The Influence of Heterogeneous Risk Preferences on Water Market Activity: an Application to the Paloma System of the Limarí Water Basin, Chile

Abstract

This dissertation contributes to our knowledge about water markets by analyzing the factors that explain market transactions of water rights when there is also a spot market for water volumes. I hypothesize that risk heterogeneity among farmers can explain those transactions. To test the aforementioned hypothesis I model farmers' decisions on investment in water rights each season under the assumptions that they face output risk and that uncertainty is generated by future water availability and price. The first order condition to this problem, which is represented by the Euler Equation, indicates that the current period reservation value of a water right depends on the current value of the amount of water accorded to water rights in the spot market, the stochastic discount factor, and the expected future prices of water rights. Using the relationship between the reservation value of a water right and the stochastic discount factor I show analytically how heterogeneous preferences are a sufficient condition for an active market for water rights. Then, I test for heterogeneous preferences by allowing them to be a function of specific characteristics of farmers. That requires the estimation of a system of equations that includes a parametric specification of the Euler Equation and the first order conditions for optimal input quantities. For that, I use an exponential utility function and a production function of the Just-Pope type. I jointly estimate the parameters that describe a farmer's utility function along with production function parameters. The empirical application uses farmer micro-level data from a two-round survey that I conducted on a sample of Limarí Basin farmers. That Basin is located in the northern part of Chile and is characterized by an active water market that has existed since 1981. Evidence rejects the hypothesis of homogeneity among farmers and suggests that those better educated and more experienced Limarí Basin farmers are less risk-averse. Results also show that water, labor and fertilizers have a positive impact on mean output per hectare but their effect on yield variability implies that those inputs are risk increasing.