Welfare Implications of Water Shortages: Higher Prices or Desalination

In this paper, I evaluate the welfare implications of shortages in renewable resources, and investigate the effects of cross-subsidization on these shortages. I set up a stochastic dynamic programming model in which a benevolent central planner allocates the resource for multiple user-groups subject to revenue and resource constraints. The central planner also has access to an external source which can be used at a certain cost. The solution to the model gives the “optimal” sectoral prices, and the demand for the external source. I find out that saving net revenues during resource scarcity allows the planner to charge prices below average costs when the resource is abundant. Using water data, I conclude that cross-subsidizing agriculture does not have any significant effect on the frequency of shortages.