The design of '' smart '' water market institutions using laboratory experiments

One of the problems with proposals for substantial institutional change in water systems is that modification and irreversibility make the process slo w, cautious and costly to society. In this paper, we discuss the role that experimental economics can play in evaluating proposed institutional change s to help facilitate a more rapid and smooth adoption of changes in the wat er system. Experimental economics yields a formal and replicable system for analyzing alternative market structures before they are actually implement ed. For example, a water market can be developed and tested in the laborato ry under supply and demand constraints that reflect drought conditions that might occur in California, or other arid regions in the world. We present a prototype of a California water transfer model and the results from a ser ies of water market experiments. Results include realized market efficiency and surplus distribution, as well as an analysis of market price volatilit y. The implications of this research extend well beyond California water ma rkets, not only to water markets in other arid regions, but also to the des ign of markets for other environmental goods, including tradable pollution permits and fishery ITQs.