I think Singaporeans would accept the water price increase if they understood the concept of long-run marginal cost. So here’s my economics 101 effort at explaining it.

First, what is marginal cost and why is it the correct basis for pricing water? It’s useful to distinguish between two types of cost – the average cost of production and the marginal cost of production. The average cost (AC) is simply the total cost of production divided by total output. Most of us understand this easily.

The marginal cost (MC) of production is a less intuitive concept. MC is the change in the total cost of production divided by the change in total output. It is the increase in total cost that arises from producing an additional unit.

The cost of producing water varies widely depending on the source and technology involved. Producing potable water from our reservoirs or from imported water costs a lot less than producing it from recycled waste water (Newater) or desalination. This cost structure also means that the marginal cost of water in Singapore refers to the cost of producing water from desalination (the most expensive technology). The marginal cost of production is therefore higher than the average cost of production.

If so, why does PUB price water using the marginal cost of production and not the (lower) average cost of production? Economists tell us that marginal cost pricing is more efficient. What they mean is that pricing it at the margin gives consumers the right price signal of what it costs to produce more water. In econs-speak, we say that marginal cost pricing produces the right incentives for consumers to economise; because if they didn’t economise and PUB has to produce more water, the cost of that additional production is indeed the cost of producing water from desalination.

In addition, as our population increases, PUB will have to adopt more expensive technologies at the margin (such as the expansion of desalination plants). The incremental costs of these technologies far outstrip PUB’s (historical) average costs of production.

Assuming you accept (more or less) the argument that marginal cost is the right basis for water pricing, the second question that arises is why long run marginal cost (LRMC) and not short run marginal cost (SRMC)?

SRMC refers to the current cost of meeting an additional unit of water demand, keeping capacity constant. In contrast, the LRMC relaxes this constraint and allows capacity to be varied.

Using LRMC rather than SRMC has two main benefits. The first is that SRMC is a lot more volatile and unpredictable. Say we have several months of unusually low rainfall. This necessarily means that SRMC increases. If water prices were based on SRMC, they would have to increase. Volatile water prices do not allow consumers (households and businesses) to make sensible consumption decisions.The second benefit of using LRMC is that it allows PUB to plan for long-term investments knowing that such investments would be (partially) financed by the water tariff.

The third question is why we have a water conservation tax (WCT) if the water tariff already prices water correctly. The reason is that (additional) water production imposes external costs on the rest of society. Water infrastructure takes up valuable land; it also consumes lots of energy. Land and energy in Singapore are scarce resources. If they aren’t priced, consumers would ignore their costs. So one way of thinking about the WCT is that it’s a way of forcing consumers of water to internalise the costs of their consumption on the rest of society. The WCT helps to ensure that their consumption of water is socially optimal.

(Post-script: I subsequently found out that LRMC = water tariff + WCT. So WCT is not a tax on the LRMC; rather, it’s included in the LRMC.)

Finally, economists are not impervious to the needs of the poor or disadvantaged. But the way to help them is not to distort prices or to depress prices artificially. Rather it is to provide them direct cash transfers. So when it comes to water pricing, the right approach should be to price water correctly and to help the poor directly through water rebates.

The economist who first explained why such an approach – price things correctly, help the poor directly – is the correct one is none other than Kenneth Arrow. He won the Nobel Prize in Economics for this and other insights in 1972. He passed away just last week.

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