Improved Management of Common Pool Resources

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

Year One Report Executive Summary

This project addresses common pool resource problems, which are characterized by myopic, individually-maximizing  users who overexploit natural resources  relative to a sustainable social optimum. Such problems can be analyzed from the perspective of differential game theory,  which can be used  1) to explain the behavior resulting from a given set of institutional  mechanisms (rules) and  2)  to design mechanisms that promote particular behavior.  We consider both aspects in this project.  We show how recent data on the performance of real-world markets can be used to develop more realistic game theoretic models of common pool problems. These models can, in turn, guide the design of effective institutional mechanisms. During the first year we made progress on both the empirical applied economic and the game theoretic aspects of the project. We selected as a field site and then visited the Murray-Darling  River Basin (MDB), which has one of the world’s largest and most advanced water markets. We  established multiple contacts, collected data, and laid the groundwork for a quantitative analysis of the markets and water transfers in the region. We also successfully formulated and solved a simple but informative common pool groundwater problem that reveals the advantage achieved  by cooperative rather than competitive use of limited aquifer resources.  Extensions of this  model that account for surface as well as groundwater resources will provide a useful basis for  assessing, in the second year, the performance of the MDB water market.

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.