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An analysis of the cost structure of water supply in Sri Lanka

Article in Journal of the Asia Pacific Economy · May 2012

DOI: 10.1080/13547860.2012.668092

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 AN ANALYSIS OF THE COST STRUCTURE OF WATER
SUPPLY IN SRI LANKA

Dinusha Dharmaratna* and Jaai Parasnis†

Development Research Unit

Discussion Paper DEVDP 10/06

Abstract
Water utilities in developing countries face a challenge in maintaining the existing supply and
extending the supply of pipe-borne water to rural areas in face of growing demand.
Understanding the cost structure is important for developing the pricing policies, regulating
the market structure and ensuring the financial viability of the supply of pipe-borne water.
This paper investigates economic parameters of water supply in Sri Lanka, which exhibits the
common physical and institutional features of water sector in Asian countries. The estimated
marginal cost of water supply of Sri Lankan rupees (SLRS) 16.50 per cubic metre in the short
run, rising to SLRS 47.25 in the long run, suggests that water is under-priced under the
current pricing regime. We find existence of economies of scale as well as significant
substitution possibilities between inputs. Thus, under correct tariff regime, there is a scope to
accelerate the expansion of water supply.

Keywords: Water supply, cost function, Sri Lanka, marginal costs, economies of scale,
Translog

JEL classification: C30, L10, L95, Q2

*
Department of Economics, Monash University, VIC 3800, Australia
Email: dinusha.dharmaratna@buseco.monash.edu.au; jaai.parasnis@monash.edu.au
†
Corresponding Author: Dr. Jaai Parasnis, Department of Economics, Monash University, 100 Clyde Road, Berwick,
Victoria 3806, Australia. Phone: 613 9904 7099 Fax: 613 9904 1747 Email: jaai.parasnis@monash.edu.au

Acknowledgements: The authors would like to thank Dr Edwyna Harris, Prof Kwang Ng, Prof Russell Smyth and Prof Rob
Brooks for their comments and suggestions. We also benefitted from the feedback from participants of the Asia Pacific
Week 2008 at Australian National University.

© 2010 Dinusha Dharmaratna and Jaai Parasnis

All rights reserved. No part of this paper may be reproduced in any form, or stored in a retrieval system, without the prior
written permission of the author.
1. Introduction

Sri Lanka presents an interesting and representative case study for analysing the structure of

water supply in Asia. Water supply in developing countries, particularly the Asian countries,

exhibits the following common characteristics. (i) These countries typically do not experience

physical scarcity of water due to a combination of adequate annual rainfall and extensive

river systems. However, high demand and unsustainably managed supply lead to water

shortages. Sri Lanka receives average annual rainfall of 1850 mm, however, the supply of

safe drinking water is inadequate, especially in the rural areas. Currently, only 14 percent of

the rural population in Sri Lanka have access to pipe-borne water.‡ (ii) This gap between

demand and supply continues to worsen as countries face growing demand for piped water

through increasing population and rapid urbanisation and increasing capacity constraints on

the supply side. (iii) The institutional setup in these countries consists of a public utility with

monopoly over water supply (National Water Supply and Drainage Board (NWSDB) in case

of Sri Lanka). The participation of private sector is low, with the exception of few examples

in urban areas such as in Manila (Philippines). The pricing policy is aimed at the recovery of

operational costs. Despite this aim, revenues collected by the NWSDB account for only a

portion of the utility’s total costs, the average contribution of water user charges is

approximately 32 percent (NWSDB, 2006). (iv) Introduction and review of tariffs is a

contentious issue as access to water is traditionally considered a right, the need to balance

competing demands, and the efficiency- equity trade-off. Sri Lanka introduced tariffs only in

1982 and tariff adjustments are hard to implement due to highly politicised nature of the

‡
95 percent of urban and 75 percent of rural population had access to safe drinking water and 75

percent of urban and 14 percent of rural population had access to pipe-borne water in 2005 (Imbulana

et al., 2006).

2
process (ADB, 2007). The current pricing regimes in the developing Asian countries

typically consist of a generous first block of consumption at a very low tariff. Tariffs need to

be affordable to enable poorer households to access safe water supply. On the other hand,

there is a need for tariffs to reflect the actual cost of sustainable supply and to act as a tool of

demand management. It is also imperative to ensure the financial viability of the water supply

bodies and to generate new investment to extend the water supply to rural areas.

Understanding the cost structure of water supply is the first step towards analysing and

devising appropriate pricing and subsidy regimes for water utilities in developing countries.

In this paper we comprehensively investigate the cost structure of pipe-borne water supply in

Sri Lanka using the production theory approach. Specifically, we estimate the marginal cost

of pipe-borne water supply in the short run and the long run. Estimation of marginal cost is

important for the benchmarking the pricing decision since the water resources can be

managed efficiently by using cost-reflective pricing (Ng, 1987; Renzetti, 1999). We then

estimate the relationship between the inputs used in water supply, thus quantifying the effect

of changes in prices on the demand for inputs as well on the cost of production. We also

investigate the economies of scale to understand the underlying market structure and to

determine the optimal levels of investment and production. We specify a cost function in a

systematic and theoretically consistent framework and differentiate between the long run and

the short run to account for the nature of capital investment in this sector.

Our results confirm the hypothesis that water is under-priced under the current pricing

regime. The estimated marginal cost of water supply is Sri Lankan rupees (SLRS) 16.50 per

cubic metre in the short run and rises to SLRS 47.25 in the long run. We find evidence of

economies of scale as well as significant substitution possibilities between inputs, particularly

between labour, capital and electricity. These estimates of important parameters of water

supply -marginal cost, elasticities of substitution of inputs, demand for inputs and economies

3
of scale- are an important input into the formulation of water policy.. Given the common

features of the water services in these countries, our results provide a benchmark for

analysing and devising appropriate pricing and subsidy regimes for the water utilities in

Asian countries. Estimations are based on cost function derived from the production theory

approach described in Section 2. Data and data sources are presented in Section 3. Section 4

contains the results and Section 5 presents the main conclusions.

2. Literature Review
Most studies estimating the cost structure of water supply have been carried out in the context

of developed countries. This paper is one of the very few quantitative studies of water supply

in developing countries. The evidence in Asian context is scarce. Altmann (2007) estimates

the marginal cost and economies of scale for Manila in context of privatisation and Nauges

and van den Berg (2007) concentrate on estimating the economies of scale for Brazil,

Vietnam, Cambodia and Moldova.

Kim (1987) analyse economies of scale while Kim (1995) estimates the marginal cost for US

residential water supply to be US$ 0.16 per thousand gallons. Estimates for Vancouver range

from 0.53 to 0.85 per cubic metre (in 1986 Canadian dollars) (Renzetti, 1992), while a study

by Renzetti (1999) for Ontario finds the marginal cost to be 0.87 per cubic metre (Canadian

dollars). Garcia and Reynaud’s (2004) estimate of the short run marginal cost for France

ranges between Euro 0.37 to 0.48 per cubic metre. Garcia-Valinas (2005) estimates the long

run marginal cost of Euro 0.97 per cubic metre and the short run marginal cost equal to Euro

0.52 per cubic metre for 2000 in Spain. In the only evidence for a developing Asian country,

the marginal cost in Manila (Philippines) is estimated by Altmann (2007). It ranges between

Philippine Peso 9.45 to 10.25 per cubic meter in 2007.

4
Other strand of literature on water supply has focused on investigating efficiency differentials

between public and private water utilities. This includes important studies by Feignbaum and

Teeples (1983), Gyler and Teeples (1987), Renzetti (1992) and Bhattacharya et al (1994).

3. Methodology
The NWSDB produces and supplies treated water using various inputs such as labour,

chemicals and energy. Hence the economic structure of NWSDB can be analysed within the

production theory framework. The production function, represented by the revenue function,

involves maximising output for given input quantities and subject to the technological

constraints. Being a publicly owned water utility, NWSDB is generally not allowed to choose

the level of production to maximize profits, but rather is required to supply all the pipe-borne

water demanded at regulated prices. Within this constraint, its behaviour would be consistent

with economic theory as decisions are made with respect to the determination of the optimal

levels of inputs. Hence, estimation of cost function, which is a dual to the underlying

production function under regularity conditions, is more relevant than the direct estimation of

the production function (Christensen and Greene, 1976) for studying the structure of water

utility costs for Sri Lanka. NWSDB seeks to minimize the cost of supplying the quantity of

output and is constrained by exogenously determined input prices, production technologies

and the operating environment. It competes with other industries for factors of production and

the water industry is small relative to the whole economy, hence, input prices are considered

exogenous. It is assumed that technology adapts slowly to the technological innovations and

that, for a given network, the technology is the same for all production units.

It is important to distinguish between the short run and the long run costs. The fundamental

difference between the two is the time frame under consideration and the implications for a

firm’s ability to adjust its production process to minimise costs (Turvey, 1976). Given the

5
size and long gestation periods involved in investment in this sector, capital is considered to

be fixed in the short run and variable in the long run.

Thus the starting point of analysis is the cost function of the following general form,

C SR = f (wL , wC , wE , wM , Q ) (1a)

CLR = f (wL , wC , wE , wM , wK , Q ) (1b)

where C denotes cost of production and subscripts SR and LR denote short run and long run

respectively , w is unit price of input and subscripts relate to the input as follows. L denotes

labour, C denotes chemicals, E denotes electricity, M and K denote maintenance and

capital respectively. Q is cubic metres of water supplied (residential + non-residential) at

time t to final customers (quantity of water reaching the final consumers).

The short run and long run cost functions for NWSDB are specified using a Translog

functional form. This form is commonly used in the studies analysing water costs such as in

Garcia and Reynaud (2004), Kim (1995) and Renzetti (1999), instead of traditional functions

such as Cobb-Douglas used by Garcia-Valinas (2005), due to its flexible nature. Most

importantly, it allows scale economies to vary with the level of output and unlike Cobb-

Douglas, it does not a priori constrain the size or the signs of the elasticities, allowing full

range of complementarities or substitution possibilities between inputs (Christensen and

Greene, 1976).

The Translog cost function takes the form,

I
1 I J 1
ln C = α 0 + ∑ α i ln wi + ∑∑ γ ij ln wi ln w j + β Q ln Q + β QQ ln (Q )2
i =1 2 i =1 j =1 2
13
I
1 I
+ ∑ β iQ ln wi ln Qω t t + ω tt (t ) + ∑ ω it ln wi t + ∑ D + ε
2
( 2)
i =1 2 i =1 i =1 i

6
where in the short run and in the long run.

The restrictions,

∑α
i =1
i =1 ( 3)
n n

∑ β iQ = 0
i =1
∑ω i =1
it =0 ( 4)
n n n n

∑ γ ij = ∑ γ
i =1 j =1
ji = ∑ ∑ γ ij = 0
i =1 j =1
(5)

are imposed on cost functions in equation (2) to ensure that they satisfy the regularity

condition of homogeneity as required by economic theory.§ For a cost function to be well

behaved, it must be homogenous of degree one in prices. In addition, a well behaved cost

structure should be monotonically increasing and concave in input prices. Monotonicity with

respect to input prices can be given as follows;

∂ ln C
>0 ( 6)
∂ ln wi

Concavity of the cost function with respect to input prices,

C (t.w + (1 − t ).w′, y) ≥ t.C (w, Q) + (1 − t ).C (w′, Q) for 0 ≤ t ≤ 1 , is an important basic property

implied by economic theory. Intuitively, it means that an increase in price of an input would

lead to substitution with other inputs and thus moderate the cost increase associated with the

initial rise in input price. At an extreme, the input bundle can be fixed. Hence, concavity of

the cost function is a basic regularity condition. A necessary and sufficient condition for

concavity is that the Hessian matrix of the cost function be negative semi-definite, which can

§
Homogeneity implies that for a given level of output, an increase in all prices leads to a proportional

increase in the total cost.

7
be checked by the Allen partial matrix (Diewert and Wales,1987; Mulik et al., 2003). If the

Allen partial matrix defined as follows,

Ψ ij =
(γ ij + Si ⋅ S j )
(7 )
SiS j

is concave, then the Hessian matrix is also concave (Mulik et al., 2003). As noted by Diewert

and Wales (1987), one of the most vexing problems confronting applied economists

estimating flexible functional forms is that the estimates very often fail to satisfy the required

curvature conditions. The curvature property of the trans-log cost function is data dependant,

hence concavity is not guaranteed if the usual estimation procedure is used. It is not possible

to impose parametric restrictions to ensure concavity of the estimated trans-log cost function

without affecting its flexibility (Chua et al., 2005). There is no consensus about the resolution

if the estimated cost function fails to satisfy concavity for a large number of data points.

Therefore, most water cost studies do not report the extent to which the estimated cost

function satisfies the concavity requirement. This paper checks for concavity and adopts a

simple approach suggested by Ryan and Wales (1998, 2000), to impose local concavity in

the trans-log form. The approach does not does not guarantee concavity for all observations

(Chua e al., 2005), but as demonstrated by Ryan and Wales (1998, 2000), it often results in a

vast improvement in the curvature while preserving the flexibility of the trans-log

specification. We estimate the general form of Trans-log cost function (equation (2)) and test

this specification by investigating whether the estimated function conforms with additional

restrictions of homotheticity, homogeneity, constant returns to scale and unitary elasticities of

substitution imposed by other functional forms. These conditions and the associated

restrictions on the parameters are reported in Table 2.

8
The input demand functions are derived using Shephard’s Lemma. Differentiating the cost

function with respect to input prices gives the derived demand for factors in a cost-share

form. The cost-minimising demand for input , , is given as

∂C ∂wi = xi (8)
and these can be conveniently expressed as follows.

∂ ln C wi ∂C wi xi n
Si = = = = α i + ∑ γ ij ln w j + β iQ ln Q + vi (9)
∂ ln wi C ∂wi C i =1

∑wx
wi xi
=C Si =
C , ∑
i i S i = 1
Note that i =1 and i =1 which results in (I-1) linearly independent

equations (where I is the total number of inputs).

There are three approaches to estimating the relevant parameters. One approach is to directly

estimate the cost function in equation (2). However, it is statistically more efficient to

estimate the system of ( I − 1 ) input demand equations as given by (9), which is the second

estimation approach. The problem with this method is, since we do not impose constant

returns to scale, the crucial parameters ( β Q & β QQ ) required to calculate the economies of

scale and the marginal cost appear only in the cost function. Hence, we adopt the third

approach by estimating the system of equations consisting of the cost equation (equation 2)

and all except one share equations (equation 9) using iterative seemingly unrelated regression

method (SUR) to obtain the maximum likelihood estimates. Christensen and Greene (1976)

conclude this to be an optimal procedure, as inclusion of cost-share equations in the

estimation provides additional degrees of freedom without adding any unrestricted regression

coefficients. An assumption underlying this method of estimation is that the random error

terms of the different equations are inter-related, but are independent of the exogenous

variables entering the right hand side of the equations (Christensen and Greene, 1976). While
9
estimating the parameters of the cost function and cost-share equations, appropriate

restrictions on parameter estimates have been imposed both within and across equations.

In order to account for the panel data ( monthly observations for 14 districts over 5 years)

used in estimation, we include the district specific fixed effects. The maximum likelihood

estimates are then used to test the alternative hypotheses of homotheticity, homogeneity,

constant returns to scale and unitary elasticities of substitution using the likelihood ratio test.

One of the important objectives of cost analysis is to estimate marginal cost, obtained as the

partial derivative of the cost function with respect to output (Chambers, 1988). Since

C(w, Q) is non-decreasing in output, marginal cost is always non-negative. Often elasticity

of cost with respect to output is measured and defined as the ratio of marginal cost and

average cost. The cost elasticity of output for Trans-log cost function is derived as follows:

∂ ln C C n
ε CQ = = β Q + ∑ γ iQ ln w j + β QQ ln Q (10 )
∂ ln Q i =1

The marginal cost equation is then obtained by the expression:

CC
MCC = ε CQ (11)
Q
The marginal cost of output varies not only with the level of output but also with level of

input prices. The effects of a change in input prices on the marginal cost of water services can

be examined from the equation (12).

∂ ln MCC γ iQ
= + Si (12)
∂ ln wi ε CQ

10
Allen partial elasticities of substitution (σ ij ) between two factors i and j can be constructed

using the estimated coefficients (Uzawa, 1962). These elasticities are useful in describing the

pattern and degree of substitutability and complementarity amongst the factors of production.

Basically, they measure the percentage change in factor proportions due to a one percent

change in their relative prices. Two inputs are Allen substitutes if σ ij ≥ 0 and Allen

complements if the inequality is reversed. These can be defined as follows:

γ ij
σ ij = +1 for i ≠ j (13)
Si S j

In addition, own-price and cross-price elasticities of factor demands can be computed. These

measure how demand for input i responds to a change in the price of input j .

η ij =
(γ ij + Si ⋅ S j )
(14)
Si
Economies of scale are defined in terms of the relative increase in output resulting from a

proportional increase in all inputs. This is expressed as one minus the elasticity of total cost

with respect to output (Christensen and Greene, 1976). A positive number indicates positive

scale economies and a negative number indicates scale diseconomies.

∂ ln C C
Ω = 1− (15)
∂ ln Q
If economies of scale are present, it is rational for utility operators to accelerate investment

and achieve higher levels of production. Economies of scale might arise because of the large

fixed capital expenditure often required by the water utilities. The physical and technical

relationships can also result in scale economies, for example, in the case of pipelines, costs

are typically closely related to the surface area of the pipeline yet output depends primarily

on the potential volume.

11
4. Data
Equations (2 and 9) are estimated using monthly observations for 14 NWSDB districts for the

period from January 2001 to December 2005. The short run cost is the operating cost,

measured as the sum of monthly expenditures on labour, chemical, electricity, maintenance

and other costs (miscellaneous expenses). Total cost, which is the long run measure of cost, is

measured by adding capital expenditure to the operating cost. Total cost, operational cost and

capital cost data were collected directly from the NWSDB.

Input price variables for labour, chemical and electricity are expressed as unit costs. The

price of labour is obtained by dividing the total labour cost per month by the total number of

employees per month. The price of electricity is the average price of electricity charged to the

industrial customers by the Ceylon Electricity Board, Sri Lanka. Expenses on chemicals are

composed of costs of different types of chemicals such as lime, chlorine gas and alum. A

price index for chemicals is computed using the total cost of chemicals and the total quantity

of chemicals used each month. Maintenance expenses consist of different categories of

heterogeneous costs consisting of different types of maintenance work including

subcontracting. A price index is constructed for price of maintenance as unit cost per cubic

metre of water as per Garcia and Reynaud (2004).

In principle, the price of capital should reflect interest rates, depreciation rates and purchase

price of capital equipment (Renzetti, 1999). Unfortunately, data on costs of capital or other

similar measures are unavailable from the NWSDB. This data limitation forces us to use an

approximation for the true cost of capital. The price of capital is constructed as long-term

interest plus depreciation allowances on the plant in service. The stock of capital is calculated

as the total expenditure on capital obtained from the data on capital fund utilization for each

year published in the NWSDB annual reports. Since the stock of capital is unlikely to vary in

12
the short run, the average price of capital has been excluded from short-run estimations

(Garcia-Valinas, 2005; Renzetti, 1992). **

The analysis here assumes that prices of labour, electricity, capital and chemical do not vary

substantially between districts. As reported in Table 1, input prices by the NWSDB districts

exhibit relatively small standard deviations. The raw water price is not included in the

empirical estimation as the NWSDB does not pay for the water initially drawn from

reservoirs or rivers. In Sri Lanka, charges are not levied for the extraction of ground water for

any purpose and are not restricted by any authority. However, not including price for

extracted water is economically erroneous, regardless of whether the water utility is paying

for raw water. Untreated extracted water is considered as a scarce resource, and hence it

should have a shadow price. Moreover, the NWSDB pays the Department of Irrigation if it

extracts water from irrigation tanks for drinking purposes. For example, NWSDB has signed

an agreement with the Department of Irrigation to release a specific quantity of water from

Thuruwila and Nilambe irrigation tanks and payment is made on monthly basis. The

payment, on average, is approximately SLRS 0.50 per cubic metre.†† In absence of any

further information or data about the cost of raw water, we add this approximation of SLRS

0.50 per cubic metre to the estimates of marginal costs as the cost of raw water.

Ideally, the long run costs should also include costs related to scarcity, negative externalities

such as water pollution and the positive externalities arising from quality potable water.

**
Most water infrastructure assets in Sri Lanka were installed many decades ago. Accounting book

values may differ from replacement value. The outstanding debt on assets might be used as a capital

stock measure but this also may not reflect the replacement value. Additional and better quality data

on capital costs, currently unavailable, will improve the estimates of the underlying costs.
††
This information was obtained from the email communication with the NWSDB officials.

13
Pollution of rivers by agricultural, industrial or human activities, poor quality and over-

extraction of ground water may contribute to treatment costs. Much of the research in this

area ignores these factors because these costs cannot be accurately estimated due to data

limitations. Due to limitations in valuing the externalities, this paper concentrates on the

long-run operational and investment costs.

Output is measured by the total number of cubic metres of water consumed by final

consumers. However, due to distribution network losses and other leakages, the amount of

water consumed is typically less than the amount supplied. (Garcia-Valinas, 2005). Non-

revenue water in Sri Lanka accounts for 30 percent on average (NWSDB, 2002). Marginal

cost is unlikely to vary for the various uses of delivered water services if the users demand

similar quality of water. Water supply for residential, industrial and commercial use is

produced under common costs and technology and cannot be properly segregated for

different uses. Therefore, a single output, the quantity of water supplied, is used in the

analysis.

INSERT TABLE 1 HERE

Table 1 presents summary statistics of the variables used in cost estimations. The summary

statistics show wide variations in variables such as total amount of consumption, real total

cost of operation and maintenance and cost shares. The panel used in the study ranges from a

very large NWSDB district treating 12.9 million cubic metres of water per month to a very

small NWSDB district treating 18,558 cubic metres of water per month. This is reflected in

the differences between minimum and maximum values of the level of output. The share of

chemicals in total costs (and in operation and maintenance costs) is small relative to those of

labour, electricity and maintenance. Labour constitutes the largest proportion of the overall

14
water board’s operation while electricity and maintenance constitute about equal proportions.

In the long run, capital constitutes the largest share in total costs.

5. Results
4.1 Cost function

INSERT TABLE 2 HERE

Table 2 summarises the various specifications of the cost function (equation 2) and the

likelihood ratio test statistics for each version. The tests indicate that the hypotheses

regarding homothecity, homogeneity, constant returns to scale and unitary elasticities of

substitution are rejected at the 5 percent significance level. Model B imposes homotheicity,

that is, separability between output and factor prices. The rejection of this restriction implies

that the input demands depend on the level of output and it is important to include a measure

of output in estimations. The cost function is homogenous in output if the elasticity of cost

with respect to output is constant (Berndt, 1991). This restriction of homogeneity is

investigated and rejected in Model C. Model D imposes constant returns to scale which are

rejected as well. Further results in Table 6 confirm the presence of economies of scale.

Models E, F, G and H restrict all elasticities of substitution to unity in Models A, B, C and D

respectively. The tests reject the hypothesis of unitary elasticities of substitution as well.

Therefore, Model A, which allows non-homotheticity and non-unitary elasticities of

substitution, is the one that better represents the production structure of the Sri Lankan pipe-

borne water sector and is used in further discussions. These results validate our use of flexible

function form which places minimum restrictions in estimations over other functional forms

such as Cobb-Douglas.

The restriction of linear homogeneity of degree one in input prices and symmetry of hessian

matrix (concavity) are imposed in all models to ensure the estimated cost functions represent

15
well-behaved production structures.‡‡ As discussed in Section 2, it is important to ensure the

estimated cost function satisfies regularity conditions of monotonicity and concavity for all

observations. The percentage of observations that satisfies concavity in the estimated short

run cost function is 48.1 percent. Therefore, curvature conditions are imposed which results

in majority of observations satisfying curvature conditions.§§ The resulting parameter

estimates from the reparameterised model, together with the associated standard errors and

_
2
Berndt adjusted generalized R are reported in the Table 3. The results for short run and long

run are reported separately.

INSERT TABLE 3 HERE

The estimates point to statistically significant non-homotheticity involving labour ( β LQ ),

electricity ( β EQ ), chemical ( β CQ ) and maintenance ( β MQ ). Moreover, all substitution

parameters except γ EC are statistically significant. This reinforces the earlier conclusions that

neither homotheticity nor unitary elasticities of substitution hypotheses are consistent with

the data. The estimated parameters are used to calculate the more interesting measures of

marginal cost and elasticities.

4.2 Input substitution

INSERT TABLE 4 HERE

Next we turn our attention to the full set of substitution possibilities between the inputs used

in pipe-borne water generation. Table 4 presents the Allen-Uzawa partial elasticities

‡‡
Breusch-Pagan test was conducted for all simultaneous equation estimations and null hypothesis of

the residuals from equations are independent was rejected.

§§
Full results of model without imposing concavity are available from the authors

16
(calculated at the means of actual cost shares of each input) of substitution in the short run

and the long run. These measure the percentage change in factor proportions due to a one

percent change in their relative prices, thus indicating the ease with which one input can

substitute for other. All partial elasticities, except σ CM and σ CK , are positive and significant

in both the short run and the long run. This suggests the existence of substitution possibilities

amongst all inputs except chemicals and maintenance and capital and maintenance.

Importantly, labour, capital and electricity are found to be substitutes in water supply.

INSERT TABLE 5 HERE

Price elasiticities of input demands are reported in Table 5 where each element is the

elasticity of demand for input in the row associated with a price change of the input in the

column. These are calculated using the estimated parameters reported in Table 2 at averages

over time. All own-price elasticities of factor demands, reported along the main diagonal in

the table, are consistent with the theory of demand and have a statistically significant

negative sign in the short-run and the long run. An increase in its own price leads to a lower

demand for an input and except for chemicals in the short run and electricity in the long run,

the input demands are (own) price inelastic. One percent increase in price of electricity in the

long-run leads to a 1.3 percent decrease in the demand for electricity, implying more energy

efficient equipment is installed in the long-run. Consistent with economic theory, the

magnitude of own-price elasticities are greater in the long-run than in the short-run,

indicating that the water utility responds more to input price changes in the long-run.

Cross-price elasticities (reported in off-diagonal cells), contain the same information as the

elasticities of substitution in Table 4, but reported values of elasticities are not symmetric as

they depend on the input shares. It can be observed that all cross-price elasticities are less

than one and the positive signs, except for capital and maintenance in the long run, confirm

17
input substitutability observed from the Allen Uzawa elasticities. An increase in price of an

input leads to an increase in the demand for other inputs as substitution takes place, however,

the demand for capital and maintenance are complementary to each other.

The substitutability between electricity and maintenance can be interpreted as empirical

evidence of a possible trade-off between electricity for production of water and maintenance

to reduce losses of water. A one percent increase in electricity price leads to a 0.09 percent

increase in demand for maintenance in the short run. An increase in maintenance costs has a

similar impact on the demand for electricity. Labour is also a substitute for electricity and

maintenance, probably for the same reasons. Maintenance includes different input categories

such as material, repairs and some heavily labour dependent components. But substitutability

between labour and maintenance implies that water utilities either use their own labour or

sub-contracted labour for maintenance activities (NWSDB, 2005). An increase in wages

leads to an increase in demand for maintenance.

4.3 Marginal cost and economies of scale

INSERT TABLE 6 HERE

Table 6 reports remaining measures of interest (at mean values) for the short run and the long

run. The estimated output cost elasticity is significant and positive as expected, one percent

increase in the level of output increases total costs by 0.7 percent in the short run and by 0.5

percent in the long run. Economies of scale are presented by evaluating equation 15 at the

mean level of output and factor prices. The positive value indicates a presence of increasing

returns to scale which is found to be statistically significant in both, the short run and the long

run. This is consistent with the rejection of constant returns scale as reported in Table 2 and

corresponds to evidence from developed countries such as Canada, France and USA (Garcia

and Thomas, 2001; Kim, 1987 and Renzetti, 1992; 1999). Bhattacharyya et al. (1994) find

18
that both, public and private U.S. water utilities enjoy increasing returns to scale. In contrast,

Altmann (2007) found decreasing returns to scale in a developing economy context, for the

Manila water concessions.

More importantly, as reported in Table 6, the marginal cost of water is found to be

statistically significant and equal to SLRS 16 in the short run and SLRS 46.73 in the long run.

After the inclusion of raw water price (a constant of SLRS 0.50), additional operational and

maintenance cost of producing an additional cubic metre of water is approximately SLRS

16.50 in the short run and SLRS 47.25 in the long run. Consistent with the literature, the long

run marginal cost is significantly greater than the short run marginal cost, reflecting capital

costs in the long run. Water services involve high capital investments, therefore, a significant

portion of expenses are fixed costs which do not vary with the water quantity consumed in

the short-run (Garcia and Reynaud, 2004).This finding is consistent with the past empirical

results (Garcia-Valinas, 2005; Renzetti, 1992, 1999). Long run marginal cost includes

marginal capacity costs, that is, the cost of extending capacity to accommodate an additional

unit of consumption. It is also affected by the different factors which influence the cost of

reservoir construction such as technology and input prices. For example, technological

advances will lower the cost but increases in input prices and increasing scarcity of suitable

sites tend to raise the costs.

These estimates of marginal cost provide a benchmark for water pricing in Sri Lanka.

Marginal-cost pricing is considered as the first-best pricing policy. Economic theory suggests

pricing according to the marginal cost, as it is efficient and maximizes social welfare (Brown

and Sibley, 1986; Ng, 1987).The current system of pipe-borne water pricing in Sri Lanka is

complex but common in Asian countries. Residential consumers are faced with an initial

connection charge, monthly fixed fee and a volumetric charge. Residential water users’

monthly bills consist of two distinct components (two-part tariff): a part based on volume of

19
water use and another part based on factors other than water use such as fixed capital

expenditure. Majority of households consume in the first two tariff blocks. First block

consisting of 0-15 cubic metre is charged at SLRS 1.25 per cubic metre and the charge for

second block (11-15 cubic metre) is SLRS 2.50 per cubic metre. This indicates that pipe-

borne water is greatly underpriced in Sri Lanka, leading to challenges in maintaining the

financial viability of the water supplier. Pricing according to marginal cost and thus, ensuring

revenue sufficiency, would enable an expansion of the network ensuring more households

have an opportunity to be connected.

Further, our estimate of short run marginal cost should be considered as a lower bound for the

actual cost as the estimate cannot capture the opportunity cost of forgone water demand and

thus, only reflects the marginal cost of production. When the demand for water reaches the

production capacity, short run marginal cost rises steeply. In an extreme case, additional

supplies can only be secured for one customer by reducing the supplies to another customer.

Therefore, short run marginal cost can rise in terms of customers who are not being served

(Ng, 1987). Since it is difficult to estimate the opportunity cost of forgone demand for water,

in practice, marginal cost is estimated based on existing operating and maintenance costs

(Marsden Jacob Associates, 2004). Including the opportunity cost of forgone demand may

result in a short run marginal cost which is greater than the long run marginal cost (Ng,

1987).

It is also useful to estimate the effect a change in input price on marginal cost. These are

evaluated at the sample means and reported in the lower panel of Table 6 which shows the

change in marginal cost with respect to input prices. The rows show the marginal-cost

elasticities of output resulting from a one percent change in input price. All elasticities of

marginal-cost of output are positive as expected; the marginal cost tends to increase when a

price of input increases. Labour costs have a large impact, a one percent rise in wages

20
increase marginal cost by 0.65 percent in the short run and 0.54 percent in the long run. An

increase in capital costs has similar effect in the long run.

6. Concluding remarks and Policy Implications

The production decision of water utility is modelled using a trans-log cost function for the

NWSDB in Sri Lanka. The trans-log cost function and cost-share equations allow the

estimation of marginal cost and economies of scale for pipe-borne water in both short and

long runs. The results support our choice of a flexible cost function for analysis; the cost

function for NWSDB exhibits increasing returns to scale and significant non-unitary

substitution possibilities between inputs. These findings suggest that analysis of water supply

in developing countries need to allow for economies of scale and non-unitary elasticities of

substitution and include a measure of output.

The average marginal cost in the short run is estimated to be SLRS 16.50, rising to SLRS

47.25 per cubic metre in the long run. The substantially higher long run marginal cost reflects

the importance of capital costs to the utility. The short run estimate represents only

expenditures on variable inputs, while the long run cost also includes expenditure on capacity

expansion (Renzetti, 1992). Our estimates of marginal cost reflect the operational and

financial costs but should be treated as lower bound of the ‘real’ costs which should also

include marginal social or user costs, fully accounting for externalities of water use.

However, all estimates of marginal cost are substantially higher than current average

volumetric charges for water in Sri Lanka, supporting the generally accepted belief that water

is under-priced. If the current charges are not increased to reflect the marginal cost, the

policymakers have to find alternative means of ensuring the financial viability of the water

supplier and funding the required infrastructure to extend the supply in rural areas. Under-

pricing of water can also pose problems from demand side, leading to excess demand and

wastage of this valuable resource.

21
The elasticities of substitution establish two interesting relationships: negative own price

elasticity and positive cross-price elasticity (except between capital and maintenance). An

increase in price leads to a decrease in its own demand but increases the demand for other

inputs due to substitution possibilities. Thus, the water utility has various possibilities to

substitute one input for other. The elasticities of marginal cost indicate that change in labour

and capital costs have a significant impact on the marginal cost.

We find existence of significant economies of scale in supply of pipe-born water, reflecting

the technology and organisational structure of the public monopoly supplier. This indicates

that there is a scope for accelerating investment and increasing production in this sector.

Under correct institutional and financial structure, it would be possible to extend the supply

of pipe-borne water in Sri Lanka.

This paper is the first attempt to estimate the cost structure of water supply for Sri Lanka.

Results of this analysis are of practical importance to the regulators, policy makers and the

NWSDB managers in the design of rate structures for water and the management of water

supply. Water supply in developing countries, particularly in Asia, share common physical

and technical features and operate under similar institutional arrangements. Our results are,

hence, applicable for policies and pricing of water supply in the wider Asian context.

22
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Chambers, R., (1988) “Applied Production Analysis: A Dual Approach”, Cambridge

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Feigenbaum, S. and Teeples, R., (1983) “Public Versus Private Water Delivery: A Hedonic

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Garcia-Valinas, M. A., (2005) “Efficiency and Equity in Natural Resources Pricing: A

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Garcia, S., and Reynaud, A., (2004) “Estimating Benefits of Efficient Water Pricing in

France”, Resource and Energy Economics, 26, 1 - 25.

Garcia, S., and Thomas, A., (2001) “The Structure of Municipal Water Supply Cost:

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Ownership Effects”, Review of Economics and Statistics, 69 (3), 399-408.

Imbulana, K. A., Wijesekera, N. T., and Neupane, B. R., (2006) “Sri Lanka National Water

Development Report”, UNESCO.

Kim, H. Y., (1987) “Economies of Scale in Multi Product Firms: An Empirical Analysis”

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Industrial Organizations, 10, 323 - 338.

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Queensland Competition Authority.

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Mulik, K., Featherstone, A., and Marsh, T., (2003) “Imposing Curvature Restrictions on a

Trans-log Cost Function using Markov Chain Monte Carlo Simulation Approach”, Paper

presented at the Annual Meeting of American Agricultural Economics Association.

Nauges , C., and van den Berg, C. (2007) “How 'Natural' are Natural Monopolies in the

Water Supply and Sewerage Sector? Case Studies from Developing and Transition

Economies”, World Bank Policy Research Working Paper 4137.

Ng, Y. K., (1987) “Equity, Efficiency and Financial Viability: Public-utility Pricing with

Special Reference to Water Supply”, Australian Economic Review, 20(3), 21 - 35.

NWSDB, (2002) “National Policy on Water Supply and Sanitation”, Retrieved 28-11-2006,

from http://www.waterboard.lk

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Colombo.

NWSDB, (2006) “National Water Supply and Drainage Board”, Retrieved 27-08-2007, from

http://www.waterboard.lk

Renzetti, S., (1992) “Evaluating the Welfare Effects of Reforming Municipal Water Prices”,

Journal of Environmental Economics and Management, 22, 147 - 163.

Renzetti, S., (1999) “Municipal Water Supply and Sewage Treatment Costs, Prices and

Distortions”, Canadian Journal of Economics, 32(3), 688 - 704.

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Some Flexible Consumer Demand Systems”, Journal of Business and Economic Statistics,

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Generalized Leontief Cost Functions”, Economics Letters, 67, 253 - 260.

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26
Table 1: Descriptive Statistics
Variable Units Mean
(Std Deviation)
Real total cost of operation and maintenance SLRS mn 31.20
(42.90)
Real total cost SLRS mn 119.00
(60.80)
Total consumption m3 mn 1.41
(2.83)
Price of chemical SLRS/kg 29.79
(12.09)
Real wage for average employee (‘000) SLRS/worker 23.50
(12.54)
Real average price of electricity SLRS/ KWh 9.60
(0.84)
Real unit cost of maintenance and other SLRS/ m3 11.80
25.74)
Price of capital index 0.13
(0.04)
Short-run cost shares
Share of wage cost % 49.12
(11.30)
Share of electricity cost % 24.97
(10.54)
Share of chemical cost % 4.12
(3.39)
Share of maintenance and other cost % 21.77
(9.62)
Long-run cost shares
Share of capital cost % 63.48
(15.13)
Share of wage cost % 18.12
(9.53)
Share of electricity cost % 8.51
(3.80)
Share of chemical cost % 1.39
(1.18)
Share of maintenance and other cost % 8.47
(7.06)
Notes: Costs expressed in Sri Lankan Rupees (SLRS). Short run costs shares indicate share of the input cost in
total short run cost. Similarly, long run costs shares indicate share of the input cost in total long run
cost.

27
Table 2: Restrictions on the Cost Model: testing the hypotheses of homothecity, homogeneity and unitary elasticities of substitution
Model Specification of Cost function Restrictions No of Calculated
restrictions Short run Long run
A Trans-log, None
non-unitary elasticities of substitution
B Homothetic, β iQ = 0 2 262.92*** 259.52***
non-unitary elasticities of substitution
C Homogenous, β iQ = 0 β QQ = 0 3 275.21*** 359.38***
non-unitary elasticities of substitution
D Constant returns to scale, β iQ = 0 , β QQ = 0 , β Q = 1 4 329.62*** 479.59***
non-unitary elasticities of substitution
E Trans-log, γ ij = 0 5 1409.50*** 2223.53***
unitary elasticities of substitution
F Homothetic, β iQ = 0 , γ ij = 0 5 1686.35*** 2804.21***
unitary elasticities of substitution
G Homogenous, β iQ = 0 , β QQ = 0 , γ ij = 0 6 1827.27*** 2819.13***
unitary elasticities of substitution
H Constant returns to scale, β iQ = 0 , β QQ = 0 6 2337.79*** 3121.67***
unitary elasticities of substitution β Q = 1 , γ ij = 0
Note: Estimations of equation (2). ***Significant at α = 0.01
Table 3: Estimations of the Short run and Long run Cost functions
Short run Long run
Parameter Estimate Std Error Estimate Std Error
βQ 0.911*** (0.181) 1.953*** (0.179)
β QQ 0.006 (0.016) -0.062** (0.016)
αK 0.255*** (0.035)
αL 0.794*** (0.014) 0.394*** (0.041)
αE 0.034** (0.011) 0.220*** (0.029)
αC 0.001 (0.003) 0.006** (0.003)
αM 0.171*** (0.017) 0.125*** (0.004)
β KQ 0.024*** (0.002)
β LQ -0.037*** (0.003) -0.060*** (0.003)
β EQ 0.007*** (0.003) 0.024*** (0.002)
β CQ -0.002*** (0.001) 0.017*** (0.001)
β MQ 0.032*** (0.001) 0.011*** (0.001)
γ KK 0.026*** (0.006)
γ LL 0.012** (0.005) 0.078*** (0.005)
γ EE 0.004 (0.005) -0.080*** (0.008)
γ CC -0.005* (0.002) 0.001 (0.002)
γ MM 0.087*** (0.001) 0.128*** (0.004)
γ LK -0.003*** (0.004)
γ LE 0.023*** (0.005) -0.007** (0.003)
γ LC 0.011*** (0.002) -0.003* (0.002)
γ LM -0.046*** (0.002) -0.039*** (0.002)
γ EK 0.071*** (0.006)
γ EM -0.031*** (0.003) 0.006** (0.002)
γ EC 0.004 (0.002) 0.012*** (0.003)
γ CK -0.005** (0.002)
γ CM -0.010*** (0.001) -0.005*** (0.001)
γ MK -0.057*** (0.002)
α0 -0.805 (1.012) -3.847*** (0.103)
0.995 0.999
~ ~
2 2
Notes: R , is the Brendt R which indicates the proportion of the generalized variance in Y explained by
variation in the right-hand variables in the system of equations (Berndt, 1991). Capital, Labour, Electricity,
Chemical and Maintenance are denoted by K, L, E, C and M subscripts respectively. All the parameters are
obtained by joint estimation of the cost function (equation 2) and input demand functions (equation 9). The
reported estimates are for curvature corrected estimations of Model A.
Table 4: Allen Uzawa Elasticites of Substitution
Elasticity of substitution Short run Long Run
(std errors) (std errors)
σ LE 1.186*** 0.884***
(0.039) (0.053)
σ LC 1.549*** 0.721***
(0.084) (0.169)
σ LM 0.571*** 0.324***
(0.022) (0.031)
σ EC 1.351*** 3.248***
(0.238) (0.535)
σ EM 0.431*** 1.195***
(0.052) (0.085)
σ CM -0.134 -0.047
(0.144) (0.201)
σ LK 0.708***
(0.036)
σ EK 2.463***
(0.130)
σ CK 0.373
(0.261)
σ MK -0.272***
(0.038)
Notes: The Allen-Uzawa partial elasticities of substitutions are
computed at the mean of actual cost shares using parameter estimates
reported in Table 2. *** Significant at α = 0.01, ** Significant at α =
0.05 and * Significant at α = 0.10; standard errors reported in
parentheses below estimates.

30
Table 5: Price elasticities of input demands
Elasticity of Demand
Change in price (Change in quantity demanded)
Labour Electricity Chemical Maintenance Capital
Short run
Labour -0.484*** 0.296*** 0.064*** 0.124***
(0.010) (0.010) (0.003) (0.005)
Electricity 0.582*** -0.732*** 0.056*** 0.094***
(0.019) (0.020) (0.010) (0.011)
Chemical 0.761*** 0.338*** -1.069*** -0.029
(0.041) (0.060) (0.060) (0.031)
Maintenance 0.280*** 0.108*** -0.005 -0.357***
(0.011) (0.013) (0.006) (0.010)
Long run
Labour -0.424*** 0.156*** 0.021*** 0.053*** 0.194***
(0.013) (0.009) (0.005) (0.005) (0.010)
Electricity 0.316*** -1.281*** 0.094*** 0.194*** 0.676***
(0.019) (0.044) (0.015) (0.014) (0.036)
Chemical 0.258*** 0.572*** -0.925*** -0.008 0.102
(0.061) (0.094) (0.062) (0.033) (0.072)
Maintenance 0.116*** 0.211*** -0.001 -0.049** -0.075***
(0.011) (0.015) (0.006) (0.025) (0.010)
Capital 0.254*** 0.434*** 0.011 -0.044*** -0.633***
(0.013) (0.023) (0.008) (0.006) (0.021)
Notes: Each element is the elasticity of demand for input in the row after a price change of the input in the column.
These are calculated using the estimated parameters reported in Table 2 at the averages over time. *** Significant
at α = 0.01, ** Significant at α = 0.05 and * Significant at α = 0.10; standard errors reported in parentheses below
estimates.

31
 Table 6: Output-cost elasticity, marginal cost and economies of scale
Short run Long run
Output-cost elasticity 0.699*** 0.547***
(0.041) (0.038)
Marginal cost 15.960*** 46.735***
(0.910) (3.246)
Economies of scale 0.301*** 0.453***
(0.041) (0.038)
Elasticity of Marginal-cost of Output
Change in input prices Change in marginal cost
Wages 0.650*** 0.544***
(0.039) (0.039)
Electricity 0.367*** 0.366***
(0.022) (0.026)
Chemical 0.056*** 0.056***
(0.003) (0.004)
Maintenance 0.357*** 0.316***
(0.021) (0.022)
Capital -- 0.546***
(0.039)
Notes: An estimate of economies of scale is obtained for each
model by evaluating the formulae (equation 15) at the mean level
of output and factor prices. The marginal costs are estimated at
the mean value of the output and input prices. The elasticity of
marginal cost of output report the effect of a change in input
prices on marginal cost, evaluated at the sample means. ***
Significant at α = 0.01, ** Significant at α = 0.05 and *
Significant at α = 0.10; standard errors reported in parentheses
below estimates.

32

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