inevitably has costs and benefits, precisely because it is a scarce and valuable resource.
Economics provides a framework for comparing the costs and benefits of water management alternatives, and for informing water use and water policy decisions. However, a number of terms used to describe economic aspects of water use can be difficult to understand, are often misunderstood, and misused. This article will provide an explanation of the terms price, value, and cost in the context of water. Our goal is to help non-economists better understand reports, analyses, and discussions on the economics of water use. The politics and law of water in the west are turbulent enough. Even if, as Mark Twain purportedly said, “whiskey’s for drinkin’ and water’s for fightin’,” at least we can try to avoid misunderstandings over economic jargon.
While the price of a good is an indication of its value, the “diamond-water paradox” alluded to in the quote above by Adam Smith, highlights how the market price of a good can be relatively unrelated to the full economic value of a good and its contributions to welfare, and in the case of water, its contribution to life itself. How could the price of something that is as essential as water be so low; and the price of something of less existential consequence be as expensive as a diamond? This “paradox” is just one example that demonstrates why economic value can be a difficult concept to grasp. The best way to develop a clear understanding of economic value is to analyze the exchange of a good in the simplest possible market.
A Textbook Model of a Market
In the simple model of a market presented in introductory economics textbooks, the observed market price is determined simultaneously by the cost to produce the good and how much consumers value it.
Producers decide to supply a good because they expect to be able to sell it for at least what it costs to produce. The term marginal cost is economic shorthand for “the cost of producing an additional unit.” When deciding how much to supply, producers will expand production as long as the price they receive per unit is greater than the marginal cost. At some point along the production expansion path, diminishing returns to production implies increasing costs per unit of production, and eventually the cost of producing an additional unit becomes greater than the price, and expansion of production ceases.
The value of a productive enterprise to producers is the difference between the market price of the goods they sell and the total cost of producing the goods at the chosen scale of production; (loosely) known as profits. Another closely related concept is opportunity cost, which means the cost of the use of a good in terms of its value in the next-best alternative use. In many cases the opportunity cost of a good can be thought of as its market price, but not always. We will return to this later.
Now that the supply side of the market has been described, consider the consumer demand side. The benefit that a consumer receives from obtaining a unit of a good is called the marginal benefit. The marginal benefit is assumed to decrease the more the consumer buys and consumes. The first cheeseburger that someone eats is usually more satisfying than the second, and the third is, more often than not for most of us, a mistake to eat.
Consumers will increase their purchase of a good as long as the price is less than the benefit they receive from it.
The fact that people limit their consumption of a good when they face a fixed price for it is evidence of diminishing marginal benefits for that good. The total value to the consumer of consuming several units of a good is the sum of the difference between marginal benefit and price over all of the good(s) consumed. Similarly, a farmer will apply (consume) water or fertilizer for producing a crop as long as the additional benefit the farmer gets from increased yields is greater than the additional cost. If the first acre-foot of water has a bigger impact on crop yield than the second acre-foot,