Transaction Costs and Policy Design for Water Markets

This chapter synthesizes the growing empirical literature on transaction costs to identify pragmatic design recommendations for water markets and related institutions. The New Institutional Economics literature recognizes that appropriate policy choice and design will be a function of the specific characteristics of the problem. The physical and institutional determinants of both transaction costs and transformation costs should be considered in the design of water markets due to potential interactions between them. Analysts also need to incorporate the extent to which the technologies, institutional environment, governance structures, or policy designs can be changed; some factors can only be adjusted to or “designed around” while others can be designed differently. This framework highlights the importance of property rights, historic water use patterns, and path dependency since transaction costs will be incurred to obtain or retain property rights to water. The physical complexity associated with water resources increases transformation costs as well as transaction costs. Uncertainty and changing societal preferences highlight the importance of flexibility and conflict resolution mechanisms in institutional design. Sequencing of policy changes is also revealed as a key design consideration.