Thursday, July 7, 2016

Markets, contracts, and uncertainty in a groundwater economy

Groundwater is a vital yet threatened resource in much of South Asia. This paper develops a model of groundwater transactions under payoff uncertainty arising from unpredictable fluctuations in groundwater availability during the agricultural dry season. The model highlights the trade-off between the ex post inefficiency of long-term contracts and the ex ante inefficiency of spot contracts. The structural parameters are estimated using detailed micro-data on the area irrigated under each contract type combined with subjective probability distributions of borewell discharge elicited from a large sample of well-owners in southern India. The findings show that, while the contracting distortion leads to an average welfare loss of less than 2 percent and accounts for less than 50 percent of all transactions costs in groundwater markets, it has a sizeable impact on irrigated area, especially for small farmers. Uncertainty coupled with land fragmentation also attenuates the benefits of the water-saving technologies now being heavily promoted in India.
Our environment is characterized by considerable land fragmentation coupled with a high fixed cost of borewell installation, on the order of US$1000 (excluding the pump-set). Fragmentation is driven by the pervasive inheritance norm dictating equal division of land among sons and the prohibitive transaction costs entailed in consolidating spatially dispersed plots through the land market. 
Our estimate of buyer bargaining-power η translates (cf., definition of δ in Table 5) into a 3.7% efficiency loss due to holdup in the per-irrigation arrangement, which is an upper bound on the overall contracting distortion. The incremental cost of cultivating leased land versus own land, γ, is precisely estimated at less than 1%.
Beginning with scenario (1), borewell owners with smaller plots, ceteris paribus, are more likely to sell groundwater and hence incur proportionally greater transaction cost than those with large plots. The difference between the dashed consolidation line and the transaction cost rebate line indicates the size of the uncertainty-induced contracting distortion; it averages about 1.5% of the total rabi surplus generated by the borewell, similar in magnitude to the average fixed transaction cost of 1.8%. For the same reason as before, the contracting distortion is greater for borewell owners with smaller plots. Interestingly, comparing the right and
left panels of the figure, the impact of groundwater market frictions on area irrigated is, in percentage terms, roughly triple its impact on welfare.

The full report is available free of charge at

by Xavier  Gine and Hanan G. Jacoby
The World Bank
Policy Research Working Paper WPS 7694; June 6, 2016

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