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Water Resources in Illinois:
Demand, Prices, and Scarcity Rents

Viju C. Ipe and Subhash B. Bhagwat

Illinois Minerals 126

Rod R. Blagojevich, Governor

Department of Natural Resources
Brent Manning, Director

ILLINOIS STATE GEOLOGICAL SURVEY
William W.Shilts, Chief

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Front Cover: The Harrison and Dever Cribs of the Chicago Water Department, active water-
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NATURAL
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Water Resources in Illinois:
Demand, Prices, and Scarcity Rents

Viju C. Ipe and Subhash B. Bhagwat

Illinois Minerals 126

Rod R. Blagojevich, Governor

Department of Natural Resources
Brent Manning, Director

ILLINOIS STATE GEOLOGICAL SURVEY

William W.Shilts, Chief

615 E. Peabody Drive

Champaign, Illinois 61820-6964

217-333-4747

Home page: http://www.isgs.uiuc.edu

Digitized by the Internet Archive

in 2012 with funding from

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Contents

Abstract 1

Introduction 1

Dynamics of Water Demand 2

Available Water Resources and Supply 2

Temporal and Spatial Variability in Water Prices across Illinois 3

Economic Value, Scarcity Rents, and Prices: The Case of Chicago 6

Theory of Scarcity Rents and Pricing of Natural Resources 6

Estimate of Scarcity Rents and Efficient Prices in the Chicago Region 8

Conclusions and Policy Implications 9

References 9

Recommended Readings 10

Appendix 1 1

Tables

1 Estimates of the regional demand for water in Illinois 2

2 Average growth rates in prices of water in selected cities in Illinois, adjusted

for inflation and growth in the Consumer Price Index 4

3 Monthly water charges and prices of selected utilities across Illinois in 1997 5

4 Annual costs for water supply across Illinois in 1997 5

5 Cost of extraction and purification of water in the City of Chicago in 1997 8

6 Marginal extraction cost, scarcity rent, and efficient price for the marginal

unit of water in the City of Chicago 8

Al Counties in 11 Illinois regions 11

A2 Cost of providing water in Chicago, 1987-1997 11

A3 Costs of pumping and supplying water in the Chicago area in 1 997 11

Figures

1 Prices paid by consumers for surface water in selected cities

in Illinois, 1975-1998 3

2 Prices paid by consumers for groundwater in two Illinois cities, 1975-1998 4

3 Marginal extraction costs 7

4 Projected marginal extraction cost of water in the City of Chicago starting

in 1998 8

Abstract

Analysis of the spatial and temporal
dynamics of demand, supply, and
prices of water in Illinois indicates
that regional scarcity of water is a
real possibility within the next few
decades. Alternative sources of water
must be found. Current pricing policies

of municipal suppliers are based on
average cost and are subject to political
considerations, causing actual reve-
nues of some utilities to be lower than
their listed price for water. Water prices
need to be based on marginal costs.
When economic concepts of scarcity
rent and efficient pricing were applied
to water resources in Chicago, the

results showed that water drawn from
Lake Michigan should have a scarcity
rent of at least $1.20 per thousand
gallons and an efficient price (exclud-
ing distribution cost) of at least $ 1 .44
per thousand gallons. Currently, water
in Chicago has a listed price of $1.07
(including distribution cost) and actual
revenues of $0.69 per thousand gallons.

Introduction

Illinois seems to have enough ground-
water and surface water resources to
meet its current needs for drinking and
for industrial, agricultural, recreational,
and other purposes. Although avail-
ability seems to be adequate for the
state as a whole, certain regions may
face water scarcity in the near future.
When such scarcity arises, additional
water must either be piped in from dis-
tant locations, or consumption must
be limited to sustainable quantities.
Because there is lack of unanimity
among hydrogeologists about the defi-
nition of "sustainability," we have used
a common sense definition in this pub-
lication that regards sustainable use
of a resource as possible in the long
run only when withdrawal matches
recharge rate.

Early signs of water scarcity have
already become evident in Cook
County and in the five collar counties
(Lake, McHenry, Kane, DuPage, and
Will) in the Chicago area where two-
thirds of the state's population live.
About 80 to 90% of the available water
supplies in this metropolitan region are
already being used, and the possibility
of water scarcity is projected for some
suburbs by the year 2020 (Northern Illi-
nois Planning Commission 2001). An
article in the Chicago Tribune (Kendall
1999) also raised the issue of potential
water scarcity in Chicago and north-
eastern Illinois. This area draws its
water from Lake Michigan, other sur-
face water bodies such as the Fox and
Kankakee Rivers, wells that tap areally
extensive but deeply buried bedrock
aquifers, and shallower wells that tap
aquifers in the near surface glacial
deposits in the area. Illinois already

withdraws the maximum legally per-
missible quantities of water from Lake
Michigan and almost the maximum
sustainable quantity from the Kankakee
and Fox Rivers, the deep aquifers, and
shallow wells (Winstanley and Peden
2000). Nevertheless, the population and
economy of this region are expected to
grow in the future, and new suburban
areas continue to be developed in Cook
County and adjoining counties, requir-
ing additional water. As the growth con-
tinues, additional demand for water
can be expected for industries, power
generation, and allied activities.

Although reliable estimates of available
water supplies and future water
demands for other parts of the state
are not available, experts suggest that
water scarcity is a distinct possibility in
some of those regions as well. The
comprehensive planning needed for
water resource use and management
requires good databases on the ground-
water and surface water resources
available for current and future pro-
jected regional demand.

The use and conservation of any
resource are also affected by pricing
policies. Even though water is a
resource in "abundance," the price
charged for its use should reflect its true
economic value. There have been some
attempts to review the available data on
the effects of water prices and family
income on per capita water demand.
For example, Wong (1972) investigated
the water demand in 130 systems in
northeastern Illinois and concluded that
household water demand was relatively
unaffected by price in the City of Chi-
cago, but was somewhat influenced by
price in the suburbs. Wong attributed
this difference to the fact that Chicago is

supplied with surface water, which is rel-
atively inexpensive to pump and distrib-
ute, whereas the suburbs mostly depend
on more expensive groundwater.

According to Wong (1972), the price
elasticity of water demand is influ-
enced by the absolute price level.
Price elasticity indicates how demand
changes with a change in price. For
most goods, a decrease in price results
in an increase in demand. For such
goods, the price elasticity of demand is
said to be -1 if a 1% decrease in price
results in a 1% increase in demand, and
vice versa; a number between 0 and
-1 indicates inelastic demand. When
industrial and commercial water uses
were included and community size was
not considered (i.e., when a cross sec-
tional estimate was made by Wong),
the price elasticity of water was deter-
mined to be -0.26 to -0.82.

Stevens and Kesisoglou (1984) studied
the price elasticity of water demand
in Massachusetts. Their findings con-
firm Wong's values of price elasticity for
water demand in northeastern Illinois.
Although price changes have a small
effect on water demand, the effect is
undeniable. The question, then, is what
price would be appropriate. This ques-
tion has not been studied in Illinois.

The economically grounded way to
determine the appropriate price level
is to match prices with the economic
value of water to society, which is
reflected in the "scarcity rent." Scarcity
rent refers to the implicit value asso-
ciated with the resource because of
its expected future scarcity. This report
presents the results of our attempt to
measure the scarcity rent of water in
northeastern Illinois.

Illinois State Geological Survey

Illinois Minerals 1 26

Dynamics of Water
Demand

Water is used in all aspects of human
activity, including drinking and sani-
tation, irrigation, generation of elec-
tricity, mineral extraction and other
industrial processes, recreation, and
transportation. Total water withdraw-
als serve as a proxy for total demand,
although private withdrawals are not
recorded in most cases. Private wells
are not limited to remote farmhouses;
these wells also supply larger demands
such as electricity generation, indus-
trial production, mineral extraction,
agriculture, and recreation (U.S. Geo-
logical Survey 1999). In some cases,
water demand (withdrawal) does not
represent consumption in the usual
sense. For example, the largest single
water use in Illinois is for cooling at
electricity generating plants, but much
of this water is returned to a surface
body of water — a river or lake — albeit
at a warmer temperature. Yet this use is
considered to be a demand for water in
the same sense as a demand for drink-
ing and other consumptive purposes
because it involves costs that must be
paid. Similarly, much of the wastewater
that is cleaned before being discharged
into a lake or stream was also previ-
ously consumed for drinking or other
human purposes.

Estimates of the regional demands for
water in Illinois are presented in table
1 . The state is divided into 1 1 regions
(appendix, table Al), and the total
water withdrawal in each region is used
as an estimate of the total demand.
Data from year to year and region to
region have been difficult to compare.
Because comparable regional data on
water withdrawals are available only for
the years 1990 and 1992, data for those
two years alone are reported in table 1.
This table shows that the demand for
water in the public supply systems of
the state increased by about 5.9% from
1990 to 1992. Similar rates of increase in
water demands occurred in all regions
except in the Peoria and Central regions
where demand declined.

Past trends suggest some possible future
scenarios regarding demand. In areas
with growing population and increasing
economic activity, demand for water
may be expected to increase substan-
tially. Chicago and its suburbs are an
example of one such area that may
experience supply problems in the
near future.

Available Water
Resources and Supply

Ground and surface waters constitute
the available water resources in Illinois.
The Mississippi River on the western

border, the Ohio and Wabash Rivers on
the south and east, and Lake Michigan
on the northeast are the major fresh
water bodies surrounding the state.
The large tributaries to these major
water systems in the state's interior
include the Illinois, Kaskaskia, Fox,
Rock, Sangamon, Big Muddy, Embar-
ras, and Kankakee Rivers. There are
88,417 inland lakes, excluding Lake
Michigan; total lake acreage is 301,209.
The Illinois-administered acreage of
Lake Michigan is 976,640 {1999 Illinois
Statistical Abstract). About 80% of the
inland lakes are artificially constructed.
The artificial lakes include dammed
streams and side channel impound-
ments, strip mines, borrow pits, and
excavated lakes. The natural lakes
include glacial lakes found in the
northeastern counties, sinkhole ponds
in the southwest, and oxbow and back-
water lakes along the major rivers.
Most lakes provide water for drinking
and cooling purposes, recreation, and
fish and wildlife habitat; provide help
in flood control and property value
enhancement; and provide valuable
ecological and aesthetic natural
resources. The state has approximately
900 interior streams and 26,443 total
stream miles (1999 Illinois Statistical
Abstract) . As shown in table 1 , surface
water accounts for the major share
(94% to 95%) of the total water with-
drawals in Illinois.

Table 1 Estimates of the regional demand for water in Illinois, million gallons per day.1

1990

1992

Region2

Surface water

Total

Surface water

Total

Chicago

9,727.42 (96.8)3

10,047.96

10,116.76(97.3)

10,396.12

Rockford

73.20 (37.3)

196.13

53.16(24.8)

214.77

Rock Island3

56.23 (52.4)

107.38

1,026.64(94.0)

1,092.04

Peoria

2,257.20 (95.6)

2,360.13

1,792.14(93.6)

1,914.53

Champaign

23.57 (32.5)

72.42

26.07 (32.3)

80.70

Decatur

548.10(95.8)

571.92

662.77(96.1)

689.43

Springfield

1,700.74(96.3)

1,766.53

1,659.51 (93.0)

1,784.35

Quincy

37.99 (57.8)

65.76

31.29(37.3)

83.90

East St. Louis

1,403.18(94.9)

1,479.04

1,429.46(94.3)

1,515.85

Central region

501.64(91.1)

550.49

429.01 (87.0)

493.05

Carbondale

737.48 (92.6)

796.18

757.11 (93.5)

809.76

Total4

17,066.75(94.7)

18,013.94

17,983.92(94.3)

1,9074.50

'Source: U.S. Geological Survey (1996, 1999). (Although the Illinois State Water Survey has published data on water withdrawals
since 1986, its data are not comparable with recent data available from the U.S. Geological Survey.) 1 gallon = 0.1337 cubic foot.
2See appendix table A1 for list of counties in each region.
'Values in parentheses are percentages of the total withdrawals.
••Original U.S. Geological Survey data source offers no explanation for the 10-fold increase in total demand from 1990-1992.

Illinois Minerals 1 26

Illinois State Geological Survey

In addition to surface water resources,
the state has an abundant supply of
groundwater resources. Major aquifers
underlying Illinois include ( 1 ) the satu-
rated sand and gravel deposits left in
the last 1.8 million years by repeated
advances and retreats of continental
glaciers and (2) aquifers in the bedrock
beneath the glacial deposit — the Penn-
sylvanian-Mississippian aquifer, the
Silurian dolomite aquifer, the Cam-
brian-Ordovician aquifers, and the Mt.
Simon aquifer (U.S. Geological Survey
1985). Large users, especially in north-
eastern Illinois, generally pump water
from the bedrock aquifers. Small users,
such as suburban residences and
farms, mostly obtain their water from
aquifers in the glacial deposits and
the shallow bedrock. These aquifers
may offer sources of water to meet
the demands from the growing popula-
tion and expanding economy in some
areas, but reliable estimates of reserves
in the aquifers are not available.

Detailed geologic, hydrologic, mete-
orologic, and engineering data on
ground and surface waters are needed
to determine aquifer characteristics
and to develop policies for the sus-
tainable use of water resources in
the state. The Chicago region, with
its great population density and high
annual rate of industrial and munici-
pal growth, is one example of a region
that had local water supply problems

as early as the late 1 950s (Suter et
al. 1959). These supply concerns are
likely to become more severe in the
future. Where available surface water
supply is a concern, groundwater
seems to be the alternative.

Temporal and Spatial
Variability in Water
Prices across Illinois

In view of the growing demand for
water and concerns regarding its
supply, and because price affects use,
it is essential to study and understand
how water prices have varied over
time and from one region in Illinois
to another. In order to analyze historic
trends, data were collected from the
major private water supply utilities
and from the public water supply
agencies in Illinois. Continuous, long-
term data could be obtained only
from the Northern Illinois Water Cor-
poration, now called Illinois-American
Water Company (IAWC), and from the
Water Department of the City of Chi-
cago. The IAWC supplies water to
consumers in Pontiac and Champaign-
Urbana in the Champaign region,
Streator in the Peoria area, and Ster-
ling in the Rockford area. Surface water
is supplied to Pontiac and Streator,
whereas groundwater is supplied to
Champaign- Urbana in central Illinois
and Sterling in northern Illinois. Other

divisions of the IAWC supply surface
water to Alton, Belleville, Granite City,
and East St. Louis and groundwater
to Pekin. The City of Chicago Water
Department gets most of its water from
Lake Michigan.

As shown in figure 1, the inflation-
adjusted prices of water in three com-
munities supplied with surface water by
IAWC and the City of Chicago decreased
from 1975 through 1982 but have gen-
erally increased thereafter. Prices for
groundwater in Champaign showed
a similar trend (fig. 2). In Sterling,
prices declined from 1975 through 1982
and then increased sharply from 1982
through 1985, declining again there-
after. Such sharp increases in prices
could have been due to a sudden
increase in fixed costs arising from con-
struction and /or maintenance of plants.

Over the 24-year period from 1975 to
1998, inflation-adjusted (with 1982 to
1984 as the basis of comparison) water
prices increased in all communities
except Chicago, where they declined an
average 1.02% per year (table 2). 1976 to
1980 was the period of greatest overall
consumer price inflation in the United
States, averaging 9.2% annually. Real
water prices in this period declined
in all cities and, in Chicago, by over
15%. After 1980, real prices generally
increased in all cities, although periods
of price decline occurred.

1975l1976l1977l1978l1979l1980l198l'l982l1983l1984l1985l 1 9861 1987'l988' 1989'l99o'l99l' 19921 1993'l994' 19951 1996'l997' 1998

Figure 1 Prices (deflated 1982-1984 = 100) paid by consumers for surface water in selected cities in Illinois, 1975-1998.
1 cubic foot = 7.481 gallons.

Illinois State Geological Survey

Illinois Minerals l 26

1 975l1976l1977i1978l1979l1980l1981l1982l1983l1984l1985l1986l1987l1988l1989l1990l1991l1992l1993l1994l1995l1996l1997l1 99
Figure 2 Prices (deflated 1982-1984= 100) paid by consumers for groundwater in two Illinois cities, 1975-1998.

The magnitude of change in the Con-
sumer Price Index is not necessarily
the same as cost inflation for the water
utilities. However, high rates of growth
in the Consumer Price Index may indi-
cate periods of large cost increases for
utilities as well. Although no single
reason can be given for the uneven
price development over time, an
important factor is pricing policy
based on average costs instead of the
economically more acceptable mar-
ginal cost basis. Marginal cost is
defined as the cost of adding one
more unit of water supply, and prices
are adjusted only after costs have
increased. For example, unusually high
inflation rates in the 1979 through
1981 period likely contributed to
increased operating costs. Moderniza-
tion and expansion might also have

been responsible for the price increase
(e.g., Pontiac) from 1991 to 1998.

Regulatory delays in allowing price
adjustments are common, and cost
increases may be accommodated in
other ways (e.g., by increasing meter
charges and/or fire protection and fran-
chise charges). Some cost increases may
not be recognized by regulators as legiti-
mate, but other cost increases may be
subsidized, keeping prices below market
cost. Drinking water is supplied by water
systems owned and operated by com-
munities or by privately owned but reg-
ulated monopolies. Regulated monop-
olies enjoy a competition-free market
within their designated geographic area,
but their prices are subject to approval
by a civic body consisting of appointed
or elected citizens. Regulated monopo-
lies are permitted a certain return on

approved investments. In general, the
prices charged by the utilities are
strongly influenced by forces other
than the market. When setting prices,
regulatory bodies generally are guided
by the average costs incurred by the
utilities instead of the marginal costs.

Customers generally pay fixed
monthly charges for the facilities
needed to bring water to the place of
use and meter its usage. A separate
fixed charge for fire protection ser-
vices is also paid by customers. The
portion of customer monthly pay-
ments for the amount of water used
varies. Across Illinois, charges in all
three categories vary widely, depend-
ing on district (table 3). Customers
in the City of Chicago pay the lowest
fixed charges as well as the lowest
price for water usage.

Table 2 Average growth rates (percentage per year) in prices of water (dollars per 1 ,000 cubic feet) in selected
cities in Illinois, adjusted for inflation (1982-1984 = 100) and growth in the Consumer Price Index (CPI).

Growth rate

CPI

Champaign

Sterling

Pontiac

Streator

Chicago

1976-1998

4.82

0.64

2.67

3.59

3.07

-1.02

1976-1980

9.23

-2.78

-6.14

-5.04

-2.71

-15.33

1981-1985

4.84

2.07

23.99

-0.64

2.51

-3.44

1986-1990

4.13

-0.88

-4.24

4.12

5.50

1.75

1991-1998

2.56

2.85

-0.83

11.29

5.52

2.35

Illinois Minerals l 26

Illinois State Geological Survey

Table 3 Monthly water charges and prices (dollars) of selected utilities across Illinois
in 1997.'

Fire protection and

Price

Water district

Meter charge

franchise charge

($/1,000gal)

Southern

10.50

1.23

2.65

Peoria

10.50

3.02

2.65

Pekin

10.50

2.40

1.82

Champaign

6.25

1.87

1.79

Streator

7.20

4.12

2.59

Sterling

7.30

3.27

1.85

Pontiac

6.60

4.99

3.01

Suburban Chicago

6.50

2.60

1.93

DuPage County

6.50

2.60

3.25

Fernway

6.50

2.60

1.75

Waycinden

6.50

2.60

2.11

Kankakee

8.00

1.02

1.83

University Park

4.50

5.75

1.29

Lincoln

5.49

2.91

3.23

Chicago

NA2

1.07

Average

7.353

2.933

2.19

'Illinois Commerce Commission, Water/Sewer Section, Rates Department, December 31, 1997.
2Although meter, fire protection, and franchise charges are not available separately, their total

for a month for Chicago was $7.99.
3Without Chicago.

Many factors are responsible for this
variation in water prices. The shares of
industrial, commercial, and residen-
tial consumption in a water utility's
total sales are an important determi-
nant of prices charged. Also significant
are the number of customers served
and the number of customers per
square mile. Some costs (e.g., meters
for monitoring usage) grow in pro-
portion to the number of customers

served. Other costs (e.g., the pipe net-
work serving each block) result in
lower cost per customer as the number
of customers increases. Maintenance
costs also increase proportionally with
the number of customers. The average
cost per customer may be lower in
high population density areas than in
low density areas, and new connec-
tions cost more than previous ones.
Chicago's low fixed charges reflect

its high customer density and are
based on average costs rather than
marginal costs. Consumption patterns
also affect price. Inner city and apart-
ment dwellers, for example, generally
use less water on lawns than do sub-
urbanites and owners of single-family
dwellings. Why spatial price variations
exist is thus a question that requires
a separate study to answer and is not
included here.

The average costs in 1997 for two
major utilities — City of Chicago and
IAWC — were examined to identify pos-
sible links between prices and cost
because most water utilities base their
pricing on average extraction costs
(Howe et al. 1986, Moncur and Pollock
1988). Accounting methods of the
two utilities differ significantly. Within
IAWC itself, cost reporting details vary
between Champaign, Alton, and Pekin
divisions (table 4). For example, the
operation and maintenance costs are
included in the extraction cost in the
Champaign division but not in the
Alton division. In the Alton and Pekin
divisions, interest payments are not
reported separately. The total costs of
all systems, however, are comparable.
A comparison of total costs per thou-
sand gallons of water sold with aver-
age prices per thousand gallons in
this limited sample of four companies
indicates only a weak statistical cor-
relation.

Table 4 Annual costs (million dollars) for water supply across Illinois in 1997.

Champaign,

Alton,

Sterling,

Belleville,

City

Streator,

Granite City,

Cost category

of Chicago

Pontiac1

East St. Louis'

Pekin'

Extraction2

36.70

10.74

NA3

0.65

Operation and maintenance

104.20

9.76

Depreciation

10.50

2.25

4.57

0.39

Interest

11.20

2.30

Other

59.20

2.94

Total cost

221.80

18.23

14.33

1.04

Average total cost, $/1 ,000 gal

0.55

2.234

0.86

0.30

Price, $/1,000gal

1.07

1.79

2.12

1.82

'IAWC.

2Cost of source of supply, power, and pumping.

3NA, not available separately.

"Costs exceed price per 1,000 gallons in 1997. Company officials pointed out that the rate-making procedure often results
in delays in cost recovery, and some costs, for example charitable sales of water, are borne by shareholders. Longer-
term aggregated accounting is needed for an accurate financial picture of the company.

Illinois State Geological Survey

Illinois Minerals 1 26

Economic Value,
Scarcity Rents, and
Prices: The Case of
Chicago

When an existing source of water is
exhausted, additional investments are
required to make a new source avail-
able. In general, the costs of accessing
the new source are greater than the
current costs because the lowest cost
source is accessed first. Underpricing
occurs when the increased costs from
a shift to the new source over the life-
time of the new source, also called
"scarcity rent," is not accounted for
in pricing decisions. Underpricing can
occur, for example, when water util-
ities base their pricing decisions on
average costs and on regulatory guide-
lines received from the Illinois
Commerce Commission. There are
also strong political incentives to
hold down water prices. However,
in view of concerns about the ade-
quacy of future supply to meet grow-
ing demands, it may be worthwhile to
examine the true economic value of
water, which is reflected in the scarcity
rent and the efficient price consider-
ing the scarcity rent.

Suppose that a water supply utility
obtains its water from a source that
has limited capacity or, like Chicago,
has quota restrictions on the amount
of water that can be pumped. Suppose
also that the demand exceeds the
supply. Then the utility must look for
alternative sources to supply water
as the currently available reserves are
exhausted or the quota limitation has
been reached. The utility must antici-
pate higher costs for supplying water
in the future. Prudent use of water
resources requires that water pricing
policies consider the scarcity rent.
Data are sufficient to estimate scarcity
rents and values for water for the Chi-
cago region.

The Chicago area water supply system is
an example of a utility facing the prob-
lem of expected future scarcity from
its current source and, hence, higher
future cost. Northeastern Illinois, with
the City of Chicago and the nearby sub-
urbs in Cook, Will, DuPage, McHenry,
Kane, and Lake Counties, could start
suffering from water scarcity in the
decades ahead (Injerd 2000, McConkey
2000, Northern Illinois Planning Com-
mission 2001). The population in this
area is expected to grow by about 25%

in the next two decades; this growing
population and accompanying indus-
trial growth will increase the demand
for water, but, as stated earlier, the
area is already near its maximum with-
drawal allowance. The scarcity rent
would be the cost savings that would
result from postponing the need to
access an alternative source or resort-
ing to backstop technology (Turvey
1976). A backstop technology is an
alternative high-cost technology or
extraction from an alternative high-cost
reserve. Depletion of current reserves
and/or degradation of the quality of the
current resource are possible reasons
why backstop technologies are adopted.
Desalination of sea water, which is more
expensive today than use of conven-
tional water sources, is one example of a
backstop technology suitable for coastal
areas. In the case of Chicago, explora-
tion for and pumping of groundwater
from deep aquifers or obtaining water
from distant areas using extensive pipe-
lines could be possible higher cost
alternatives. If the new source requires
additional steps for water purification,
cost increases further. In addition, other
potential users may be considering the
new source, leading to competition in
the water market.

Theory of Scarcity Rents and Pricing of Natural Resources

For the efficient use of a natural resource such as water, the price should equal the sum of the marginal cost of extraction and
the scarcity rent (Howe et al. 1986, Moncur and Pollock 1988). Let Cbe the marginal extraction cost 9 and be the scarcity rent;
then, the efficient price of a marginal unit of water may be represented as shown by Moncur and Pollock (1988):

P = C +

(1)

Assume that water scarcity problems will occur in T years. After T years, a higher-cost alternative source will have to be found to
supplement the currently available reserves. Assume that the costs in both the periods — up to and after year T— increase at an
exponential rate. Let the growth rates of costs during the first (before the year T) and second periods (Tand later) be g, and g2,
respectively. Letting Ct denote the extraction cost function in year t, then

Cx = Kxe

:-.','

c, =

C, = tf,e'

o</<r

t>T.

(2)

where C, is the extraction cost until year T, C, is the extraction cost after T years, and AT, and K, are constants. The postulated
extraction cost curve represented by these functions is shown in figure 3.

At the end of year T, the cost curve is assumed to shift up because an alternative source of water supply or a backstop
technology is more expensive. After T years, the cost curve rises at the exponential rate, gr The expected upward shift in
the cost curve after Tyears should result in scarcity rents in the period before T. The magnitude of the scarcity rent then
is equal to the decrease in the present value of future costs if year T can be postponed, thus postponing the use of the
alternative source or backstop technology (Moncur and Pollock 1988). Given the cost functions presented in equation (2),
the present value of the future stream of costs at time t, assuming that the cost function shifts at year T, is

Illinois Minerals 1 26

Illinois State Geological Survey

f v 8ll ~r(<l~t) i f v gj< r(q-t) ,

I K jg * e dq < K 2e *e dq

(3)

where r is the discount rate, and q corresponds to T, the base change of the integration. Conservation and/or an increase in
efficiency of water use can postpone the year T. Now assume that the current water conservation practices result in more
efficient use of water and that the supply agency does not have to shift to the higher-cost alternative at year T. The present
value of the future stream of costs, then, is

Kxe *e dq.

(4)

The present value of the additional costs (C;n.) of resorting to the next higher-cost alternative and/or backstop technology is

7" 00 DC

(v g\' -r(q-t) , r „ gJ -r(q-t) , f „ g,t -r(q-t) ,

Cpv= lKle *e dq + \K-,e *e dq - \K{e *e dq

I T I

= K2e

t -r(q-t)

*e i

gJ-r(T-t)

Kxe

g\~r

(5)

The derivative of Cpv with respect to time, T, measures the present value of savings in costs from postponing the switch to the
higher cost alternative by one time period. Thus, the scarcity rent, SR, is

PV - V „ SiT-rfT-t) r gJ-r(T-t)

(6)

In other words, equation (6) measures the savings in costs per unit time if the water supply agency can postpone resorting to
the higher-cost alternative sources of water supply to meet the demands.

T, years

Figure 3 Marginal extraction costs.

Illinois State Geological Survey

lllinoi

s Minerals 1 26

Estimate of Scarcity
Rents and Efficient
Prices in the Chicago
Region

In order to estimate the scarcity rent,
SR, estimates of T, g,, g,, and rare
needed. Tis assumed to be 50 years
based on expert assessment that the
Chicago area may experience water
shortages from current sources by the
middle of the twenty- first century or
earlier (Injerd 2000, McConkey 2000,
Northern Illlinois Planning Commis-
sion 2001). Extraction costs for the
Chicago water system in the 1987
through 1997 period grew at an annual
exponential rate of 5.0%. This rate is
assumed to continue in the future.
Thus, g,, and g, are both assumed
to be 5.0% (table A2). At this time,
neither the alternative water sources
after Tnor the future costs are known.
Therefore, three alternative scenarios
are considered. The first scenario
assumes that the cost curve shifts
upward by 10% at T- 50 years. The
second and third scenarios consider
cases in which the cost curve shifts up
by 20% and 30%, respectively, at T= 50
years. The discount rate r is assumed
to be 2%.

In order to compute the current extrac-
tion cost, we used the expenditures
associated with source of supply, power
and pumping, and purification in the
1997 financial report of the City of Chi-
cago water supply system (table A3).
The extraction costs in 1997 were about
$0.22 per 1,000 gallons (table 5).

The future extraction costs were esti-
mated on the basis of current costs,
projected growth rates, and estimated
upward cost shifts at T= 50 years; these
costs are depicted in figure 4. Cost curve
MCI represents the projected marginal
extraction costs under the assumption
that the cost shifts up by 10% in year
T. Curves MC2 and MC3 depict the
projected marginal costs when the cost
curves shift up by 20% and 30%, respec-
tively, at year T.

The projected marginal extraction costs,
scarcity rents, and estimated efficient
prices under the three hypothetical
scenarios over 50 years, starting in 1998,
are presented in table 6. All scenarios

Table 5 Cost of extraction and purification of water in the City of Chicago in 1997.

Expenditure
(million $)

Average cost
($/1 ,000 gal)

Source of supply

Power and pumping

Purification

Total operating expenses

0.20
36.50
48.10
84.80

0.00
0.09
0.12
0.222

'Source: Department of Water, City of Chicago.
2Total does not add up due to individual rounding.

Figure 4 Projected marginal extraction cost (MC) of water in the City of Chicago starting
in 1998.

Table 6 Marginal extraction cost (MC), scarcity rent (SR), and efficient price (EP)
for the marginal unit of water in the City of Chicago.

SR1

EP1

SR2

EP2

SR3

EP3

$0.24

$1.20

$1.44

$1.31

$1.55

$1.42

$1.66

$0.30

$1.31

$1.60

$1.43

$1.72

$1.55

$1.85

$0.38

$1.45

$1.84

$1.59

$1.97

$1.72

$2.11

$0.50

$1.61

$2.11

$1.76

$2.26

$1.91

$2.41

$0.65

$1.79

$2.43

$1.95

$2.60

$2.12

$2.76

$0.84

$1.98

$2.82

$2.17

$3.00

$2.35

$3.19

$1.09

$2.20

$3.28

$2.40

$3.49

$2.60

$3.69

$1.41

$2.43

$3.84

$2.66

$4.07

$2.88

$4.29

$1.83

$2.69

$4.52

$2.94

$4.77

$3.19

$5.01

$2.37

$2.98

$5.35

$3.25

$5.62

$3.53

$5.90

$3.08

$3.30

$6.37

$3.60

$6.67

$3.90

$6.98

$0.00

'T, time

in years, starting in 1998.

Illinois Minerals 1 26

Illinois State Geological Survey

assume a 2% discount rate and a switch
to the higher cost alternative in 50 years.
Assuming a 5.0% exponential growth
rate, the average extraction cost will
increase from $0.24 per thousand gal-
lons to $3.08 per thousand gallons in
50 years.

The results in table 6 suggest that,
under scenario 1, the water reserves in
the Great Lakes in 1998 would have a
scarcity rent of $ 1 .20 per thousand gal-
lons. Under scenarios 2 and 3, the esti-
mated scarcity rents would be, respec-
tively, $1.31 and $1.42 per thousand
gallons. In 50 years (in 2047), the rents
would rise to $3.30 per thousand gal-
lons in scenario 1, $3.60 in scenario 2,
and $3.90 per thousand gallons in sce-
nario 3. In all three scenarios, the scar-
city rents fall to zero in the 51st year
because the water supply system, by
assumption, shifts to the higher cost
alternative in year T and then remains
on the higher cost trajectory after year
T. Efficient prices recoup the marginal
cost as well as the scarcity rent. As
shown in table 4, the total average
cost per thousand gallons in Chicago
in 1997 was $0.55. The marginal cost
per thousand gallons in 1997 was $0.22
(table 5). Thus, the average cost was
about $0.33 higher than the marginal
cost to cover the costs of distribution
and administration. This relationship
may or may not continue in the future;
marginal cost may exceed the total
average cost. Therefore, future water
prices should be determined by the
greater of either the average or the
marginal cost, plus the scarcity rent.

Scarcity rents provide an indication of
the suggested price that will account for
the potential scarcity of the resource in
the future. A suggested price incorpo-
rating this consideration then would be
the sum of the average cost and the
scarcity rent. In 1998, the total cost of
supplying water would have been $1.78
per thousand gallons ($0.24 marginal
cost + $0.34 distribution cost + $1.20
scarcity rent), assuming that distribu-
tion and administration costs increased
by 5.0% from 1997 to 1998. Similarly,
under scenarios 2 and 3, the prices
would be $1.89 and $2.00, respectively.
These results indicate that the current
price charged by the City of Chicago,
$1.07 per thousand gallons, is sub-
stantially less than the estimated effi-

cient price. Actual water sales and
revenues received in 1997, according
to the accounting report of the City
of Chicago water system, indicate that
the effective average receipts were
only about $0.69 per thousand gallons.
The real magnitude of the underpric-
ing thus remains uncertain because of
discounts for greater use, charitable
activities, and the absence of any
consideration of marginal cost and
scarcity rents.

Conclusions and Policy
Implications

This report considers the economic
value of water as an essential resource
in the state in relation to its growing
demand, especially in the fast-growing
northeastern areas. Indications of an
impending water shortage in the Chi-
cago area are revealed by expert opin-
ions from important water research
agencies in the state. The City of
Chicago water system already pumps
about 85 to 90% of the maximum
legally allowable quantity of water
from Lake Michigan and is probably
approaching the limits of sustainable
groundwater extraction from aquifers
in the area. Because of the lack of
sustainable yield estimates for the vari-
ous aquifers, however, it is impossible
to make definitive assessments as to
when water scarcity may become a
reality and what additional costs will
have to be paid to secure alternative
water resources. It appears certain that,
as demand grows, water scarcity will
eventually occur. Previous research has
indicated that water demand responds
to price changes, although neither
strongly nor uniformly across commu-
nities. Water demand is influenced also
by factors such as household income.
However, little research exists to deter-
mine what price levels would be eco-
nomically rational.

The concepts of marginal costs and
scarcity rent are used in this paper to
present a guideline to calculate an eco-
nomically rational price level for water
in the Chicago area. Data show that
current prices are determined more by
average costs than by marginal costs.
Moreover, prices currently charged by
water utilities do not account for the
true value of water in the face of antic-

ipated scarcity. Political factors also
have a strong influence on water pric-
ing policies. Real water prices in the
Illinois communities studied followed a
downward trend from 1975 until 1982,
which continued in Chicago through
1998. In the other studied communi-
ties, real water prices generally have
been increasing since 1982, although
neither consistently nor uniformly
among communities.

Scarcity rents provide a means to price
current water supplies to account for
future scarcity costs. However, relevant
data for estimating scarcity rents of
water resources were available only
for the Chicago region. Those data
strongly suggest that computed prices
including scarcity rent would be much
greater than the prices Chicago cur-
rently charges for water. The results of
the study also suggest that consideration
of scarcity rents and marginal costs in
the pricing of water could encourage
reduced water consumption and help
postpone the occurrence and/or inten-
sity of the anticipated water scarcity.

References

Howe, C.W., D.R. Schurmeier, and
W.D. Shaw, Jr., 1986, Innovative
approaches to water allocation —
The potential for water markets:
Water Resources Research, v. 22,
p. 439-445.

Injerd, D., 2000, Lake Michigan diver-
sion— Current status and future
outlook: Paper presented at the
Conference on Illinois Water Sup-
plies: Is the Well Running Dry?,
Holiday Inn Chicago City Center,
July 18-20, 2000.

Kendall, R, 1999, Chicago's water
world — A saga told dryly: Chicago
Tribune, September 26, 1999, p. 1, 4.

McConkey, S., 2000, Hindsight is 2020;
A comparison of water demand pro-
jections to 2020 and actual water
use since 1950: Paper presented at
the Conference on Illinois Water
Supplies: Is the Well Running Dry?,
Holiday Inn Chicago City Center,
July 18-20, 2000.

Illinois State Geological Survey

Illinois Minerals 1 26

Moncur, J.E.T., and R.L. Pollock, 1988,
Scarcity rents for water — A valuation
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v. 64, no. 1, p. 62-72.

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Stevens, T.H., and E. Kesisoglou, 1984,
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Suter, M., R.E. Bergstrom, H.E Smith,
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Turvey, R., 1976, Analyzing the marginal
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U.S. Geological Survey, 1985, National
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Virginia, U.S. Geological Survey,
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U.S. Geological Survey, 1995, Esti-
mated water withdrawals and use in
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Department of the Interior, Open
File Report 95-309.

U.S. Geological Survey, 1996, Esti-
mated water withdrawals and use in
Illinois, 1990: Urbana, Illinois, U.S.
Department of the Interior, Open
File Report 95-396.

U.S. Geological Survey, 1999, Estimated
water withdrawals and use in Illinois,
1992: Urbana, Illinois, U.S. Depart-
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Reports 95-309, 96-396, and 99-97.

Winstanley, D, and M. Peden, 2000,
When a water witch won't work: Illi-
nois Issues, November 2000, p. 33-35.

Wong, S.T., 1972, A model on municipal
water demand — A case study of
northeastern Illinois: Land Eco-
nomics, v. 48, no. 1, February 1972,
p. 34-44.

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