Impacts of water rights security on water markets: experimental evidence

Water markets are expected to lead to efficient use of scarce water by re-allocating water from low value uses to high value uses. However a water allocation system must not only allocate specific volumes of water among users but also allocate the risk of supply shortages. The existence of both a market of water rights and a market of seasonal water allocations is necessary to allow users to manage better the risk of increased supply uncertainty. Whether the water rights market should be further sophisticated by offering different levels of security for rights is unclear. Indeed, increasing the complexity of water markets can eventually reduce efficiency gains and cost-effectiveness of water trade. We propose an experimental design that captures the main characteristics of water markets. Farmers first participate in the market for water rights while facing uncertainty on water allocations. Once the water supply is known, they can trade their water allocation on the spot market. We examine two water right scenarios, one with a unique security level and another with two levels of security and we compare them in terms of allocation efficiency, risk allocation and cost effectiveness. We vary transactions costs as a treatment variable and elicit risk preferences of subjects. By comparing the performance of the markets in each treatment, we can measure the benefits of having two levels of security for water rights and test whether they are contingent on the characteristics of transaction costs and risk aversion