Markets for Water Rights under Environmental Constraints

The cumulative impact of pollutants on water quality at a given location along a river is a function of prior loadings, as well as pollution and surface flows at that particular site. The question of whether it is possible to maintain water quality under alternative mechanisms for allocating surface water and pollution rights is addressed. We model the optimal allocation of surface water and pollution rights along a river with water quality constraints. Due to cumulative effects, the shadow values of water and pollution rights are contingent on location. It is shown that a Nash equilibrium in a market for tradable surface water rights in conjunction with a market for pollution damages implements the optimal solution. The market supports location-specific prices for both consumptive water rights and pollution damages.