Last updated March 2008
Andrew Foster; Sheetal Sekhri
The development of markets for natural resources can help to ensure that individual users appropriately internalize the opportunity cost of these resources and thus can decrease resource use. However, expansion of markets also makes it possible to sell these resources, which may lead to more rapid extraction. A simple model of markets for groundwater suggests that the latter effect dominates and that water transactions should be increasing in the fixed costs of pumping water. We construct an alternative model in which there are nonconvexities with respect to water in the agricultural production process and there are important externalities arising from well interference. We then examine these predictions using a data set from northern India that integrates farm-level information on the buying and selling of water and village-level panel information on water table depths in an instrumental variable framework. As predicted by the alternative model, we find that water transactions are decreasing in the level of fixed costs and that increased market breadth results in lower levels of aquifer depletion.