Johannes Holler
Matr. Nr.: 9611729
Water Pricing
Introduction
Over the last ten years, there has been considerable evolution in the way water pricing
policies and their contribution to sustainable water management have been viewed by the
international community.
Due to economic theory, pricing a good at its marginal cost, creates the highest net social
benefit and therefore is the most efficient way of pricing. At this point, the question arises,
why the inefficient average cost pricing method is nevertheless most commonly used.
A natural monopoly is assumed to be existent inside the water utility industry. Marginal cost
pricing in the case of a natural monopoly creates a financial deficit within the industry, since
here average cost is higher than marginal cost for observed consumption levels. Under this
circumstances the industry can only be self supporting, if the price of water covers at least
average cost. This incapability of marginal cost pricing to cover average cost in the case of a
natural monopoly, is the main argument for the use of the average cost pricing method.
Because of recently developed interpretations of marginal cost for the water utility industry,
following an adoption of the marginal opportunity cost approach, the assumption of the
existence of a natural monopoly inside the water utility sector has to be questioned.
An answer to this issue and, correspondingly, a solution within the discussion about the
optimal pricing method, is the purpose of this study.
Natural Monopoly:
A natural monopoly is characterised through average cost higher than marginal cost for the
observed demand level. Water utility is often assumed to be such a natural monopoly.
Graph 1: natural monopoly
MC,AC,D
D
Deficit
MC
AC
Qt*
Qt
Johannes Holler
Matr. Nr.: 9611729
The graph clearly shows that for the demanded level of water, Qt*, marginal cost are lower
than average cost. In this case if water is priced at marginal cost a deficit is generated. The
generated deficit is the vertical distance between marginal cost and average cost at the
demand level Qt*
Marginal opportunity cost pricing:
Marginal cost of water should equal all forgone opportunity benefits of consumption.
Marginal opportunity costs are reflecting this property. The price should therefore be set equal
to marginal opportunity cost.
p  MC  MOC
Marginal opportunity cost can be split into three main parts:
MOC=MPC+MUC+MEC
Where: MPC is the marginal production cost
MUC is the marginal user cost
MEC is the marginal environmental cost
Marginal production cost:
Marginal production cost include all the costs occurring before consumption: the marginal
costs of pumping the water from the aquifer to the storage tank (MCP), marginal costs of
transporting the water to the consumer (MCD) and the marginal costs of treating the water
before use (MCT).
Measuring pumping costs:
Are the costs of pumping the water from the well up to the surface.
 2 MC P
MC P
0
 0,
2
Qt
Qt
Distribution Costs:
Are the costs of distributing the water from the storage tank to the consumer. The distribution
industry is a classical example of an economies of scale industry where average cost of
distribution (ACD) is decreasing for an increase of Qt and MCD is always below the ACD.
 2 MC D
MC D
0
 0,
Qt
 2 Qt
Johannes Holler
Matr. Nr.: 9611729
Treatment Costs:
The treatment sector is again best described by an economies of scale industry. Average
treatment costs are therefore decreasing and always above marginal treatment costs.
 2 MCT
MCT
0
 0,
Qt
 2 Qt
Putting all MPC components together:
MPC
0
Qt
if
MC P MC D MCT


Qt
Qt
Qt
Marginal Production costs are increasing, if the increase of marginal pumping cost is bigger
than the sum of the decrease of marginal distribution and marginal treatment cost.
MPC
0
Qt
if
MC P MC D MCT


Qt
Qt
Qt
For realistic consumption levels (served by the same reservoir) it is very likely that an
additional unit of Qt leads to decreasing marginal production cost.
Marginal environmental cost:
Environmental costs or externality costs can arise at the production and consumption stages.
The costs arising at the production stage are already included in the production costs through
the treatment costs before use. Therefore the MEC only have to reflect the externalities arising
at the consumption stage. These costs can be split into 2 parts:
MEC = MCPO + MCE
MCPO……..Marginal cost of pollution (treatment cost after use)
MCE………Marginal cost of ecosystem degradation
Marginal cost of pollution (MCPO):
This cost part can be seen as a second part of treatment costs. MC PO reflects all the costs
arising from cleaning the water after consumption.
 2 MC PO
MC PO
0
 0,
Qt
 2 Qt
Johannes Holler
Matr. Nr.: 9611729
Marginal cost of ecosystem degradation (MCE):
This part of marginal environmental cost is again twofold. Part one contains the costs
associated with the discharge of uncleaned water into nature. The second part reflects the
costs to society due to a reduction in biodiversity and damaged ecosystem because of a
reduction in the stock level of water.
 2 MC E
MC E
0
 0,
Qt
 2 Qt
Properties of marginal environmental cost:
MEC
0
Qt
if
MC PO MC E

Qt
Qt
MEC
0
Qt
if
MC PO MC E

Qt
Qt
In reality even for very low consumption levels it is very likely that the effect of an increase
of Qt on the marginal pollution cost is less than the effect on the marginal cost of ecosystem
degradation since the costs on the ecosystem are partly irreversible. Therefore the MEC is
likely to be increasing for all consumption levels.
Marginal user cost:
The marginal user cost is the difference between the present worth of the marginal
opportunity cost of the substitute (MOCb) and the present worth of the marginal extraction
cost (MXC) of the existing technology.
MUC = (MOCb – MXC(St)/(1 + r)T
The marginal user cost can be interpreted by the discounted sum of future marginal extraction
cost increases.
Putting all components of MOC together:
MPC
0
Qt
if
MCT MC D MC p


Qt
Qt
Qt
MPC
0
Qt
if
MCT MC D MC p


Qt
Qt
Qt
Johannes Holler
Matr. Nr.: 9611729
MOC- curve
MOC
0
Qt
Relationship between average cost and marginal opportunity cost:
AC,
MOC
AC
0
MOC
A
Qt