The Market and Common-Pool Resource Problem: Surface Water Trading and Groundwater Depletion in California

This paper examines how a surface water market affects the performance of a groundwater basin that is in open access. The market only solves the groundwater over-extraction problem when pumping costs are high, while market failure arises when the common pool resource (CPR) problem is severe. I build a theoretical model to analyze the agricultural water use in California Central Valley. The model establishes the link between the efficacy of surface water market and the farmers' crop choices in response to water supply changes. I use a micro level crop choice data to test the theory and find that the farmers rarely react to short-term water supply variations. In particular, crop acreage does not fall during droughts. This implies that pumping costs are low and sellers replace whatever amount they sell with groundwater. Therefore, surface water trade is inefficient when taking into account the depletion of groundwater resource and should be curtailed until the CPR problem is addressed.