The Illiquidity of Water Markets

We explore a particular historical episode that switched from a market institution (auctions) to a non-market institution (fixed quotas with a ban on trading) to allocate water. This water is used by farmers for agricultural purposes; some of the farmers are liquidity constraints. We present a model in which farmers face liquidity constraints to explain why the change took place. From a positive perspective, we show that demand is underestimated if these liquidity constraints are not taken into account. We use a dynamic discrete choice model to estimate demand during the auction period; we also estimate the probability of being liquidity constrained by a farmer. From a normative perspective, auctions achieve the first-best allocation only in the absence of liquidity constraints; the quota achieves the first best allocation only if farmers are homogeneous in productivity. We compute the welfare under both institutions using the estimated parameters of the structural model.