Increasing Block Tariffs in the Water Sector - a "fair" Vs. a "welfare"-approach

Abstract: The pricing of water is particularly akin to political, socio-economic, and cultural influence. Empirical evidence suggests that the level and the structure of water prices rarely correspond to welfare-optimality. Increasing block tariffs (IBTs), by which higher-income consumers cross-subsidize poorer consumers, prevail (Whittington, 2003). In this paper, we try to explain why water pricing, as observed in reality, differs considerably from the first-best, welfarist approach of standard regulation theory (e.g. Goldman, Leland, and Sibley, 1984). Our theoretical model is based on the assumption that policy makers are concerned with “fairness” and “transparency”. We also introduce asymmetric information into the model (i.e. income is not observable) and construct incentive compatible constraints. From there we calculate the “fair” and “incentive-compatible” nonlinear expenditure function for water. The model is indeed able to explain the dominance of increasing block-tariffs, observed particularly in developing and emerging countries. Increasing block tariffs can be derived using a “fair” approach, and the construction is transparent and easy, thus in sharp contrast to the welfare approach. We also perform numerical simulation for real data from the Water sector of Bangladesh. We finish with policy conclusions; and suggest that further research should look more deeply into the “fairness” issue in order to indicate the sensitivity to the new system.