Price signals vs coercion

Sydney’s water crisis is over, for the moment. Our dams are now 65.5% full – up from 33.9% on the 8th February 2007. That will last us around two to three years without any more rain, at the current rate, which feels like a reasonable cushion. Not coincidentally, Sydney’s water consumption went from an average of 1,800 or so Megalitres per day back in 2001, to around 1,300 or so now.  Although there has been an increase in price during that time period, according to this study (from Cyprus!), demand in Sydney barely changes with an increase in price – the price inelasticity is -0.09, which means that an increase in price has very little effect on consumption.

So the way in which Sydneysiders have dramatically reduced their water consumption has been through restrictions – good old government regulation.

I find this interesting. It is very common to find economist authored opinion pieces in the papers commenting that if only the government would use price signals for this or that issue, the market would automatically find the correct level.

But, price inelasticity is straight from Economics 101. Some commodities aren’t much influenced by price – at least in the current ranges of prices and consumption (I don’t doubt that if water was per litre as expensive as (say) scotch for the average household, the use of plumbing and tolerance of dirt would drastically change). At the margin, using restrictions rather than water pricing will potentially stop some high value uses of water that would occur if pricing were to be used.

So the government turned to non price signals – a combination of coercion and shaming (mostly coercion, through water restrictions, but public opinion has turned against people wanted to maintain lush green lawns).  This study, from IPART (which is the independent pricing tribunal responsible for setting water prices) suggests that to replicate the effect of the water restrictions we have now you would need around a 200% increase in water prices (if you wanted to have a block safety net of water with an price that didn’t vary).

Although I’m in the camp that we very much need a carbon tax to at least start down the path of reducing greenhouse gases, price increases are not necessarily a panacea for every type of product. Sometimes it is easier to reduce consumption in other ways, particularly if the price is cheap enough to start with that substnatial waste is a result.