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 Water Policy 17 (2015) 316–331

Marginal value of natural water in agriculture: a study in the

suburbs of Mekelle City, Ethiopia
Tafesse W. Gezahegn* and Xueqin Zhu
Environmental Economics and Natural Resources Group, Wageningen University, 6706 KN, Wageningen, The Netherlands
*Corresponding author. E-mail: tafpeace@gmail.com

Abstract

In areas where markets for natural water are lacking, information on its marginal value can be an important tool
for proper pricing to achieve efficient allocation of the resource. This article investigates the marginal value of
natural water (rainwater used as a proxy) in agricultural crop production in the suburbs of Mekelle City, Ethiopia,
by econometrically estimating individual value functions for three selected crops: wheat, barley, and teff (a staple
food crop in Ethiopia). Results show that, on average, an additional 0.30 birr (birr ¼ Ethiopian currency: 1 euro
≈ 23 birr) worth of output is generated for each extra cubic meter of rainwater used. This result provides the mar-
ginal value (shadow price) of water in crop production at a certain point of the water cycle. It thus provides useful
policy information for efficiently pricing water resources based on full-cost recovery, implying that the current tap
water prices should be increased at least by 0.30 birr/m3 if the scarcity value of natural water is to be accounted for.
The marginal value of natural water turned out to be the highest in teff production, suggesting that producing this
crop would be the most water-efficient decision in the area.

Keywords: Marginal value; Mekelle; Natural water; Production function; Rainwater

1. Introduction

The design of institutions that maximize water’s beneficial use is a central policy issue in water allo-
cation. Information on water’s economic value enables decision makers to make informed choices on
water development, conservation, allocation, and use, when demands for all uses are growing in the
face of increasing scarcity. Conceptually correct and empirically accurate estimates of the economic
value of water are essential for rational allocation of scarce water across locations, uses, users, and
time periods. Rational decisions supporting water resource management require measuring the value
of water in alternative uses (Ward & Michelsen, 2002).
In the early stages of water management, water as a resource was treated as an abundant, and thus
freely available, non-economic good and, therefore, was free of charge in many regions of the world.
doi: 10.2166/wp.2014.146

© IWA Publishing 2015

 T. W. Gezahegn and X. Zhu / Water Policy 17 (2015) 316–331 317

The International Conference on Water and the Environment (ICWE) that took place in Dublin in 1992
admitted that the lack of recognition of the economic value of water in the past has led to excessive and
inefficient use of this resource. Acknowledging water as an economic good in its management is an
important means to achieve a consumption pattern that is efficient and favorable to the preservation
and protection of water resources (ICWE, 1992). The aim of economic valuation is to secure efficient
water resource allocation (Brouwer et al., 2009). To implement the most efficient social and economic
policies that prevent the excessive use of water resources, it is necessary to establish their full value, and
to incorporate this into private and public decision-making processes (Birol et al., 2006). At the Second
World Water Forum, held in The Hague in 2000, a particular emphasis was placed on the valuation of
this natural resource (World Water Forum, 2000).
Water is allocated efficiently when it is put to its highest-valued use. Achieving efficient or optimal
water allocation requires that marginal benefits be identical for all users (Zhu & Van Ierland, 2012).
Under an efficient allocation, no reallocation can make anyone better off without making at least one
person worse off (i.e. Pareto optimality). While water is an essential input for production, it is, however,
one of the most subsidized or underpriced inputs in many countries. Moreover, there is usually no
charge for the use of natural water. Underpricing of water leads to inefficient allocation of the resource.
With the ever-increasing scarcity, it seems logical to use a pricing mechanism to allocate water resources
in a more efficient way (Zhu & Van Ierland, 2012). Efficient water pricing implies the maximization of
net benefits of water, which requires marginal benefit to equal marginal cost (Griffin, 2006). Therefore,
understanding the marginal benefit or marginal value of water is essential for water pricing. With other
values, such as average values, it is impossible to determine which use should be discarded if water
availability is restricted (Hellegers & Davidson, 2010), since average values do not show us the most
or least valuable use at the margin.
The natural1 water resources in the present study area, mainly groundwater, are being extracted for
free for the purpose of urban water supply. Markets for natural water are non-existent. An important
question, then, is ‘What is the value of natural water in the area?’ Urban tap water prices are set
based on the average cost of water supply, reflecting only the costs of groundwater extraction, treatment,
storage, and distribution, but not the value of the resource itself. This leads to an underestimation of the
full social cost of urban water supply, which will inevitably cause a continued and excessive extraction
of groundwater for urban use while the resource has alternative uses, such as for agriculture. The full
cost of water supply, beyond the engineering costs of water extraction (diversion) and conveyance,
includes also the alternative costs associated with the different uses of water at present and in the
future (Tsur, 2005). Agriculture is a vital economic sector in the study area. Therefore, determining
the marginal value of natural water in agricultural crop production can support efficient water allocation
through designing a proper pricing system. One way of doing this can be the incorporation of farmers’
forgone benefits (i.e. the marginal value of water in crop production) into tap water prices.
The marginal value of natural water in agricultural production has been studied in the literature of agri-
cultural water management (e.g. Faux & Perry, 1999; Ward & Michelsen, 2002; Leyva & Sayadi, 2005;
Hussain et al., 2007; Samarawickrema & Kulshreshtha, 2009; Hellegers & Davidson, 2010; Mesa-
Jurado et al., 2010; Al-Karablieh et al., 2012; Chowdhury, 2013). These studies use irrigation water to

1
The terms ‘natural water’ and ‘raw water’ are used interchangeably throughout the paper.
318 T. W. Gezahegn and X. Zhu / Water Policy 17 (2015) 316–331

estimate the marginal value of natural water. Their approaches are applicable to areas where irrigation
facilities are well established and the amount of irrigation water used by individual farmers in a given pro-
duction year is recorded. In some cases, rainwater has also been valued. For example, Hoekstra et al. (2001)
estimated the value of rainwater in rain-fed agriculture in the Zambezi basin. Supposing that water is the
limiting factor, Hoekstra et al. (2001) argue that a reduction in water will result in reduced crop production
and thus a reduced benefit, adding that in the most extreme case, if there were no rainwater at all, crop pro-
duction would be zero. Thus, the authors assumed the total value of rainwater falling on rain-fed croplands
to be equal to the net benefit in the rain-fed agriculture. Albersen et al. (2003), on the other hand, used the
capital theory procedure to price a raindrop in a process-based model. A paper by Mutabazi et al. (2005)
demonstrated the economic benefits of rainwater management for crop production in a semi-arid Makanya
Watershed in the Pangani River Basin, Tanzania, arguing that the findings justify investment and technol-
ogy transfer in rainwater harvesting for crop production. Another paper by Hatibu et al. (2006) presented an
analysis of the economics of rainwater harvesting by poor farmers in Tanzania.
In the present study area, irrigation facilities are limited and the scanty irrigation water is not metered;
that is, it is not known which farmer uses how much irrigation water and when. Agricultural production
is dependent on erratic and possibly inadequate annual rainfall. In this study, therefore, we employ the
quantity of rainwater (calculated based on meteorological records) used for crop production in selected
villages on the outskirts of Mekelle City as a proxy variable to estimate the marginal value of natural
water. The marginal value of natural water in crop production is the direct economic benefit of water at
the margin, or the marginal value of water in situ. It could, therefore, be an indication of the extra costs
to be charged for urban water consumption, as water uses for urban consumption and agriculture are
competing in the same water cycle. Moreover, since the marginal value of natural water in crop pro-
duction is reflective of farmers’ maximum willingness to pay for the resource, it makes sense to
charge irrigators (current and potential) a price at least as high as the estimated marginal value of natural
water in the area if all the water resources are fully priced. The main purpose of this study is, therefore,
to estimate the marginal value of natural water in agricultural crop production on the outskirts of
Mekelle City in a bid to initiate a basis for proper water pricing in the area, which is useful for creating
an efficient water market based on full-cost recovery.
The rest of the paper is organized as follows: Section 2 briefly describes the study area; Section 3
outlines the methodological approaches; in Section 4, results are presented and discussed; Section 5 pre-
sents some plausible policy implications; and Section 6 concludes.

2. The study area

This study focuses on four deliberately selected villages on the outskirts of Mekelle City, namely:
Aynalem/Shibita, Debiri, Romanat/Mahbere Genet, and Mesobo (see Figure 1). We selected these vil-
lages on account of their close proximity to Mekelle City and the fact that the main source of the city’s
water supply is groundwater from boreholes located in or near these villages. The selected villages
belong to the Enderta district (woreda) in Tigray Region. This district lies in the midland agro-ecology,
characterized by dry climatic conditions and erratic annual rainfall of 450–600 mm. The terrain is
mostly plains and hills, with bush scrub vegetation. Water for human consumption is collected from
deep and shallow wells, springs, and minor rivers. Crop and livestock production are the main economic
 T. W. Gezahegn and X. Zhu / Water Policy 17 (2015) 316–331 319

Fig. 1. Map of Enderta District.

activities in the zone. Crop production is dependent on the short rainy season from April to May and the
main rains, which, in a good year, start in June and last until mid-September (USAID, 2009).
Most households use animal manure and compost on the clay soils to improve crop production. Oxen
are the most important asset, after land, mainly owned by better-off households. Crops cultivated in the
area include wheat, barley, teff, vetch, and lentils. The decision to grow these short-cycle crops is to some
extent influenced by the unreliable rainy season (USAID, 2009), as they need water for only a relatively
short period of time. The study area is known for having a unimodal rainfall pattern that covers the period
from June to September. A small area (16%) of the district has a bimodal rainfall pattern. Enderta district
has a total area of 193,309 hectares, of which the total cultivated land covers 49.03%. Of this, agricultural
land contains 48.48% of rain-fed crops and 0.55% of irrigated crops. Officially, water projects focusing on
drinking water were started in 1998 in the district. About 73 large and small projects of dam, diversion,
and source development were carried out (Amleset, 2011). The district’s groundwater serves as the main
source of Mekelle City’s water supply; water boreholes are located in this district within a 20 km radius of
the city (Derbew et al., 2006, cited in Castro & Maoulidi, 2009).
The yearly extraction of groundwater from the villages in the study area for urban water supply has
been as shown in Table 1.
320 T. W. Gezahegn and X. Zhu / Water Policy 17 (2015) 316–331

Table 1. Yearly extraction of groundwater from the villages in the study area.
Year 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Water extraction (million m3) 3.05 2.83 3.00 3.15 3.46 3.78 4.21 3.95 4.76 5.02
Source: Mekelle Water Supply Office (2012).

3. Materials and methods

There are numerous methods of water valuation mentioned in the literature. Among these, Zhu & Van
Ierland (2012) propose water valuation in a welfare program. The marginal value of water in a welfare
program, which reflects its marginal contribution to the objective function, is also called the shadow
price of water. There are other water valuation methods for natural water, including the hedonic pricing
method, travel cost method, replacement cost method, production function method, cost-of-illness
method, market prices, contingent valuation method, and choice experiment method (see Birol et al.
(2006) for an overview).
Some studies (e.g. Wang & Lall, 2002; Nahman & De Lange, 2012) modify the production function
into a value (output multiplied by price) function to determine the marginal value of water. According to
the value function approach, the marginal value of water is estimated by measuring the additional rev-
enue obtained due to a unit increase in water as an input in a production process, where the output value
is a function of labor, man-made capital, intermediate input, and natural capital including the water
resource (Brouwer et al., 2009). This approach is generally used to value non-marketed resources
(e.g. natural water) that serve as an input to the production of marketed goods. It relates the revenue
from a particular marketed good or service (e.g. agricultural output) to the inputs necessary to produce
it (Birol et al., 2006). Regressing revenue on these inputs and taking the first derivative of the revenue
function with respect to the quantity of water input yields the marginal value of water (Brouwer et al.,
2009). The value function can be expressed as:

V ¼ A(t)f (x) (1)

where V is output value; f is a production function in value terms (quantity multiplied by price) without
a term for technological progress; x is a vector of inputs indexed by j ( j ¼ 1, 2, …, n). In the case of time
series or panel data, the term A(t) (where A ¼ technology parameter and t ¼ time trend) is usually intro-
duced into the production function to capture technological changes over time, where the multiplicative
factor A(t) measures the cumulative effect of shifts over time (see Solow, 1957). Given that V represents
the value of output, instead of just quantity of output, the first derivative of the value function with
respect to input j (e.g. water) gives the marginal value of that input (MVj), as in Wang & Lall (2002):

MVj ¼ @V=@xj (2)

Regarding rainwater, Hoekstra et al. (2001) estimated its value in rain-fed agriculture in the Zambezi
basin by drawing a crop demand curve. The net benefit in rain-fed agriculture was, then, approximated
by the area below the crop demand curve minus the total costs of crop production.
 T. W. Gezahegn and X. Zhu / Water Policy 17 (2015) 316–331 321

3.1. Model specification

Wang & Lall (2002) proposed the use of a marginal productivity approach to estimate the value of
industrial water use, and included water along with capital, labor, energy, and raw materials as inputs in
a production function. The study argues that a marginal productivity function of water can be developed
by taking a routine derivative of a production function. Strzepek et al. (2006) followed a similar
approach with land, capital, intermediate inputs, and water as inputs to a production function. Another
study by Nahman & De Lange (2012) also adopted a comparable methodology to that of Wang & Lall
(2002), using data from a number of South African firms in the industrial sector with four inputs,
namely: capital, labor, water, and energy.
Following Wang & Lall (2002), Strzepek et al. (2006), and Nahman & De Lange (2012), we adopted
the value function approach to estimate the marginal value of rainwater in agricultural crop production
as a proxy for the marginal value of natural water. We used panel data collected from 16 farmers for the
period 2003 to 2012. We decided to use panel data with the intention of minimizing estimation biases
that would arise because of yearly fluctuations in the amount of rainfall. We focused on three crops:
wheat, barley, and teff, as these are the typical agricultural crops in the area. Production of the three
selected crops needs six inputs including land, labor, capital, seed, fertilizer, and water. However,
land is not directly included in the model because the amount of rainwater depends on land area,
and land can reasonably be viewed as a fixed input in the short run. As a result, the value function
can be written as: Vit ¼ V(Bit ,Kit ,Sit ,Fit ,Wit ,hi ,t), where Vit ¼ output value (birr), Bit ¼ labor (number
of workers), Kit ¼ capital (number of oxen used), Sit ¼ seed (quintal), Fit ¼ fertilizer (quintal), Wit ¼
water (m3) of farmer i in year t, and hi ¼ unobservable farmer-specific characteristics (unobserved het-
erogeneity), which controls for farmer-specific fixed effects that remain constant over time. Capital is
represented by number of oxen in this study because oxen are the most important assets, next to
land, for farmers in the study area.
Wang & Lall (2002) and Strzepek et al. (2006) estimated three different production functions: Cobb–
Douglas (C–D), translog, and translog with sector dummies, while Nahman & De Lange estimated only
the translog version. Another study by Madariaga & McConnell (1984) obtained the marginal value of
irrigation water for the Middle Atlantic region by estimating an aggregate total value product function of
the C–D specification. In this study, also, the value function is represented by a C–D specification. The
translog form, a commonly used specification in the literature because of its flexibility, was considered,
but not chosen. The choice between the translog and C–D specifications was made based on hypothesis
testing. The C–D specification is nested in the translog specification, which includes squared and inter-
action terms on top of the C–D terms. Therefore, a testing procedure was conducted to check whether
the coefficients of the extra terms in the full model (translog) are all zero (H0: the squared and interaction
terms of the translog specification have zero coefficients). The test results indicated a lack of evidence to
reject the null hypothesis even at the 10% level of significance2. This led to the acceptance of the
reduced C–D model as an appropriate specification for the panel data at hand. The log-linear form of

2
The F-statistics of the tests for wheat, barley, and teff were F ¼ 1.3 (p ¼ 0.2253); F¼ 1.45 (p ¼ 0.1537); and F ¼ 0.89 (p ¼
0.5423), respectively.
322 T. W. Gezahegn and X. Zhu / Water Policy 17 (2015) 316–331

the C–D specification, including an error term εit, is given as follows:

ln Vit ¼ a þ lt þ b1 ln Bit þ b2 ln Kit þ b3 ln Sit þ b4 ln Fit þ b5 ln Wit þ g ln hi þ 1it (3)

where, ln ¼ natural logarithm; α ¼ a technology parameter, which determines the technical relationship
between output value and inputs; λ ¼ a measure of the proportionate change in output value per year
(assumed to be the same for all farmers) as a result of technical progress with input levels held constant;
i and t represent individual farmers and time, respectively. This specification incorporates neutral tech-
nical change; that is, there is no impact of technological progress on the marginal rate of technical
substitution among inputs. This formulation implies that the technical change is exogenous and disem-
bodied (Fraser, 2002).
The parameters b1 ,b2 ,b3 ,b4 ,b5 &g are elasticities of output value with respect to labor, capital, seed,
fertilizer, water, and unobserved heterogeneity, respectively, which are determined by the available tech-
nology. This relationship expresses the notion that each farmer has a C–D production function with
common coefficients: a,l,b0 s,&g. However, there are differences in how efficient the farmers are,
which arise from variations in hi among farmers. The farmer-specific effects can be given by:
ai ¼ a þ g ln hi so as to reduce Equation (3) to the fixed-effects (FE) model given by Equation (4)
below. Although α is constant across individuals and over time, αi varies across individuals (due to
hi). The fixed-effects (FE) model controls for all time-invariant differences among individual farmers
(via αi).

ln Vit ¼ ai þ lt þ b1 ln Bit þ b2 ln Kit þ b3 ln Sit þ b4 ln Fit þ b5 ln Wit þ 1it (4)

This model has two elements that capture unobserved characteristics of farmers: αi and εit. We could
interpret αi as a term that captures unobservable farmer-specific characteristics, such as management
quality and location, which may not change over time, while εit captures unobserved and/or unobserva-
ble factors that vary over time and across individuals. A Hausman test was conducted to make the choice
between the FE and random-effects (RE) models of panel data. The results supported the rejection of the
null hypothesis that the RE is consistent, leading to reliance on the FE estimator3. Thus, the value func-
tions (one for each crop) were estimated using the FE panel data model. In using the FE model here, it is
assumed that only the time-invariant part of the unobserved characteristics (αi) is relevant for farmer i’s
choice of inputs, and not the part that varies over time (εit). This might be reasonable if εit represents
factors that cannot be predicted at the time the farmer chooses his inputs (e.g. weather conditions).
One of the problems of panel data is the inconsistency of the sample size over time due to withdrawal of
some farmers from the panel; that is, not all the initially selected farmers can be tracked for the entire study
period, resulting in unbalanced panel data (which was the case in this study). This may lead to a selection
bias in the data set if there is a systematic pattern behind the lower number of farmers in some years. It
could, for example, be that more innovative farmers shift to more profitable cash crops as time goes by.
If that is the case, the estimation results are not representative of the whole population, making inference
problematic. To take care of this potential problem of selection bias, a simple test was conducted by

3
The results of the test, for wheat, barley, and teff respectively, were: chi-square ¼ 16.01 (p ¼ 0.0137); chi-square ¼ 12.87
(p ¼ 0.0452); and chi-square ¼ 13.74 (p ¼ 0.0326).
 T. W. Gezahegn and X. Zhu / Water Policy 17 (2015) 316–331 323

introducing a new variable u, signifying the total number of years a particular farmer was observed, into
the regression procedure. Then, we estimated an RE model including u as an additional explanatory vari-
able and observed whether the coefficient of this new variable was significant, in which case there would
be a potential selection bias (the RE model was used because u is time-invariant for a specific farmer i).
The test results4 for each crop showed a lack of sufficient evidence to reject the null hypothesis of no selec-
tion bias in the data set; this makes the inference safe at least from the viewpoint of selection bias.
The marginal value of rainwater was then calculated from the above-specified value function for each
year of the study period. Estimating year-specific marginal values (MVs) based on Wang & Lall’s
(2002) method does not require the estimation of a separate value function for each year individually.
Instead, a single value function is estimated for all years in the sample for each crop. This ensures that
the value functions are estimated based on a sufficiently large number of observations. Thereafter, it is
possible to estimate year-specific MV based on the parameters of the common value function and the
year-specific sample averages of output value and amount of rainwater. By construction of the model,
the elasticity of output value with respect to water is constant over time and across individuals (β5).
Since Vit represents the value of output for farmer i in year t, @Vit =@Wit gives the marginal value of rain-
water for farmer i in year t (MVit):

MVit ¼ @Vit =@Wit ¼ @ ln Vit =@ ln Wit Vit =Wit

(5)
¼ b5 Vit =Wit

If we take the average values of Vit and Wit over individuals for each year t, the marginal value of
rainwater in year t is given by

 t =W
MVt ¼ b5 V t (6)

Here, V  t represent the average output value and rainwater quantity of all farmers respectively
 t and W
for year t. Therefore, the marginal value of rainwater in year t is calculated as the product of output elas-
ticity of water (β5) and the ratio of average output value to average rainwater quantity for the year in
question.

3.2. Data sources and collection methods

Using the list of farmers documented by the Enderta District Agriculture and Rural Development
Bureau (EDARDB) as a sampling frame, sample respondents were selected using a simple random
sampling technique. A total of 16 farmers, four from each village (Aynalem, Debiri, Romanat, and
Mesobo), were randomly selected. Then, data on the quantities of output (quintal), fertilizer (quintal),
seed (quintal), and land size (ha) were obtained from EDARDB for each farmer and each crop (wheat,
barley, and teff) for 10 years (2003–2012). However, data on yearly labor and capital usage were gath-
ered directly from the selected farmers via interview because data on these variables were not available
in the EDARDB documents. For the interview, the farmers were contacted by paid enumerators mainly

4
For wheat (z ¼ 1.25, p ¼ 0.212); for barley (z ¼ 1.11, p ¼ 0.266); and for teff (z ¼ 1.41, p ¼ 0.158).
324 T. W. Gezahegn and X. Zhu / Water Policy 17 (2015) 316–331

on Sundays, the farmers’ dayoff. The descriptive statistics of the inputs and output values are included
in Tables A1 and A2 of the Appendix for the three types of crops (available online at http://www.
iwaponline.com/wp/017/046.pdf).
Moreover, data on the amount of rainfall in millimeters (mm) in each village per production period
(from time of sowing to time of harvest: for wheat, mid-June to end of October; for barley, mid-June to
early October; for teff, mid-June to early November) were taken from the meteorological records of
EDARDB. This information was used to calculate the total amount of rainwater in cubic meters that
each farmer received during the production period of a crop, based on the number of hectares of
land allotted to the crop. One hectare (¼104 m2) of land under a rainfall of 1 mm receives 104 m2 
0.001 m ¼ 10 m3 of water. Therefore, the amount of rainwater W (m3) received by a farmland of a
given size L (ha) under a rainfall of a given amount R (mm) can be calculated as:

W ¼ 10RL (7)

(see Brouwer et al., 1985). This means that farmers having the same land size in the same village receive
the same amount of rainwater during the same production period.
The yearly output value of each crop is a measure of farm revenue determined as yearly farm-level
output multiplied by average yearly price. To make the comparison of yearly output values meaningful,
we measured crop prices relative to the overall price level (crop prices were measured in real rather than
nominal terms). Real prices are nominal (current) prices adjusted for inflation to remove the effect on
output value of price changes over time. The real price of a given crop was determined as its price rela-
tive to an aggregate measure of prices: the Consumer Prices Index (CPI). The CPI of year t (CPIt) and
yearly nominal price of crop k (NPkt) were taken from the bureau of the Central Statistical Agency
(CSA) of Ethiopia, Mekelle branch office5. Then, the real price of crop k in year t (RPkt) was calculated
in terms of 2003 birr as: RPkt ¼ CPI2003 =CPIt  NPkt for t ¼ 2003, 2004, …, 2012 and k ¼ wheat,
barley, teff. A constant or real price was used here to avoid the impact of inflation on the comparability
of the real value of output, and hence the real value of water in agriculture across the years (see Table A2
of the Appendix for the average output values and rainwater quantities for the three types of crop).

4. Results and discussion

Table 2 presents the FE regression results of the log-linear form of the C–D value function based on
Equation (4). On the basis of the estimated coefficients (Table 2) and the sample averages of output
value and amount of water in each year, the yearly MVs of water use for each crop were calculated
(see Table 3). The FE estimator includes a fixed average intercept (constant) and the individual fixed
effects are considered as deviations from this constant. Regarding wheat production, labor (lnB), seed
(lnS), and water (lnW ) were shown to have a statistically significant role in explaining the variation
in the value of output, all with the expected direction of relationship (positive). For barley production,
on the other hand, only labor and water had a statistically significant effect on output, whereas in the
case of teff production, only fertilizer and water turned out to be significant. Considering the estimation

5
The yearly CPIs were based on the year 2005 (i.e. 2005 ¼ 100).
 T. W. Gezahegn and X. Zhu / Water Policy 17 (2015) 316–331 325

Table 2. Estimation results of the FE C–D specification.

Wheat Barley Teff
Regressors Coefficient S. Error Coefficient S. Error Coefficient S. Error
Constant 4.88*** 0.98 4.46*** 0.95 3.19* 1.84
lnB 0.24*** 0.08 0.35*** 0.08 0.02 0.14
lnK 0.16 0.11 0.06 0.11  0.06 0.19
lnS 0.46*** 0.14 0.18 0.15 0.16 0.23
lnF 0.08 0.05 0.19 0.10 0.36*** 0.12
lnW 0.31** 0.13 0.36*** 0.12 0.56*** 0.20
t 0.03** 0.01 0.01 0.01  0.01 0.02
F-statistic: 34.56 ( p ¼ 0.000) 32.86 ( p ¼ 0.000) 13.70 ( p ¼ 0.000)
R2– within: 0.63 0.62 0.52
A a: 2.90 ( p ¼ 0.1094) 1.01 ( p ¼ 0.3315) 14.53 ( p ¼ 0.002)
***Significant at 1%.
**Significant at 5%.
*Significant at 10%.
a
Refers to the Wooldridge test for auto-correlation in the panel data. Note that the Wooldridge test statistic is basically an F-
statistic. The letter A is used here for the test statistic simply to avoid confusion with the F-statistic of the overall model test.

Table 3. Marginal value (MV) of rainwater used by crop and year (birr/m3).
Year Wheat MV (birr/m3) Barley MV (birr/m3) Teff MV (birr/m3) Yearly average MV (birr/m3)
2003 0.33 0.32 0.41 0.35
2004 0.23 0.22 0.31 0.25
2005 0.34 0.37 0.34 0.35
2006 0.26 0.23 0.27 0.25
2007 0.31 0.27 0.39 0.32
2008 0.31 0.23 0.39 0.31
2009 0.31 0.30 0.34 0.32
2010 0.36 0.31 0.29 0.32
2011 0.26 0.25 0.21 0.24
2012 0.27 0.26 0.24 0.26
Crop average 0.30 0.27 0.32
Overall average 0.30

technicalities of the FE (within) estimator, the variation in the significance of the different inputs in
explaining output values of the three crops can partly be explained by the degree of variability of
input levels of the farmer i over time. Within estimation is based on within variation (variation over
time for a given farmer). As a result, explanatory variables with little within variation will be insignif-
icant in explaining the dependent variable. In this study, capital, labor, seed, and fertilizer had relatively
little within variability in the production of (1) all three crops, (2) teff, (3) barley and teff, and (4) wheat
and barley, respectively.
Interestingly, the regression results show that water is a significant input in the production of all three
crops (the coefficient of lnW is significantly different from zero at the 5% level for wheat, and the 1%
level for barley and teff). The other test statistics (F, R2, A) given in the last three rows of Table 1
326 T. W. Gezahegn and X. Zhu / Water Policy 17 (2015) 316–331

confirm the significance of the model (the included farm inputs) in explaining output value (significant
F-statistic), the good explanatory power of the model (fairly high R2) for each crop, and the absence of
serious auto-correlation of the specified variables over time (non-significant A) except for teff. The sig-
nificant test statistic of the Wooldridge test for auto-correlation in the case of teff indicates that the null
hypothesis of no auto-correlation in the data is rejected. Because of the small number of time periods
(only 10 years) considered, no attempt was made to remedy the problem of auto-correlation in the fixed
effects model for teff. In the presence of auto-correlation, the parameter estimates are still linear,
unbiased, and consistent. The major consequence of auto-correlation is that parameter estimates will
no longer be efficient (i.e. will not have minimum variance), in which case the odds of obtaining stat-
istically insignificant parameter estimates become higher. For example, labor (lnB) is not significant in
teff production, while it is significant in wheat and barley production. This might be the result of ineffi-
cient estimates (large standard errors) due to the presence of auto-correlation in the data for teff.
However, β5 (the coefficient of lnW ), which constitutes the formula for determining the marginal
value of water (see Equation (6)), turned out to be significant, defying the major consequence of
auto-correlation.
The coefficients of lnW of 0.31, 0.36, and 0.56 respectively for wheat, barley, and teff in Table 2
indicate the elasticity of the output value of each crop with respect to the amount of water input. The
elasticity of output value with respect to water of 0.31 for wheat implies that, on average, the value
of wheat output increases by 0.31% if the amount of water input increases by 1%. Similarly, the
values of barley and teff output increase respectively by 0.36 and 0.56% if the amount of water
input increases by 1%. Technological progress was shown to be significant only in the production of
wheat over time (significant coefficient of t). This means that the same levels of labor, capital, seed,
fertilizer, and water inputs resulted in higher wheat output, on average, over time. The non-significant
coefficients of t for barley and teff, on the other hand, are indications of the lack of technical headway in
the production of these crops during the period addressed in this study. Given the data collected for the
study, it was not straightforward to explain the differences in technological progress in the production of
wheat on the one hand, and the implied lack of technological progress in the production of barley and
teff on the other.
Table 3 presents the MV of rainwater in each year by crop. The last column provides an estimate of
the yearly average marginal value of rainwater use over the three crops. The distribution of these yearly
average MVs ranges from 0.24 birr/m3 in 2011 to 0.35 birr/m3 in 2003 and 2005. Comparing each
specific crop, one cubic meter of rainwater during the study period, on average, generated the highest
marginal value of 0.32 birr/m3 in teff production, followed by a marginal value of 0.30 birr/m3 in wheat
production, with barley production bringing the least marginal value of 0.27 birr/m3. The overall mar-
ginal value of water use (average over all years and across all crops) was 0.30 birr/m3. This implies that
an additional 0.30 birr worth of output was generated for each additional m3 of rainwater used in agri-
cultural production of the three crops during the period considered in the study (2003–2012).
The value, to farmers, of an additional m3 of water is therefore 0.30 birr, on average. This is what the
typical farmer (in this specific study area) would be willing to pay for an additional m3 of water in crop
production. This value can be a reasonable estimate of the marginal value of natural water in crop pro-
duction in the present study area as the selected crops are the most commonly grown ones in the region.
The fact that the MVs are non-zero implies that there is water scarcity, as Zhu et al. (2013) note. Com-
parably, with an average rainfall of 875 mm/yr, Hoekstra et al. (2001) calculated an average rainfall
value of 0.2 dollar cents per cubic meter in the Zambezi basin.
 T. W. Gezahegn and X. Zhu / Water Policy 17 (2015) 316–331 327

Table 4. Relationships among yearly MV, amount of rainwater (W), and real prices (P) for each crop.
Wheat Barley Teff
Year MV W P MV W P MV W P
2003 0.33 1,217.81 5.25 0.32 1,233.84 6.52 0.41 1,269.09 6.95
2004 0.23 1,917.91 2.60 0.22 1,793.25 3.07 0.31 1,582.28 7.56
2005 0.34 1,543.00 5.17 0.37 1,234.40 6.22 0.34 1,543.00 7.55
2006 0.26 1,879.58 3.86 0.23 1,691.63 4.46 0.27 1,691.63 6.34
2007 0.31 1,539.00 7.09 0.27 1,767.00 9.02 0.39 1,254.00 12.04
2008 0.31 1,949.06 7.80 0.23 1,496.25 8.79 0.39 1,417.50 12.31
2009 0.31 1,758.28 5.77 0.30 1,701.56 9.11 0.34 1,172.19 11.37
2010 0.36 1,701.56 5.71 0.31 1,701.56 8.77 0.29 1,096.56 10.48
2011 0.26 2,962.50 5.06 0.25 2,567.50 5.80 0.21 2,287.71 7.62
2012 0.27 3,357.50 6.09 0.26 2,863.75 6.99 0.24 2,238.33 10.20
MV ¼ marginal value (birr/m3); W ¼ amount of rainwater (m3); P ¼ real price per kg (birr).
Source: Enderta District Agriculture and Rural Development Bureau; Central Statistical Agency; and own calculation.

The variation in the MVs across the years can be linked to variations in the amount of rainwater and
crop prices over time (see Table 4). Since output elasticity of rainwater for each crop is fixed over time
(by construction of the model), years with a higher ratio of average output value to average quantity of
rainwater (or the relative output value of water input) will have higher marginal value; the less the aver-
age amount of rainwater, the higher the ratio; and the higher the ratio, the higher the marginal value.
This indicates that drier years have higher relative output values and higher MV of rainwater, suggesting
that relative rainwater scarcity brings a higher marginal value of the resource. This fact is, however, not
consistent over the entire period of this study. In some cases, an increase in the amount of rainwater
causes an increase in its marginal value. For example, the marginal value of water for wheat production
increased from 0.26 birr/m3 in 2011 to 0.27 birr/m3 in 2012 even though the water amount increased by
13% from 2,962.5 to 3,357.5 m3 (see Table 4). During this same period, the price of wheat also
increased from 5.06 birr in 2011 to 6.09 birr in 2012 (a 20% increase). Therefore, the ultimate trend
of the marginal value of rainwater depends on the resultant effect of both water scarcity and crop
price (a higher real price of a crop induces a higher output value and hence a higher marginal value
of rainwater). Therefore, the simultaneous increase in the marginal value of water, the amount of
water, and crop price can be explained by the fact that the effect of crop price outweighs the effect
of water scarcity.

5. Policy implications

The marginal value of rainwater in the study area was found to be the highest for teff, followed by
wheat and barley, with an overall average of 0.30 birr/m3. It could, however, be argued that the marginal
value of rainwater in this water-scarce region would be higher than those estimated using the current
methodology, which assumes all the rainwater to be automatically utilized for crop production without
regard to water losses due to evaporation and run-off. The most important implications of the findings
are as follows.
328 T. W. Gezahegn and X. Zhu / Water Policy 17 (2015) 316–331

First, the variation in the MVs (shadow prices) of water among crops would indicate potential gains
from reallocation of the resource. The highest marginal value of water in teff production implies that,
given the current level of production of each crop, it is more water-efficient to grow teff in the area,
followed by wheat. To maximize the social benefit from the available water, the resource should be
diverted from low-value crops to high-value ones, as Kumar et al. (2008) note: social benefit in the
study area can be maximized by reallocating water (through harvesting if the social benefits of doing
so can more than compensate the social costs thereof) and possibly its complementary resources
such as land and labor among the three crops until the MVs of water in the production of all these
crops become equal. However, it should be emphasized that other crops can still be cultivated, for
example, in the form of crop rotations to make use of the soil fertility. The usefulness of the findings
is that they give an insight into water’s value at the margin that would be helpful in reallocating a given
quantity of the resource among various crops.
Second, due to the absence of a natural water pricing policy in the study area, the role of market forces
in ensuring transfer of water to high-value uses is deficient. There are no prices for natural water
included in the current water policy to reflect the scarcity value of the resource. The missing water
charges can have an adverse impact on the effectiveness of potential irrigation systems and the allocative
efficiency of water resources. Our estimated marginal value of rainwater can be used as an approximate
measure of the marginal value of natural water in the study area (which is currently not priced), indi-
cating a scope for pricing natural water in order to promote the resource’s allocative efficiency. It
may be unwarranted to assume one cubic meter of water from random rainfall to have the same marginal
value as one cubic meter of water from a river, lake, or groundwater. A farmer with a known supply of
water may use the right amount of other inputs (e.g. fertilizer), or may choose a higher planting density
than under uncertain rainfall, though there is limited substitutability between water and other inputs in
agricultural production. Nevertheless, the result of this study is useful, at least in that it can be used as a
lower bound to set prices for natural water resources (rivers, lakes, and groundwater) in the study area. It
would not be unreasonable to charge current or potential irrigators a price equal to the estimated mar-
ginal value for the amount of natural water they use, as the marginal value is reflective of farmers’
willingness to pay for the resource. More importantly, the current study shows the importance of
water pricing in social benefit maximization because charging natural water users a price equal to the
estimated marginal value can help achieve more efficient water use in water management.
Third, as any single water use cannot typically be viewed in isolation from potential alternative uses
(Ward & Michelsen, 2002), the results have implications for the current urban water management in
Mekelle City. In principle, the Ethiopian Water Resources Management Policy (EWRMP) demands
that water be recognized as a scarce natural resource with an economic value and that fees be paid
for services rendered. Though the policy recognizes that the basic minimum requirements (such as
water for human drinking) have the highest priority in any water allocation plan, it focuses on appor-
tioning the rest of the resource for uses and users that result in the highest socio-economic benefits.
Furthermore, EWRMP advocates that urban water prices should be set based on full-cost recovery to
ensure conservation, protection and efficient use of the resource. Practically, however, the full-cost
recovery rule does not seem to be observed, as natural water is assigned no value in Mekelle City:
the water utility in the city does not pay for the natural water resource it uses to supply tap water for
its urban customers. As a result, the price it charges for tap water reflects only the costs of groundwater
extraction, treatment, storage, and distribution, but not the scarcity value of the resource itself. There-
fore, in order to achieve efficient use of water resources, urban water in Mekelle City should be
 T. W. Gezahegn and X. Zhu / Water Policy 17 (2015) 316–331 329

priced based on its full cost of supply, that is, the marginal value of natural water should be reflected in
the production costs of urban water. There are no economic grounds to say that urban water use is
always more valuable than other uses, such as irrigation, as Griffin (2006) notes. Thus, part of the
water supplied to urban consumers might be applied more efficiently to agriculture. Urban consumers
might use water for high-value applications (such as drinking, cooking, and hygiene) and low-value
applications (such as sidewalk washing). Though the high-value uses are hardly affected by water
prices, the low-value uses can be curbed if the price increases: as the price of water increases, people
demand less. Paying attention to the marginal value of water in agriculture will motivate urban users
to avoid low-value uses of water, as Griffin (2006) argues. Therefore, a policy is needed to get
urban water users to recognize the marginal value of water in agriculture and behave accordingly. If
urban water prices do not reflect the forgone benefits of farmers, then urban water consumers cannot
be expected to observe them. It is important to incorporate scarcity values into prices so as to transmit
signals to consumers. On the whole, the results provide useful information for water policy makers in
Mekelle City for efficient pricing of the current natural water resources based on full-cost recovery and
the possibility to reallocate the resource between agriculture and urban consumption in the study area.

6. Conclusions and discussion

This article attempts to estimate the marginal value of rainwater in the agricultural production of three
crops: wheat, barley, and teff on the outskirts of Mekelle City, Ethiopia. The marginal value of rainwater
was found to be the highest for teff (0.32 birr/m3) followed by wheat (0.30 birr/m3) and barley (0.27
birr/m3) in the period 2003–2012. The average marginal value of rainwater for the three cereals is
0.30 birr/m3. On the basis of these results, it is reasonable to make policy recommendations regarding
the possibility of water demand management strategies based on natural water pricing. The endeavor
here is not to recommend prices for rainwater. It is not straightforward to reallocate rainwater via pri-
cing. Any attempt to do so would call for rainfall collection and distribution costs, among others, which
might counterbalance the efficiency gains from reallocation. The aim is to approximate the marginal
value of other water resources (e.g. groundwater), which is the value of an additional unit of water
to the consumer.
However, caution is advised in extrapolating the marginal value estimates of this study to other areas.
This is because the marginal value of water is sensitive to areas where crops are grown. There is no
single marginal value of water. Furthermore, in our analysis we did not consider the rainwater lost
due to evaporation and run-off but took all rainwater as input, which might have caused the shadow
price of rainwater to be underestimated. On the other hand, the sampled farmers in this study were
drawn from areas in the close vicinity of a city, which has implications for access to market, which
in turn implies better output value or prices and hence a higher marginal value of natural water.

Acknowledgements

We would like to express our appreciation to some anonymous employees of Enderta District Agri-
culture and Rural Development Bureau for their honest cooperation in providing the relevant data for the
330 T. W. Gezahegn and X. Zhu / Water Policy 17 (2015) 316–331

study. We also thank Hans-Peter Weikard (PhD) for his useful comments on an early version of this
article.

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Received 13 March 2014; accepted in revised form 18 June 2014. Available online 11 August 2014