Irrelevant economics: The water pricing and pollution charging debate

Conventional economic appraisals of the water industry have concentrated on economic efficiency defined almost entirely in allocative terms, the key issues being the efficiency with which available water resources are allocated between users and with which factors of production are invested in new facilities. Since marginal cost pricing has been viewed as the mechanism theoretically capable of bringing about optimality in resource allocation, assessments of water industry practices have all too often been reduced to reiteration of the extent to which current pricing practices diverge from the theoretical optima. This paper, based on empirical work on water suppliers in both Britain and Australia, questions the relevance of this conventional approach.First, it is argued that the concentration on allocative efficiency has diverted attention from the equally crucial issue of whether the industry is efficient in managerial, technical and product terms. Since technological efficiency must exist in an industry before a Pareto optimal allocation of resources can occur, the presupposition, in papers which argue that the introduction of optimal pricing rules will ensure allocative efficiency, must be that the industry is already producing an appropriate product using least cost production methods. No such presupposition can be made in an industry where the profit motive and competitive forces do not operate.Second, it is argued that optimal pricing policies can only produce optimal resource allocations if consumers act in a prescribedly rational way to the prices set. Although it is well known that ‘second-best’ pricing rules may be needed to counter inefficient conditions prevailing in other sectors of the economy, the effect of market imperfec- tions on the way consumers react to prices has been less well analysed. Using results from a study of firms' reactions to trade effluent charges, it is shown that the structure of companies and the way they operate their revenue and capital budgets may severely limit the effectiveness of the price mechanism in ensuring allocative efficiency.Finally, the paper considers the ‘equity’ with which the costs of water services are distributed between consumers. Once again it is argued that the issue has been neglected since the distribution of income is irrelevant to the achievement of allocative optimality in Paretian terms. Evidence is presented that contradicts the popular myth that, although current pricing arrangements may be less than efficient, they are at least ‘broadly fair’. It is shown that, in practice, price discrimination against low income consumers is widespread, and this can hardly be regarded as equitable, whatever definition of equity is used.