The cumulative impact of pollutants on water quality at a given location al
ong a river is a function of prior loadings, as well as pollution and surfa
ce 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 o
f surface water and pollution rights along a river with water quality const
raints. 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 loc
ation-specific prices for both consumptive water rights and pollution damag
es. (C) 2001 Academic Press.