California is perpetually portrayed as suffering from a shortage of water. Case in point: Gov. Arnold Schwarzenegger recently declared a statewide drought, telling citizens to prepare for rationing. But the state's problems are not a result of too little water.
The real problem is that the price of water in California, as in most of America, has virtually nothing to do with supply and demand. Although water is distributed by public and private monopolies that could easily charge high prices, municipalities and regulators set prices that are as low as possible. Underpriced water sends the wrong signal to the people using it: It tells them not to worry about how much they use.
I lived next door to a psychology professor who had just started at Mizzou in 1993. She was aghast that we actually had to pay for water in Columbia. She had grown up in California and she didn't recall having to pay for water.
Low prices lead to shortages. Water managers respond to them with calls for conservation. But this often fails. Residents in San Diego County, for example, were asked in June 2007 to cut their water use by 20 gallons a day. They used more. When voluntary conservation fails, water agencies impose mandatory rationing, which is unfair and inefficient because people who have historically been water misers are cut back by the same percentage as water hogs.
If water was priced to reflect scarcity, a decrease in supply would lead to an increase in price, and people would demand less. Consider another precious liquid: oil. Despite popular perception, there is no shortage of oil; supply does equal demand at the present price. It's just that supply meets demand at a higher price than it did a few years ago.
In a sensible water pricing system, everyone would be guaranteed a base quantity of water at a low price. Those who used more would face a steep price hike.
The laws of demand and supply apply to water too. Just because it is a publicly-provided good does not repeal these laws. As I say, X marks the spot, even in water markets.
Lynne Kiesling has thoughts here, Warren Meyer here.