Economic parameters of water demand management for domestic use in urban China[Ⅲ]


9. WATER SUPPLY, LONG RUN MARGINAL COST

In theory, if resources are to be allocated in an economically efficient manner, prices must have regard to the marginal costs of supplying services. The ‘efficient‘ price is not the cost of using the system now, but is the price that equals the supply cost of the next increment in the size of the system. With water, marginal cost is the additional cost of producing and delivering one more unit of water.

However, marginal cost has practical limitations associated with large and long-term additional capacity in water supply. Therefore, marginal cost prices send signals to consumers about the resource cost consequences of their consumption decisions. If water prices are set under its long-run marginal costs, then excessive demand is formed. While if marginal costs exceed water revenues, it is impossible to recovery sufficient costs to increase water supply to meet the excessive demand. The aim of reforming water prices is to bring the marginal costs and marginal benefits into balance.

An example of marginal cost analysis is given in Table5, including the capital investments and operating costs associated with increased capacity of water supply as well as sewerage and wastewater treatment costs. All these are rough estimates of marginal cost depending on recent surface water and ground water developments in Shijiazhuang City, and discounted at an economic rate of discount of 10 percent.

However, it must be identified clearly whether the water utility is operating below capacity. If it is true, marginal cost should involve the incremental operating cost of producing more water within the existing system capacity. This situation in recent year exists in many cities in China.

When demand is excessive, the economical long run marginal cost of meeting that demand is likely to be higher than the long run price that equates marginal cost and marginal benefit. The appropriate economical long run marginal cost is likely to lie between the present price charged and the economical marginal cost of meeting the present demands. This is generally approaching to the financial cost or present full cost recovery level.
9. THE DYNAMICS OF DEMAND AND PRICE MANAGEMENT
With economic development and income increases, the demand for urban water has risen faster than before. Thus, management demand and price are important issues. Although subsidies to water supply utilities provided by government try to solve the financial loss as supplying excessive water, the price under subsidy does not reflect the real price and sends a wrong signal to consumers and decision-makers. While the price is controlled, the price has a low marginal cost, and the price elasticity is low. Moderate price changes have little effect. Gradual increases in tariff are swamped by the income effect, and by urban population growth. The result is that demand is becoming excessive with marginal costs exceeding marginal benefits. If this status is not changed, the costs which will be met the increased demand will be unsustainable. Potentially of more harmful is that wrong demand projecting could be made if the water demand was projected based on this demand while the price is lower.

The aim of price and demand management is to bring the price trend to the price where marginal cost and marginal benefit balance. It can be seen from Figure 5 an example of 1997 water supply curve and demand curve for domestic use. The tariff for domestic water supply is 0.55yuan/m3 in 1997 and actual water demand per capita is 135 Liters （Q1）. The long-run marginal cost of meeting the demand （Q1）is 2.2yuan/m3, if tariff rises to the level of marginal cost needed, the demand would reduce to (Q2), and a surplus would occur. Repeating the process shown above will get in the two curves intersecting at the market equilibrium. With the income increases, the demand curve will shift from left to right and more upwards, and the supply curve will shift from right to left and more upwards. It can be seen that water price and demand is a cycle and continuos dynamic process.

At the same time, comprehensive methods should be taken whenthe price and demand management, including institutional reform and making associated laws and regulations, some necessary financial supports before subsidies are canceled, and public education.

Figure 5 Dynamics of Price and Demand Management

References
[1] China Statistical Yearbook‘ China Statistical Publishing House, 1997
[2] China Urban and Rural Construction Development Report‘ China Urban Press 1997
[3] China Urban Statistical Yearbook‘ China Statistical Publishing House, 1996
[4] Microeconomics Analysis‘ Li Zhiyuan Qinghua University Press, 1997
[5] MICROECONOMICS‘ Third Edition, R. S. Pindyck and D. L. Rubinfeld Prentice-Hall International, Inc. 1996
[6] ECONOMICS OF WATER RESOURCES PLANNING‘ L. Douglas James R. LEE McGraw - Hill Book Company 1971