The Negative Externalities of Water Consumption

by Jesse Hermans

Water is a scarce, finite resource that is critical for life, as well as many commercial activities. This common resource is a fundamental raw input taken from the commons and then combined with land, labour and capital to produce goods such as agricultural produce. In a country such as Australia, where droughts are frequently experienced, ensuring optimal and efficient use of water resources is critical for both the economy and environmental sustainability.

Without sufficient public regulation, rivalrous consumption of finite water resources from rivers would lead to severe destruction to the sustainability of both dependent commerce and the environment. While public regulation currently exists to help improve total surplus, the structure of regulatory systems could be overhauled to achieve both more efficient and more equitable outcomes.

The negative externalities from excess water consumption arise due to the quality of water being a common resource. Before the application of property rights and related titles and licenses, water could be extracted from a river such as the Murray-Darling Basin at no more than its extraction cost. This cost only takes into account the cost to an individual producer, but does not take into account the costs of depleting the commons – both in what it does to degrade the environment, as well as depriving other producers of equal opportunity.

Where the private marginal cost is significantly lower than the social marginal cost, the result is to not factor in the true social and environmental cost of extracting water from the basin – this is the definition of a negative externality.

Due to the true cost not being reflected in the production (extraction) price, an unregulated market would lead to excess water consumption. When taken to the extreme, such excess consumption of a finite resource could lead to significant environmental damage as well reduce the resource quality and availability to other producers further downstream, or worse – complete exhaustion of the resource. This problem is known as the tragedy of the commons. Total surplus, consumer surplus, producer surplus and government surplus are all at risk of being significantly reduced due to this issue.

It is therefore imperative that a regulatory system is devised and used to ensure an efficient as well as equitable distribution of finite water resources. Such a system needs to also be flexible, to cope with the fluctuations in basin capacity as well as meet environmental needs. Provided the system is designed well, productivity can be promoted while ensuring surplus is safe guarded and even increased.

Water, being a common resource, should be thought of as part of the commonwealth – initial ownership of such a resource should belong to the public, with the state acting as a trustee. From here the decision of how to regulate water consumption must be made. Market based systems in this instance are favoured by Australian governments.

For urban water use, pricing water through publicly owned utilities is utilised as a policy – the government acting as a water producer. This acts as a corrective taxi and allows governments to collect revenue while ensuring consumers of water are provided sustainable, reliable and sufficient access to water. For river systems such as the Murray-Darling Basin however, it is necessary to have more stringent requirements for consumption. Governments in this area have opted instead for direct regulation, with creation of property rights assigned to annual water stocks. This has led to the creation of an Australian water market, where water licenses can be traded. These water licences consist of both temporary allocations and permanent entitlements. Through this system the problems associated with the tragedy of the commons has been avoided and efficiency has been greatly improved, although in recent years it has been criticised for its environmental allocation ambitions at the expense of agricultural (see here, here and here).

Murray-Darling Basin

However a much greater issue lies in the structure of this water market system – the appropriation of resource rents by private license holders. This system has allowed speculators to buy up permits for the purpose of accruing capital gains during times of drought and increasing water scarcity. This is both an inefficient and inequitable management of scarce resources. The Australian water market was estimated at over $40bn in 2012.

For a more equitable and efficient market, the state could collect the resource rents from the licenses via annual tender or similar lease charges. This would eliminate the price of the licenses which arises from the capitalised resource rents, removing barriers to entry for more productive water users and return the resource rents to the rightful owners – the public.


Utilising market regulation allows governments to correct for negative externalities such as excess water consumption. These systems avoid the tragedy of the commons and allow for more optimal allocation of scarce common resources. This improves productivity and surpluses for all parties involved.