Tropentag, October 11 - 13, 2006 in Bonn "Prosperity and Poverty in a Globalized World – Challenges for Agricultural Research"

Incentive Contracts Linked with Market Mechanisms: Can We Address the Water Allocation Problems in a More Effective Way?

¹Justus Liebig University, Institute of Agricultural Policy and Market Research, Germany
²Justus-Liebig-University Giessen, Institute of Agricultural Policy and Market Research, Germany

Abstract

Even though price driven mechanisms like water markets, at least theoretically, induce efficient allocation of the water resource, they often fail to achieve the goal especially in low income countries where the transaction costs are prohibitively high (especially due to extensive fragmentation of lands and peculiarities of cropping systems) and the returns from agricultural enterprises are meagre. The low price elasticity of water use coupled with political infeasibility of higher water prices are frequently driving these markets to malfunction though many international agencies advocate the formation of water users association and economic pricing of water. We believe that these failures stem from the frequent assumptions of zero transaction costs and no political infeasibility. We see a serious need of designing mechanisms that aim to fill this void. The current paper intends to propose an incentive framework that induces farmers to save water and ensures them the benefits of water trading especially in a transboundary river basin setting.

The proposed mechanism visualises a principal, who is having authority to make legally valid contracts with farmers (agents) and who prescribes a set of technical and management measures to reduce water use, who charges a penalty for the farmer, failing to adopt a subset of measures for meeting a minimum reduction, and who shares the income from the trade of saved water. This principal can be a Water Users Association holding a water use right by a grandfathering system or an authority. Any reduction from the entitled level is assumed to be transferred to the upper layer water authority that act as an agency to reallocate the saved water to those economic activities where the marginal value of water is higher, like for instance industries. The key task of this paper is to craft a principal-agent model addressing moral hazard (as efficiency of farmers in employing the technical and management measures is hidden) and to optimise the contract. The main benefits of the system can be lower transaction costs, better income for the farmers, higher political feasibility and more efficient water allocation.

Keywords: Incentives, moral hazard, principal-agent, transbounday issues, water allocation

Contact Address: T. S. Amjath Babu, Justus Liebig University, Institute of Agricultural Policy and Market Research, Senckenbergstr. 3, 35390 Giessen, Germany, e-mail: amjathbabugmail.com