Water tariff setting and its welfare implications: Evidence from Chinese cities

We study urban water tariff setting and its welfare implications with a unique panel of Chinese cities in the 2000s. First, we find that peer cities' water tariff levels have a significant influence on a city's choice of tariffs. Using the peer cities' average tariffs as instrumental variables in estimating water demand functions, we obtain price elasticities around −0.41 for both residential and industrial sectors. Our estimation of cost functions reveals the supply of urban water services to be characterized by strong economies of scale and economies of scope. More than half of the sample have residential water tariffs higher than the corresponding marginal costs while the share increases to 71% for industrial sector. The deadweight loss calculated under first-best pricing suggests moderate welfare loss due to prices deviating from marginal costs.