Pricing Policies in Managing Water Resources in Agriculture: an Application of Contract Theory to Unmetered Water

This paper uses contract theory to study a mechanism to price irrigation water when individual water uses are unobserved (asymmetric information). The study is inspired by the pricing policies of a reclamation and irrigation board (RIB) in Northern Italy where farmers are allowed to choose between a tariff calculated on irrigated land area and a tariff applied over the total harvested area. On the basis of a quota of irrigated area threshold, set by the ratio of the optional tariffs per unit area, farmers are induced to prefer a contribution formula rather than the other partially revealing their water consumption at the expense of monitoring costs. On a private perspective the paper examine farmer’s behavior given the consortium choice set. The optimal design of the contract menu is evaluated with respect both to the RIB's goals and to an ideal regulator driven by the Water Framework Directive targets. The analysis is based on a combination of non linear programming with discontinuous derivatives and a Principal Agent model. Given the contract design and assuming zero transaction costs, results show an improvement in allocative efficiency both for the RIB and the ideal regulator. Transaction costs arise when farmers choices the contribution calculated on irrigated areas due to audit requirement. Surplus differences between the investigated scenarios and a conservative one (zero transaction costs) show the limit under which transaction costs favors the contract design. The study ends highlighting the increasing importance of contract theory in defining efficient economic tools of water policy under asymmetric information.