A Transactions Cost Approach to the Theoretical Foundations of Water Markets1

Abstract: Water marketing is often cited as a means of alleviating the stresses attached to allocation of water use. Frequently, marketing is suggested in a context that implies substitution of competitive markets for the allocation based on the prior appropriation doctrine. This study examines water marketing from the perspective of a transactions cost approach to the private and broad social agreements (contracts) that support water allocation. It examines the major behavioral challenges faced by any contract, and the alternative approaches to those challenges, with respect to water allocation. It also examines the impact of market design on the existence of externalities, costs imposed by transactions on society and individuals not party to the transaction. It finds that the most robust water market designs will be found in systems with sufficient property rights protection to support investment, sufficient hydrologic information to provide accurate analysis of third party effects, conjunctive management of surface and groundwater, and a governance structure capable of administering the rules while not determining outcomes.