Why haven’t I heard about market thickness before?

My friends.  I am wroth with you.  You are brilliant and tell me the things I should know, but none of you have mentioned “market thickness” or “matching mechanisms” to me before.  I had to stumble on the concept by accident, while reading about market design.  Lack of market thickness is a type of market failure, but not on the usual list of market failures (negative externalities, failure to provide public goods, etc).  This is new to me, but I will rush right in.  Market thickness seems to mean lots of buyers and lots of sellers who can make lots of matches.  Market thinness means not many buyers and not many sellers, who can’t find each other to make the transactions both want.  Lack of market thickness creates three kinds of market failure, the first of which is “the inability of the market to pool a sufficient number of buyers and sellers for carrying out transactions.”

I have heard a couple of economists say on different occasions that they ‘don’t know why the California water market never takes off, but it just doesn’t, maybe it is the transaction costs’.  But reading about market thickness makes me think it is an inherently thin market (sellers and buyers each in the dozens, if that), and that’s not going to change.

There are not going to be new sellers:

  • There cannot be a new supply of senior water rights holders that have more than they want from their historical luck and want to sell.
  • The water we’ve got is more than allocated, and the climate forecasts predict more years like our drought years.
  • We won’t allow people to sell unreplaced groundwater out of basin anymore.
  • There is some potential for ‘conserve and market’, but we’re seeing that farmers want to use better irrigation technology and use that water on their own lands (as well as sell it).  Often, farmers want to farm more than they want to sell water because they like farming.
  • It may be the case that we want farmers to become sellers and exit farming.  That’s largely what happened in Australia.  But so far, we don’t say that part out loud and we worry about what happens to rural economies.  So far, we pretend that’s not how we will get additional sellers.

There are not going to be many new buyers:

  • Mostly, cities have the water they need for their current populations and would prefer to develop local supplies (water conservation, stormwater treatment) so they don’t have to depend on flaky other people for something as crucial as water.
  • It is really very difficult to take possession of water, and the initial capital costs of storing and moving it are huge.  People won’t want to get into that business without an assured supply.  The possibility of buying some maybe water is not the same as a right to whatever’s there in perpetuity.  The cities and the projects we’ve already got are the only real prospective buyers, and most of them want to use what they’ve got and control their water supplies other ways.

Other factors:

  • Buyers and sellers must be within a somewhat small radius and have connected infrastructure, before the transaction costs of moving water make water more expensive for the buyer than re-treating local water.  This decreases the market thickness.
  • Very limited pump capacity through the Delta, effectively creating two smaller pools of buyers and sellers.  Within those pools, the buyers and sellers are often facing the same hydrologic conditions, so there’s less potential for arbitrage.
  • Storing water is a difficult problem, as is accounting for water.  Buyers are at risk on both fronts.
  • There are different pools of buyers for kinds of water.  Not everyone can use raw water, nor afford the capital to turn it into potable water.  This also limits buyers.
  • There is a narrow time window for wanting to make the purchase/sale.  Neither the buyer nor seller know what is available much before April.  Agricultural buyers are primarily interested in water they can use before September.  Buyers and sellers can’t know what is available the following year.
  • In drought years, there will be more buyers but fewer sellers (because sellers don’t have any water or want to use it themselves).  In wet years, there will be more sellers but fewer buyers (because of the storage problems and getting water through the Delta pumps).

Some implications:

  • Barely anyone is talking about this. Two hits!  I am not seeing an application to California.
  • I now understand that people who say “remove ‘use it or lose it’ from California water rights” are trying to increase the market thickness by reassuring sellers they are safe to participate.
  • We already see active small-scale intra-district water markets.  There are buyers and sellers for water on that scale.  Larger intra-California water transfers are perennially stalled.  Urban users have no interest in purchasing water in daily sales; they just want it to appear at their tap, cleaned and pressurized.
  • Having a thin market makes it difficult for buyers and sellers to find each other, but the problem isn’t going to be solved by communications or a ‘central trading post’.  With relatively few sellers and relatively few buyers, there aren’t many potential matches.

 

I should think about this more before hitting post, but when have I ever shown good judgment before?  This ‘market thickness’ concept explains a lot.

ADDED 12/1:  I was thinking about attempts to enter as a buyer or seller.  Cadiz is trying to enter as a seller, trying to prove the water is really there and sustainable, overcome repugnance and court a few southern California buyers.  Poseidon finally became a seller, and now its only buyer has a glut.  The only successful new entrant as buyer and seller is the Resnicks, with the Kern County Water Bank, more than twenty extremely lucrative years ago.

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6 Comments

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6 responses to “Why haven’t I heard about market thickness before?

  1. I am tempted to ask whether market thickness correlates with thickness of the head, but I think you are correct. In California the water market will always be thin. The truth is that it is pretty thin in Australia also, and that the success in Australia is over-promoted by people who have a vested interest in it.

    Robert Pyke Ph.D., California Resident Australian-American Citizen

  2. You’re list covers most of the important issues. Another term used in financial markets for “thickness” is “liquidity” (how ironic.) The two primary issues, using more jargon, summarizes what you’ve listed, which are riskiness, both in property rights and hydrologically, and fungibility–the ability to move water with similar properties through the market with few losses. High transaction costs impede fungibility. I discussed many of these issues in my 1996 paper and a later chapter in my dissertation.

  3. greg c

    “Who Gets What” sounds interesting. Is it only about non-traditional markets, or is it broader than that?

    • onthepublicrecord

      It is OK. It is mostly about matching very large pools of buyers and sellers simultaneously. It focuses on matching medical residents to hospitals, and students to public schools in NY and Boston.

      The author does have a throwaway paragraph at the end about how California needs a water market, but as is often the case, he isn’t familiar with water issues.

  4. The last thing we need in CA is a thicker water market. All scientific and political official reports stress that extracting less water from the Delta is required for future water reliability and environmental health. We should be more aggressively controlling the use of this public trust resource, not leaving the use/abuse/misuse/overuse of it flapping in the breeze of the “market.”

    • Diane, as I’ve posted elsewhere here, leaving resource allocation decisions among many small individual actors (such as farmers) is a recipe for disaster. Market mechanisms, properly designed (please leave the lawyers at the door), are better as achieving good resource use. Setting broad targets and allowing individual actors to trade among themselves will achieve results much more quickly and effectively.