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Valuing Options in Water Markets: A Laboratory Investigation

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  • Hansen, Kristiana
  • Kaplan, Jonathan D.
  • Kroll, Stephan

Abstract

Risk and reliability dominate water supply discussions in the arid western United States in light of increasing demand and finite, weather-dependant supply. Thus water agencies increasingly turn to contractual mechanisms such as dry-year options to manage supply risk in advance of need. Although a few water agencies across the West have implemented dry-year options, sufficient data for conventional econometric analysis do not yet exist. We thus utilize experimental economics to analyze the effect of annual dry-year options on water markets. We consider how market structure (competitive versus monopsony power) and option contract availability affect water price and allocation within a market and find that realized gains from trade are on average higher when options can be traded, by 46% in competitive markets and by 63% in dominant buyer markets. Important for the political feasibility of such markets, we also find that gains from trade, once an options market is available, are much more evenly distributed between the single buyer and the many sellers in the case of monopsony.

Suggested Citation

  • Hansen, Kristiana & Kaplan, Jonathan D. & Kroll, Stephan, 2008. "Valuing Options in Water Markets: A Laboratory Investigation," Working Papers 108722, Colorado State University, Department of Agricultural and Resource Economics.
  • Handle: RePEc:ags:csdawp:108722
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    Keywords

    Resource /Energy Economics and Policy; D23; L22; Q25;

    JEL classification:

    • D23 - Microeconomics - - Production and Organizations - - - Organizational Behavior; Transaction Costs; Property Rights
    • L22 - Industrial Organization - - Firm Objectives, Organization, and Behavior - - - Firm Organization and Market Structure
    • Q25 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Renewable Resources and Conservation - - - Water

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