Improved Management of Common Pool Resources

Dennis McLaughlin, Bhumibol Professor of Water Resource Management
Parag Pathak, Professor of Economics

Final Executive Summary

One of the greatest challenges we face when managing natural resources for long-term human benefit is the “common pool” problem. This is the tendency for individual users to exploit limited resources to capture benefits that would otherwise go to their competitors. In a common pool situation users who forgo exploitation to conserve the resource do not benefit from their actions because their competitors simply exploit more.This can prompt overexploitation by all users that ultimately provides less benefit to everyone. There are many familiar examples, including management of mineral resources, fisheries, air quality, and agricultural water supplies. In this ESI project, we focus on a critical renewable resource: fresh water. We use differential game theory to show that cooperative allocation of water based on welldefined ownership rights can provide greater benefit to all users than a non-cooperative arrangement that leads to overexploitation. Water markets provide a particularly promising means to achieve this greater benefit. We show this in a detailed analysis of water market data from the Murray-Darling river basin in Australia.The analytical methods developed in the project accommodate more physically and economically realistic descriptions of the resource and its users than previous work and provide a substantive advance in understanding of practical common pool problems.

Proposed Work

As water supplies across the world dwindle in the face of rising demand and impending climate change, several state and national governments have experimented with a range of schemes for managing water resources. Motivated by these emerging efforts, our project, “Improved management of common pool resources,” joins MIT researchers in Engineering and Economics to identify optimal water management practices, based on more realistic models of dynamic common pool resource use and newly available empirical evidence from fledgling markets.

Effective water management depends on whether regulators can connect institutional design with environmental processes and economic incentives. Our collaboration consequently draws on complementary disciplines: Prof. McLaughlin brings experience with environmental processes and Prof. Pathak brings experience with economic theory and market design. The project’s PhD students, an engineer (Anjuli Jain) and an economist (Will Rafey), provide parallel contributions.

Combining expertise in economic and scientific modeling may also help to narrow the gaps between the complex models often used by scientists and engineers and the stylized models favored by economists, and between analytical, academic methods and management practice—and thereby help to convince regulators and governments to implement the practical environmental solutions that we propose.

Specifically, the project aims to (i) derive more realistic mathematical descriptions of common pool problems, (ii) test these descriptions against empirical evidence from real-world situations, and (iii) calibrate resulting predictions for optimal design of water market and management mechanisms.

In particular, we hope to develop a general method for using performance data to guide market design in environmental settings. We will draw on state-of-the-art market design and game theory, scientific and engineering understanding of environmental processes, and recently developed methods in structural econometrics, alongside newly available data on water market performance in places like Australia, Chile and the arid western United States. With these techniques, we can quantify the costs of inefficient or suboptimal resource use in specific settings, and predict how new market mechanisms might affect water prices, resource allocation, and social welfare.

The true measure of our project’s success will be the extent to which we can apply our methods to improve existing market institutions in Australia and the western United States, and to guide the design of new institutions in other places facing imminent water crises. With Australia currently revising the rules governing its water market—the largest in the world and worth approximately $26 billion—and other countries/regions looking to develop water markets, our results should provide insight for ongoing, collective decisions about responsible water stewardship.