Pricing of water: Optimal departures from the inverse elasticity rule

Abstract

We consider the problem of water usage, developing a model to analyze the optimal pricing of water within a second-best economy. A benevolent supplier provides water to multiple user groups and chooses sectoral prices to maximize social welfare subject revenue and resource constraints. We first analyze the optimal pricing rule in a static setup, and examine when it is optimal to deviate from the inverse elasticity rule. Then, we investigate the effects of both revenue and resource constraints in the dynamic model. We find that it could be possible to for the supplier to charge a higher price to the more elastic demand, when water gets scarce. © 2013. American Geophysical Union. All Rights Reserved.