Privatization of Water-Resource Development

This paper analyzes the inefficiencies from market power and return-flow externalities in private construction of a water project. The model pays special attention to increasing groundwater pumping costs, project set-up costs, limited project capacity, and return flow to the aquifer. For a given capacity, the return-flow externality causes project owners to construct the project too late when the price of groundwater is too high because the external benefit of return-flow to the aquifer is not captured. Market power exacerbates these effects since the project owner delays construction to accelerate groundwater overdraft. The return-flow externality and market power also decrease installed capacity and increase overdraft from the aquifer. Applying the model to the construction of the Central Arizona Project (CAP) for a given capacity, the estimated deadweight loss from hypothetical private construction of the project ($0.853 billion) is substantially less than the literature’s estimate of deadweight loss from actual construction by the Bureau of Reclamation ($2.603 billion). However, under the federal subsidies and insecure property rights that accompanied the CAP, private construction results in a larger estimated efficiency loss ($6.126 billion).