Why markets fail: Part I

February 21, 2016

People often misunderstand how markets work—and why they fail. As our team has gone around the world to learn about them, two primary, and underappreciated, issues emerge. In this two-part series, we highlight them with some examples.


Market Structure as a Means for Fairness

There’s no shortage of studies on market structure. So why is it that we think this is an underappreciated issue in the development of water markets?

Great question.

Most of the studies out there on market structure and design seem to have two dominant motivations: (1) increasing market efficiency and (2) testing strategic behavior. We think these are important motivations for studying market structure, but one that doesn’t get enough attention is market structure as it relates to fairness.

Markets? Fairness? Huh? Why do we care about that?

The way that a market is designed affects incentives for its buyers and sellers, and this has serious implications for participation. When we think about markets, a farmers’ market might come to mind: many buyers, many sellers, and many items to choose from. This is a good resemblance of a water market, where there should be many participants on both sides and that the commodity traded—water—can have diversified properties (e.g. seniority, time and purpose of use, quality, etc.).

Yet, several water markets have been set up in a way that inadvertently discourages participation—perhaps among the buyers only, or among the sellers only, or (as we’ll discuss in Part II) among both. The important point is that even though a water market represents a voluntary transaction, it can be structured in a way that favors one side of the transaction. If that’s the case, some people might be discouraged from participating as they don’t view the process and being fair to them. And with less people taking part, you got it, we’ve lost market efficiency.

Let’s go through a quick example: a reverse auction. A reverse auction is typically set up for the purpose of a water agency to buy back water rights, either temporarily (e.g. in the case of a drought) or permanently (e.g. in the case of over-appropriation). In a reverse auction, the sellers undercut each other to sell water to the buyer until they reach the lowest price anyone is willing to accept. The buyer—in this case, the water agency—essentially drives down prices through this mechanism, extracting all of the benefits from the sellers. Can you see why reverse auctions can be unpopular among sellers? The same goes for auctions being unpopular among buyers. Market structure is very important to how potential participants perceive the fairness of transactions.

All of this gets at the issue of fairness, one of the most underappreciated aspects of water trading. We regularly run into people that are unwilling to take part in markets and market-like transactions because they are concerned that they won’t be treated fairly in the process.