Efficiency, Equity, and Cost-Recovery Trade-Offs in Municipal Water Pricing
In this working paper, we explore how water utilities often set rates that lead to inefficient water use and budget shortfalls, and suggest that fairer pricing could improve both efficiency and affordability.
Abstract
Municipal water utilities choose rates to recover costs, encourage conservation, and reduce burdens on low-income customers, which may deviate from optimal two-part tariffs. Theory suggests that prices should equal marginal cost with fixed costs recovered via fixed fees or alternative tax revenues. Using rate structure and municipal finance data for more than 700 utilities, I show that prices are discounted severely for low levels of consumption within nonlinear rate structures, leading to suboptimal usage and budget deficits, particularly in poorer and smaller communities. Marginal-cost pricing corrects allocative inefficiencies, and equity and cost-recovery goals can be achieved through more progressive approaches to fixed costs, which are both highly regressive and a large share of total costs.
Key Words: water pricing; utility management; natural monopolies; two-part tariffs; nonlinear pricing; affordability; municipal finance.
JEL codes: D12, H23, L95, Q25
