Urban Water Journal

ISSN: 1573-062X (Print) 1744-9006 (Online) Journal homepage: http://www.tandfonline.com/loi/nurw20

How should urban water be priced? – An empirical

analysis for the city of Mekelle, Ethiopia

Tafesse W. Gezahegn & Xueqin Zhu

To cite this article: Tafesse W. Gezahegn & Xueqin Zhu (2017) How should urban water be
priced? – An empirical analysis for the city of Mekelle, Ethiopia, Urban Water Journal, 14:4,
409-415, DOI: 10.1080/1573062X.2016.1175484

To link to this article: http://dx.doi.org/10.1080/1573062X.2016.1175484

Published online: 04 May 2016.

Submit your article to this journal

Article views: 71

View related articles

View Crossmark data

Full Terms & Conditions of access and use can be found at

http://www.tandfonline.com/action/journalInformation?journalCode=nurw20

Download by: [Mekelle University] Date: 24 January 2017, At: 07:38

Urban Water Journal, 2017
VOL. 14, NO. 4, 409–415
http://dx.doi.org/10.1080/1573062X.2016.1175484

RESEARCH ARTICLE

How should urban water be priced? – An empirical analysis for the city of Mekelle,
Ethiopia
Tafesse W. Gezahegna,b and Xueqin Zhua
a
Environmental Economics and Natural Resources Group, Wageningen University, Wageningen, the Netherlands; bCollege of Business and Economics,
Mekelle University, Mekelle, Ethiopia

ABSTRACT ARTICLE HISTORY

Urban water utilities have focused on setting water prices to cover average costs, usually using increasing Received 22 May 2015
block rate designs. In an attempt to contribute to the use of efficient, equitable, and revenue-sufficient Accepted 4 April 2016
pricing, this paper estimates the long-run marginal and average social costs of water supply in Mekelle city
KEYWORDS
using a multi-product translog cost function that incorporates the shadow price of natural water. Findings
Marginal social cost;
show that the marginal social costs of providing one m3 of residential and non-residential water are Birr marginal value; translog
5.33 and 7.71 (Birr = Ethiopian currency: 1 Euro ≈ 23 Birr), respectively, while the average current prices are cost function; natural water;
Birr 4.46 and 6.10/m3. On the other hand, the average social costs of residential and non-residential water Mekelle
are estimated at Birr 14.34 and 16.36/m3, respectively, implying that marginal social cost-based prices
would still lead to a revenue deficit of approximately Birr 9/m3.

1. Background
In many cities, public attention has focussed mainly on techno-
logical solutions to water shortage (Sibly 2006b). To economists,
however, pricing is the central mechanism that determines the
efficient allocation of water (Zhu and van Ierland 2012). Pricing
would ensure that available water goes to the most valuable
uses, and that new supplies will be developed only if consumers
are willing to pay for them (Pint 1999). The problem of burgeon-
ing water scarcity could be solved if water is properly treated
as an economic good (Dinar and Nigatu 2013). Achieving this
goal requires taking account of the full cost of water supply (Tsur
2005). Rogers et al. (1998) argue that sustainable and efficient
use of water requires water prices match the full cost: operating,
maintenance, capital, opportunity cost (OC), and externalities
(Sibly 2006a). Ignoring the OC undervalues water and causes
misallocations of the resource (Rogers et al. 1998). When the
price of water reflects its full cost, the resource will be put to its
most valuable uses (Rogers et al. 2002). Urban water utilities tra-
ditionally set water prices to cover average cost (AC) (Pint 1999).
However, Griffin (2006) argues that efficiency is not well served
by average cost pricing (ACP). Efficient pricing is equivalent to
marginal cost pricing (MCP). What’s more, the ACP scheme used
by urban water utilities does not account for the scarcity value of
natural water (Pint 1999). Mekelle is among the cities where effi-
cient water pricing has received little attention. Mekelle Water
Supply Office (MWSO) falls back on supply augmentation to
address the chronic water shortage in the city, and sets water
prices to cover ACs. Moreover, natural (raw) water is assigned no
value in Mekelle: MWSO doesn’t pay for the raw water resource
it uses to supply tap water to its customers. As a result, the price
it charges for tap water accounts only for the AC of water extrac-
tion, treatment, storage, and distribution, but not the scarcity
value of the resource itself. Besides, MWSO seems to follow
defective accounting practices that might undervalue its capital
costs: e.g. no interest and depreciation costs were reported for
the period 2003--2007. As well, the costs of treatment material
(chlorine) were zero for this period. It’s quite possible that these
missing costs would result in a lower AC which may eventually
lead to under-pricing of tap water, not to mention the inher-
ent incompatibility of ACP with economic efficiency. Besides
economic efficiency, criteria for water rate design should also
consider revenue sufficiency and equity, as water is an eco-
nomic and social good (Hall 2009). MCP may fail to address the
efficiency, equity, and revenue sufficiency issues at a time (Sibly
2006a). Since an urban water provider is a natural monopoly, AC
declines as production increases, implying that marginal cost
(MC) is lower than AC (Sibly 2006b). As a result, an MCP scheme
leads to revenue deficiency (Sibly 2006b).
In Mekelle, water is priced based on Increasing Block Rate (IBR)
structure. However, Sibly (2006b) presents several disadvantages
of IBR. First, IBR-pricing has the effect of insulating typical consum-
ers from facing the cost of decreased water availability. Second,
with IBR-pricing, large but low-income families are likely to face a
higher price as compared to small but high-income households.
Third, it sends the wrong price signals not only to consumers,
but also to the water providers themselves: IBR-pricing usually

CONTACT  Tafesse W. Gezahegn  tafpeace@gmail.com

© 2016 Informa UK Limited, trading as Taylor & Francis Group
410    T. W. Gezahegn and X. Zhu
undervalues the water sold in the first tier, and thus provides
insufficient incentive to expand supply. With a typical IBR, price
signal becomes misleading when water use moves from one
block to another. Whittington (1992) adds a serious problem with
IBRs: they can only work if each household (rich or poor) has a
private, metered water connection. Yet, many cities in develop-
ing countries do not meet this condition. Usually, the poor buy
water from relatively rich neighbors with private connections. The
sellers can capture the benefits of the first block, while charging
buyers a price that will recover the highest per unit charge in the
IBR plus some mark-up. In this case, IBR will have precisely the
opposite effect of its intent: the poor will pay higher prices than
the rich (Boland and Whittington 2000).
The purpose of this study is to estimate the MC of water sup-
ply and analyze the implications for more efficient, equitable,
and revenue-sufficient water rates in the city of Mekelle based
on a full economic cost approach: full supply cost (operating,
maintenance, and capital costs) plus OC, as Rogers et al. (1998)
put it. The OC is proxied by the marginal value (MV) of natural
water in agriculture in the outskirts of Mekelle estimated by
Gezahegn and Zhu (2015). This makes sense since agriculture
and urban water use are the two major sectors competing
for raw water in the area. Since the externalities related to
the city’s water use are difficult to quantify, we exclude them
from the analysis. Thus, it should be noted that the estimated
MCs in this paper can only serve as the lower bound of the
true MCs of water supply in Mekelle. The phrase marginal
social cost (MSC) is used to refer to MC of water supply with
MV of natural water taken account of. What we estimate is
the long-run MC (LRMC)1: the cost of an extra unit of water
when all factors of production (including capital) vary incre-
mentally (Sibly 2006b). By their nature, capacity expansions
of water networks are often lumpy rather than incremental
(Sibly 2006a). Yet, Turvey (1976) distinguishes between the
distribution network and the central system: distribution net-
work can expand through many small investments, while the
central system can expand by large investments, often at long
intervals. Thus, treating distribution network as a variable that
can be incrementally increased may be justified for Mekelle
due to the dominance of the expansion of distribution net-
works to meet increasing demand without major investment
in the central system. LRMC-pricing is preferable to short-run
MC pricing in the water industry to ensure stable financing
of long-term investments (Economics 1997). As a volumetric
rate based on LRMC is stable (Sibly 2006b), the LRMC method
is relatively administratively less expensive than the more
dynamic short-run MC method (Garcia and Reynaud 2004). We
adopt a three-product (residential, non-residential, and wast-
age) translog cost function accounting for the OC of natural
water in the context of a developing country. The inclusion of
the OC in the cost function of a water utility in an area where
natural water is assigned no value is an innovative feature.
What’s more, the paper empirically tests the cost complemen-
tarities among different water outputs, giving an insight into
whether it is advantageous to “produce” wasted water jointly
with residential and non-residential water outputs. Here, we
do not claim any methodological innovation but the inclusion
of the value of natural water in the cost function is a novel
contribution to the empirical literature on water pricing.
The remaining part of the paper proceeds as follows: Section 2
presents a brief description of the study area; Section 3 outlines
the methodological approaches followed; Section 4 presents and
discusses results; and Section 5 concludes.
2.  The study area
Mekelle is located on the northern edge of Ethiopia situated
at a distance of 783 km from the national capital, Addis Ababa.
It lies in the country’s temperate highlands of Tigray region at
an altitude of about 2000 meters above sea level with a total
area of 150 km2 (in 2011) (MCI 2012). The city has shown a rapid
growth and development in all social, economic, political and
cultural spheres (Gebreegziabher and Tadesse 2011). MWSO
is responsible for the city’s water supply. For technical sup-
port, it relies on Tigray Regional Bureau of Water, Minerals, and
Energy Resources. Activities such as drilling deep and shallow
wells, reservoir construction, electro-mechanical installation
and spring development are undertaken by Tigray Water Works
Construction Enterprise. The main source of Mekelle’s water
supply is groundwater from about 20 boreholes (in 2011) that
range from 32–250 meters in depth. The distribution system
depends primarily on gravity, but it also relies on pumps (Castro
and Maoulidi 2009). Since 2008, water is priced according to IBR
structure for residential users: for a consumption of up to and
including 5 m3, the price equals 2.30 Birr/m3; for any amount
greater than 5 m3 up to and including 10 m3, 3.50 Birr/m3; for
any amount greater than 10 m3 up to and including 20 m3,
4.90 Birr/m3; and for any amount above 20 m3, the price is 6.10
Birr/m3. For non-residential users, the rate is flat at 6.10 Birr/m3
(1Birr ≈ 0.042 euro), and the billing period ranges from day 1 to
day 30 of each month.
3.  Materials and methods
The translog function is often used for the purpose of repre-
senting the water production technology (Grebenstein and
Field 1979, Kim 1987, Steven Renzetti 1999, Tsegai et al. 2009).
This function has the advantage of being flexible with only
few restrictions on its input data. It is parsimonious and satis-
fies price homogeneity assumptions by imposing a set of linear
restrictions on the parameters to be estimated (Reynaud 2003).
Besides its flexibility, it can also accommodate the multi-product
nature of an industry. With time series data, Verbeek (2012) notes
that for applying standard estimation or testing procedures, the
variables are required to be stationary (the mean, variances, and
co-variances of variables are finite and independent of time).
If a non-stationary variable Yt is regressed on another non-sta-
tionary variable Xt, estimators and test statistics will be
misleading. An important exception arises when two or more
non-stationary variables with the same order of integration
(the number of times a non-stationary variable should be differ-
enced2 to get a stationary series) are co-integrated: there exists
a particular linear combination of these non-stationary variables
which is stationary: Yt − βXt is stationary for some β although Yt
and Xt are both non-stationary. Thus, for the estimated cost func-
tion to be econometrically valid, all variables must be integrated
of the same order (Moss et al. 2003) and must have a stationary
linear relationship.

3.1.  Model specification
Kim (1995) regards U.S. water utilities as multi-product firms
providing residential and non-residential services; Hayes
(1987) examines the cost structure of the water industry in the
U.S. by considering it a multi-product firm producing whole-
sale and retail products; Garcia and Thomas (2001) regard the
water industry as a multi-product firm producing two out-
puts: losses and the actual water produced; Martins et al. (2012)
estimate a cost function with two outputs: water loss and ser-
vice output. Following the lines of argument in favour of the
multi-product approach, the present study treats MWSO as a
three-output firm producing residential (qr), non-residential
(qn), and wasted (qw) water outputs. A time variable t has been
included in the model to account for a Hicks-neutral technical
change, as in Ray (1982). Since all the variables included in the
estimation of the translog cost function are non-stationary,
a test for the presence of a co-integrating relationship was
conducted using Dickey–Fuller tests (Verbeek 2012). The test
results indicate that the null hypothesis of non-stationarity
can be safely rejected, indicating a long-run co-integration
among the variables.3 Besides qr, qn, qw, and t, the multi-prod-
uct cost function includes prices of labour (pl), capital (pk),
energy (pe), materials (pm), and natural water (pW) as its argu-
ments. That is, C = C(qr , qn , qw , pl , pk , pe , pm , pW , t)implicitly.
The translog specification is:
ln C = 𝛼0 +
∑
𝛼i ln qi + 1∕2
∑∑
𝛼ih ln qi ln qh
i i h rate (monthly), taken from the National Bank of Ethiopia, was
∑ ∑∑
+ 𝛼j ln pj + 1∕2 𝛼jf ln pj ln pf
j j f
∑∑
+ 𝛼ij ln qi ln pj + 𝛼t t + 𝜀
i j
where subscripts i and h refer to the three outputs (r = residen-
tial, n = non-residential, and w = wastage); j and f refer to the five
inputs (l = labour, k = capital, e = energy, m = material, W = natu-
ral water); and ε is the error term. The translog cost function and
the input cost shares (except the cost share of material to avoid
multicollinearity) were estimated as a system. The cost share of
input j is derived using Shephard’s Lemma as follows:
∑ ∑
Sj = 𝜕 ln C∕𝜕 ln pj = pj xj ∕C = 𝛼j + 𝛼jf ln pf + 𝛼ij ln qi + 𝜀j
f i
(2)
where xj denotes the quantity demanded of input j. An estimate
of the MSC of output i (MSCi) is computed as follows:
MSCi = (𝜕 ln C∕𝜕 ln qi ) × C∕q
̂
i = 𝜉i × C∕qi
̂ (3)
where Ĉ = fitted value of the cost function (Equation (1)) as in
Kim (1995) and ξi = ∂ ln C/ ∂ ln qi= elasticity of cost with respect
to output i. Measures of economies of scale (ES) are also meas-
ured as follows (Coelli et al. 2005):
[ ]−1
∑ significant parameters, as one would normally expect: cost of
ES = 𝜉i
MWSO would exhibit increasing, constant, or decreasing returns
to scale if ES is greater than, equal to, or less than one.
Urban Water Journal   411
3.2.  Data and variable description
Monthly time series data (10-year) on total costs (TC) of water
supply, quantities of water outputs, and input prices were uti-
lized. Monthly TC includes costs of capital (approximated by
network expansion costs), labour, energy, material and natural
water. Data on input (other than water) prices, capital mainte-
nance cost, and input cost shares are the result of own calcu-
lation. The price of labour was calculated as the ratio of total
monthly wage (including salary) to total monthly number
of hours worked. The price of energy was determined as the
ratio of total monthly energy cost to total amount of electricity
used per month in kilo-watt-hour (kWh). Likewise, the price of
materials was approximated by the ratio of total monthly cost
of materials to total monthly quantity (kg) used. Theoretically,
the price of capital is determined as the sum of depreciation
rate and interest rate (Pindyck and Rubinfeld 2001). Yet, it was
hard to find documented depreciation costs. So, following IBRD
(2006), monthly depreciation rate was approximated by the
ratio of monthly capital maintenance cost (approximated by the
excess of monthly TC over the summation of monthly network
expansion, labour, energy, and material costs) to total capital.
The capital maintenance approach focuses on measuring the
expenditure needed to maintain assets at their current level of
serviceability, and recognizes that assets like pipes don’t gen-
erally wear out and then get replaced all at once, but rather are
maintained and renewed in a continual process. Finally, interest
added to the approximated depreciation rate to arrive at the
(1) price of capital. Monthly prices of natural water were approxi-
mated from the yearly MVs of rainwater in agriculture in the
close vicinity of Mekelle estimated by Gezahegn and Zhu (2015).
Input cost shares were calculated as the ratio of the monthly
cost of each input to monthly TC (Table 1).
It should be noted that for some variables, monthly data were
available not for all the 10 years of the study period. For some
years, especially years earlier than 2008, only quarterly data
were available at best. In some instances, no data were available
for some years. For example, the distinction between qr and qn
became evident only from 2008 onwards. So, the monthly distri-
bution of data on these variables for the earlier years was deduced
on the basis of latter years’ data (using regression of each variable
on time). The regression residuals of this deduction are likely to
carry over to subsequent analyses, and might affect the accuracy
of the estimated parameters, though, we believe, only to a level
that does not seriously bias the results.
4.  Results and discussion
The model (Table 2) seems to fit the data well, explaining 99%
(R2 = 0.99) of the variation of the dependent variable. qr and qn,
and all input prices except pm turned out to have positive and
(4) water supply increases with the level of output and input prices,
ceteris paribus. The parameter of qw, however, has a negative
sign, which looks odd at first sight. Note, however, that the cost
of water supply includes costs associated with avoiding water
412    T. W. Gezahegn and X. Zhu

Table 1. Descriptive statistics.

Variable Description (units) Mean S.D.

C Cost of water supply (105 Birr/month) 24.47 41.16
qr Residential water (105 m3/month) 1.38 0.36
qn Non-residential water (105 m3/month) 1.21 0.33
qw Wastage (105 m3/month) 0.63 0.33
pl Price of labour (Birr/hour) 0.96 0.49
pk Price of capital per month (Birr)a 5.90 11.56
pe Price of energy (Birr/kWh) 0.58 0.07
pm Price of material (Birr/kg) 8.85 3.19
pW Price of natural water (Birr/ m3) 0.30 0.04
l-share Labor cost share/month 0.21 0.12
k-share Capital cost share/month 0.48 0.30
e-share Energy cost share/month 0.15 0.10
m-share Material cost share/month 0.02 0.01
w-share Raw water cost share/month 0.14 0.10
Customers Number (average over 2003-2012) Average consumption/month/individual (m3)
Residential 21,544 6.41
Non-residential 1375 88.03

Source: Mekelle Water Supply Office (2012) and own calculations based on 120 observations.
a
Price of capital refers to the monthly user cost of a 100-Birr-worth capital (monthly depreciation plus interest).

Table 2. Parameter estimates of the translog cost function (standard errors in parenthesis).

Variable Parameter Estimate Variable Parameter Estimate Variable Parameter Estimate

Constant α0 1.775*** (0.072) lnqr*lnpW αrW 0.023 (0.020) lnpl*lnpe αle 0.008 (0.007)
lnqr αr 0.186** (0.165) lnqn*lnqn αnn −0.442** (0.210) lnpl*lnpm αlm 0.016** (0.008)
lnqn αn 0.828*** (0.213) lnqn*lnqw αnw 0.224* (0.131) lnpl*lnpW αlW −0.046*** (0.009)
lnqw αw −0.184** (0.087) lnqn*lnpl αnl −0.008 (0.033) lnpk*lnpk αkk 0.094*** (0.002)
lnpl αl 0.163*** (0.022) lnqn*lnpk αnk −0.024 (0.037) lnpk*lnpe αke −0.049*** (0.002)
lnpk αk 0.382*** (0.011) lnqn*lnpe αne −0.011 (0.020) lnpk*lnpm αkm −0.012*** (0.002)
lnpe αe 0.228*** (0.022) lnqn*lnpm αnm −0.005 (0.020) lnpk*lnpW αkW −0.048*** (0.002)
lnpm αm 0.007 (0.035) lnqn*lnpW αnW 0.049* (0.026) lnpe*lnpe αee 0.039*** (0.005)
lnpW αW 0.220*** (0.025) lnqw*lnqw αww 0.086*** (0.032) lnpe*lnpm αem −0.0193** (0.008)
lnqr*lnqr αrr 0.377 (0.243) lnqw*lnpl αwl −0.001 (0.011) lnpe*lnpW αeW −0.018** (0.007)
lnqr*lnqn αrn −0.614** (0.270) lnqw*lnpk αwk 0.037*** (0.014) lnpm*lnpm αmm 0.004 (0.006)
lnqr*lnqw αrw 0.254 (0.155) lnqw*lnpe αwe −0.018*** (0.007) lnpm*lnpW αmW 0.007 (0.008)
lnqr*lnpl αrl 0.034 (0.025) lnqw*lnpm αwm −0.000 (0.007) lnpW*lnpW αWW 0.053*** (0.005)
lnqr*lnpk αrk −0.042 (0.032) lnqw*lnpW αwW −0.018** (0.009) t αt 0.004*** (0.000)
lnqr*lnpe αre −0.031** (0.015) lnpl*lnpl αll 0.051*** (0.006)
lnqr*lnpm αrm 0.016 (0.015) lnpl*lnpk αlk −0.079*** (0.003)
*** significant at 1%; ** significant at 5%; * significant at 10%; R2 = 0.99; Subscript of lower-case w refers to wasted water and upper-case W refers to raw water.

losses, which wouldn’t be incurred if leaks are not taken care of.
Wasted water doesn’t necessitate network maintenance costs,
leading to a lower total cost of water supply given that wastage
is not compensated for by more costly production.
The negative and significant parameter of the interaction
between qr and qn(αrn) implies that an increase in qn would cause
a decrease in the MC of qr (∂ 2C/ ∂ qr ∂ qn < 0)and the other way
around. This result is an implication for the prospect of econo-
mies of scope (Leathers 1992) in Mekelle if the OC of raw water is
accounted for in the cost structure of MWSO, which is not the case
currently. The positive and significant parameter of the interaction
between qn and qw(αnw) implies that an increase in qw would cause
an increase in the MC of qn (∂  2C/ ∂ qn ∂ qw > 0 = diseconomies
of scope). Yet, the parameter of the interaction between qr and
qw(αrw) turns out to be insignificant, implying that the MC of qr
would not depend on the level of qw(∂  2C/  ∂  qr  ∂  qw  =  0). The
implication of these results combined is that there would be cost
advantages in producing qr and qn jointly, but none in producing
qw jointly with qr and qn in Mekelle. The bottom line is that it would
be cheaper to repair leaks (to meet demand) than to pump more
water in Mekelle if raw water is accounted for. This finding is a
disclosure of the presence of incentives to reduce water loss in the
city, and supportive of the concern that available water should be
used carefully. Water loss reduction has economic and financial
impacts, among others. Economically speaking, it alleviates water
scarcity; financially, it avoids the loss of potential revenue, which
has implications for water prices: with water loss, MWSO may
overcharge consumers to compensate for the wastage, leading
to a dead-weight loss, as Cousin and Taugourdeau (2015) note.
The parameter of t is positive and significant, indicating that
cost increases with time for fixed output levels and input prices.
Material costs, depth of ground water, and distance of borehole
locations are increasing with time, according to MWSO (2012).
This can be a possible explanation for the rise of cost of water
supply as time goes by. The values of MSCs for each customer
category (Table 3) indicate that serving non-residential customers
induces a higher MSC than serving residential customers. This is
contrary to prior expectations that serving residential customers
would be more expensive due to more distribution networks,
higher system losses, and the larger number of smaller accounts
associated with residential customers than with non-residential
customers as reported by Diakite et al. (2008). A possible explana-
tion for this contradiction could be the fact that non-residential
customers of MWSO get extra services, such as water supply from

Table 3. Estimates of average prices, MSC, ASC (Birr/m3), fixed charge (F = ASC-MSC), and ES.
Output p̄ ASC
qr 4.46 14.34
qn 6.10 16.36
qw 0.00 31.42
Cost Elasticity with respect to:
qr(ξr) qn(ξn)
0.30 0.38
mobile tankers during times of network water shortage, which
induces extra costs. The negative sign of the MSC of qw indicates
a decrease of Birr 5.03 in the cost of water supply if one m3 of
water is wasted, arguably due to cost savings from avoided main-
tenance costs, assuming that no more water is extracted to make
up for the loss (not to be confused with the impact of loss on the
forward-looking MCs of qr and qn discussed above).
MSCs were calculated based on Equation (3), and ASCs as
ASCi = MSCi/ξi. Note that because of the inclusion of the price,
rather than the stock, of capital in the cost function, the esti-
mated MC is LRMC. This implies that not only expenditures on
variable inputs, but also expenditures on network expansion are
accounted for, as Renzetti (1992) notes. In order to understand
to what extent water is underpriced in Mekelle, we calculated IBR
∑4
prices (p̄ ) as p̄ = i=1 wi pi (where p̄ = marginal price in block i; wi =
the share of total water consumed in block i) and compared it with
the estimated MSC and ASC. The values of p̄ - MSC for qr and qnare
negative, suggesting that the current IBR-pricing in Mekelle leads
to a considerable difference between what it costs the society to
supply an additional m3 of water and the price actually paid by
consumers (qr and qn are priced, respectively at a rate of 16% and
21% below their MSC). Given the monthly qr and qn (at the current
prices) of 6.41 m3 and 88.03 m3 for the average consumer (Table
1), respectively, implementing MSC-pricing in Mekelle may have a
significant impact on the consumption decisions of users and the
revenue of MWSO. As of January 2013, MWSO implemented a new
relatively expensive five-tier rate structure with the aim, among
others, of discouraging excessive water use and promoting use
efficiency (MWSO 2012). Yet, trying to discourage excessive water
use with an IBR-pricing is a dubious approach. Apparently, exces-
sive refers to using water in a way that fails to provide a benefit
commensurate with the cost of delivering it. But, economic theory
holds that only MCP can give sufficient incentive to discourage
excessive use. IBR-pricing is, however, not consistent with MCP:
different customers pay different prices (most of them different
from MC) for the same service. The degree of scale economies
has a value of 1.82 (Table 3). This value means a 10% increase
in all inputs gives rise to an 18.2% (more than proportionate)
increase in aggregate water output. This implies the conformity
of MWSO to the natural monopoly nature of water utilities. This
entails a higher AC than MC of water supply in Mekelle, and has
implications for the cost recovery if water prices are set at a rate
equal to the estimated MSC: revenues will be lower than costs,
leading to a deficit.
Apart from the inherent problems of IBR-pricing, the revealed
under-pricing effect of IBRs in Mekelle calls for a more appropriate
pricing scheme. As well, since IBRs are inflexible, their application
stands against economic efficiency on account of the inconsistent
nature of water availability in the city, where water variability is
Urban Water Journal   413
MSC F p̄ -MSC (p̄ -MSC)/MSC
5.33 9.01 −0.87 −0.16
7.71 8.65 −1.61 −0.21
−5.03 − 5.03 −1.00
Overall cost elasticity
qw(ξw) (ξcq = ξr + ξn + ξw) (ES = 1/ξcq)
−0.13 0.55 1.82
rampant. Failure to cover cost of water provision is another prob-
lem, since p̄ is lower than ASCs. On average, the city suffers a reve-
nue deficit of approximately Birr 10/m3 (ASC-p̄ ) in supplying qr and
qn alike. Though MCP is superior to the IBR-pricing on efficiency
grounds, MSC-pricing will not address the revenue sufficiency cri-
terion (because MSC < ASC), and since the MSC (for a given level
of output) is a fixed value, poor and rich households will face the
same water price, disregarding equity. Given the under-pricing
and revenue non-sufficiency effects, respectively of MCP and IBRs
in Mekelle, we recommend a two-part tariff, consisting of a volu-
metric charge (= MSC) and a fixed charge (F = ASC - MSC) to serve
the efficiency and revenue sufficiency goals simultaneously. F is
set to make up for the shortfall between the revenue from an MCP
and the revenue needed to cover total costs (Sibly 2006a). Since
it is independent of the volume consumed, F does not influence
consumers’ choice of volume. Thus, setting volumetric charges
of Birr 5.33/m3 and Birr 7.71/m3, together with F = Birr 9.01 and
Birr 8.65 for qr and qn, respectively can be proposed for Mekelle.
This implies that water prices for qr and qn would, respectively
be 3.2 and 2.7 times higher than the current ones if raw water is
accounted for.
Yet, since F is given as ASC - MSC, its magnitude may vary
with the level of production and, thus, cannot remain constant
no matter what the level of consumption. To transform this figure
into real fixed charge, one assumption needs to be imposed here:
the vertical distance between the ASC and MSC curves remains
constant within the relevant range of water consumption. In prin-
ciple, there is no requirement that F be equal across consumers
in order to achieve allocative efficiency (Sibly 2006a), though it
should be kept so small that it doesn’t influence a consumer’s
connection decision. Equity issues can be addressed by imposing
an F that varies for different classes of consumers: high-income
consumers might pay more F than low-income consumers. This
approach is unlikely to entail additional assumptions that might,
in practice, affect the efficiency gain from the analysis performed
in the paper. A rebate of F to low-income consumers after cover-
ing the costs of water supply can also address the equity issue.
5. Conclusions
We used the cost function approach to empirically estimate the
MSCs of water supply in Mekelle, Ethiopia. Particularly, we con-
sidered the value of natural water in the cost function so that the
OC of urban water use will be captured. This is a new contribu-
tion to the literature of water pricing, especially for areas where
natural water is taken for granted with no value assigned to it.
Our findings show that the IBR prices in Mekelle were found to
be lower than the estimated MSCs of water supply in the city:
qr and qn are priced inefficiently at rates below their respective
414    T. W. Gezahegn and X. Zhu
MSCs. As we have pointed out in the introduction, our analysis
does not include any externalities related to urban water sup-
ply. Therefore, the IBR prices are even much lower than the real
MSCs, a condition necessitating higher water prices in Mekelle.
Not only inefficiency, but also failure to cover cost of water pro-
vision is a problem: the city suffers a revenue deficit in supply-
ing water. What’s more, MSC-pricing would not be appropriate
either, since it fails to address the revenue sufficiency and equity
issues. To make up for the shortfall between the revenue from an
MSC-pricing and TC, a two-part tariff is proposed for Mekelle: set-
ting volumetric charges of Birr 5.33 and Birr 7.71 together with
fixed charges of Birr 9.01 and Birr 8.65 for qr and qn, respectively,
seems to serve the efficiency and revenue sufficiency purposes,
under the technology considered in this study. Equity issues
would also be addressed either by imposing a fixed charge that
varies across different classes of consumers, or via a rebate of the
fixed charge to low-income consumers after covering the costs
of water supply.
Adopting a flexible volumetric rate based on MSC would incur
some additional costs. Yet, since the estimated MC is LRMC, it may
not be so flexible that its costs can outweigh the benefits of intro-
ducing more efficient, equitable, and revenue sufficient water
prices that bring an insight as to how water should be priced
efficiently in the study area. Setting water price at a value equal to
the estimated MSC would bring about two positive effects. First,
it is expected to give incentives for households to conserve water
as a result of the higher price which would translate into a better
use efficiency, assuming that people will be more careful about
water use if prices rise. Second, charging a higher price will partly
assist MWSO in recovering its supply costs. This effect will have
implications for the extent of groundwater extraction: higher
prices would mean higher revenue, which in turn translates into
lower extraction of groundwater to the advantage of resource use
efficiency. Therefore, it is necessary to increase prices to the MSC
of water supply in order to convey the correct signals to water
users about the social cost of a unit increase in their demand. If the
price of water is low compared to the social cost of supply, users
do not treat water as an economic resource. Users will obtain a
better understanding of the costs of satisfying water demands
and have a greater incentive to use water more carefully if prices
are scaled-up to the estimated MSCs.
Although our analysis in this paper has focused on the water
pricing issue in Mekelle, Ethiopia, the approach can be applied
to many cities in developing countries, where water pricing does
not fulfil the efficiency and revenue sufficiency conditions. For
future research, it is also interesting to include the externalities
in the empirical analysis as well. This needs, for example, close
collaboration with engineers to measure the external effects of
urban water supply.
List of Acronyms
AC Average Cost
ACP Average-Cost Pricing
ES Economies of Scale
IBR Increasing Block Rate
IBRD International Bank for Reconstruction and Development
kWh kilo-Watt-hour
LRMC Long-Run Marginal Cost
MC Marginal Cost
MCI Millennium Cities Initiative
MCP Marginal-Cost Pricing
MSC Marginal Social Cost
MV Marginal Value
MWSO Mekelle Water Supply Office
OC Opportunity Cost
TC Total Cost
US United States
Notes
1. 
Note here that “long-run” refers to the time period during which
distribution network expands, rather than the construction of the
central system of water supply.
Differencing refers to taking the time difference of a variable: Yt − Yt-1
2. 
3. 
A test statistic of −3.604, versus a 1% critical value of −3.505,
supports the rejection of the null hypothesis.
Acknowledgements
We are greatly indebted to Hans-Peter Weikard (PhD) for his useful com-
ments on an earlier version. We would also like to thank two anonymous ref-
erees and the Editor-in-Chief for their valuable comments that significantly
improved the quality of the article.
References
Boland, J. and Whittington, D., 2000. The Political Economy of Water Tariff
Design in Developing Countries: Increasing Block Tariffs vs. Uniform Price
with Rebate. In: A. Dinar, ed. The Political Economy of Water Pricing Reforms,
World Bank. Oxford: Oxford University Press, 215–235.
Castro, A. and Maoulidi, M., 2009. A Water and Sanitation Needs Assessment
for Mekelle City, Ethiopia. MCI Social Sector Working Paper Series. New
York: Millennium Cities Initiative.
Coelli, T.J., Rao, D.S.P., O'Donnell, C.J. and Battese, G.E., 2005. An introduction
to efficiency and productivity analysis. New York: Springer.
Cousin, E., and Taugourdeau, E., 2015. Trade-off between water loss and water
infrastructure quality: A cost minimization approach. Paris: Université
Panthéon-Sorbonne (Paris 1), Centre d'Economie de la Sorbonne.
Diakite, D., Semenov, A., and Thomas, A., 2008. A Proposal for Social Pricing
of Water Supply in Cˆote d’Ivoire. Journal of Development Economics, 88
(2), 258–268.
Dinar, A. and Nigatu, G.S., 2013. Distributional considerations of international
water resources under externality: The case of Ethiopia, Sudan and Egypt
on the Blue Nile. Water Resources and Economics, 2, 1–16.
Economics, L., 1997. Water pricing: The importance of long run marginal costs.
London: London Economics.
Garcia, S. and Reynaud, A., 2004. Estimating the benefits of efficient water
pricing in France. Resource and Energy Economics, 26 (1), 1–25.
Garcia, S. and Thomas, A., 2001. The structure of municipal water supply
costs: application to a panel of French local communities. Journal of
Productivity Analysis, 16 (1), 5–29.
Gebreegziabher, K. and Tadesse, T., 2011. Household demand for improved
water supply services in Mekelle City, Northern Ethiopia. Water Policy, 13
(1), 125–142.
Gezahegn, T.W. and Zhu, X., 2015. Marginal value of natural water in
agriculture: a study in the suburbs of Mekelle City, Ethiopia. Water Policy,
17, 316–331.
Grebenstein, C.R. and Field, B.C., 1979. Substituting for water inputs in US
manufacturing. Water Resources Research, 15 (2), 228–232.
Griffin, R.C., 2006. Water resource economics. Cambridge, MA: MIT Press.
Hall, D.C., 2009. Politically feasible, revenue sufficient, and economically
efficient municipal water rates. Contemporary Economic Policy, 27 (4),
539–554.
Hayes, K., 1987. Cost structure of the water utility industry. Applied Economics,
19 (3), 417–425.

IBRD, 2006. The International Bank for Reconstruction and Development/
The World Bank: Approaches to Private Participation in Water Services.
Washington, DC: World Bank.
Kim, H.Y., 1987. Economies of scale in multi-product firms: an empirical
analysis. Economica, 54 (214), 185–206.
Kim, H.Y., 1995. Marginal cost and second-best pricing for water services.
Review of Industrial Organization, 10 (3), 323–338.
Leathers, H.D., 1992. Allocable fixed inputs as a cause of joint production: an
empirical investigation. Agricultural Economics, 7 (2), 109–124.
Martins, R., Coelho, F. and Fortunato, A., 2012. Water losses and hydrographical
regions influence on the cost structure of the Portuguese water industry.
Journal of Productivity Analysis, 38 (1), 81–94.
MCI, 2012. Invest in Ethiopia: Focus Mekelle, the Earth Institute, Columbia
University. New York: Millennium Cities Initiative.
Moss, C.B., Erickson, K.W., Ball, V.E., and Mishra, A.K., 2003. A Translog Cost
Function Analysis of US Agriculture: A Dynamic Specification. Miami, FL:
Institute of Food and Agricultural Sciences, Food and Resource Economics
Department, University of Florida.
MWSO, 2012. Annual activities report. Unpublished report. Mekelle, Ethiopia
(Amharic version).
Pindyck, R.S., and Rubinfeld, D.L., 2001. Microeconomics. 5th ed. London:
Prentice Hall International, Inc.
Pint, E.M., 1999. Household responses to increased water rates during the
California drought. Land Economics, 75 (2), 246–266.
Ray, S.C., 1982. A translog cost function analysis of US agriculture, 1939–77.
American Journal of Agricultural Economics, 64 (3), 490–498.
Renzetti, S., 1992. Evaluating the welfare effects of reforming municipal
water prices. Journal of Environmental Economics and Management, 22
(2), 147–163.
Urban Water Journal   415
Renzetti, S., 1999. Municipal water supply and sewage treatment: costs,
prices, and distortions. Canadian Journal of Economics, 32 (3), 688–704.
Reynaud, A., 2003. An econometric estimation of industrial water demand in
France. Environmental and Resource Economics, 25 (2), 213–232.
Rogers, P., Bhatia, R. and Huber, A., 1998. Water as a social and economic
good: How to put the principle into practice. Stockholm, Sweden: Global
Water Partnership/Swedish International Development Cooperation
Agency.
Rogers, P., Silva, R.D. and Bhatia, R., 2002. Water is an economic good: How to
use prices to promote equity, efficiency, and sustainability. Water Policy,
4 (1), 1–17.
Sibly, H., 2006a. Efficient urban water pricing. Australian Economic Review, 39
(2), 227–237.
Sibly, H., 2006b. Urban water pricing. Agenda, 13 (1), 17–30.
Tsegai, D.W., Linz, T., and Kloos, J., 2009. Economic analysis of water supply cost
structure in the Middle Olifants sub-basin of South Africa. Bonn: Center for
Development Research. Available at SSRN 1402624.
Tsur, Y., 2005. Economic aspects of irrigation water pricing. Canadian Water
Resources Journal, 30 (1), 31–46.
Turvey, R., 1976. Analyzing the marginal cost of water supply. Land Economics,
52 (2), 158–168.
Verbeek, M., 2012. A guide to modern econometrics. 4th ed. Rotterdam: John
Wiley and Sons.
Whittington, D., 1992. Possible adverse effects of increasing block water
tariffs in developing countries. Economic Development and Cultural
Change, 41 (1), 75–87.
Zhu, X. and van Ierland, E.C., 2012. Economic modelling for water quantity
and quality management: a welfare program approach. Water Resources
Management, 26 (9), 2491–2511.