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REPLY TO DISCUSSION by Donald E. Agthe and R. Bruce Billings 1

The fundamental message of "Economic Incentives..." (Haddad, 2000) is that water planners should look beyond existing institutional arrangements for water supply in their ever-growing challenge to match supply with demand. My article presents a marketbased approach to water conservation that is a hybrid of numerous existing approaches specifically adapted to urban/suburban water conservation. Its core features are an adjustable cap on regional water use combined with a system of tradable use-rights. The approach satisfies environmental stewardship requirements, enables new development, and provides incentives for creative and effective conservation measures from any households or businesses so inclined. The distinguished commenters (Agthe and Billings, 2000) raise a number of concerns and issues to which I now respond. The first concern — that initial allocation of userights to water is necessarily arbitrary — is inaccurate. A deliberative public-policy process will yield an initial allocation. I present four alternatives, including one I prefer. None are arbitrary in that they emerge from prior accepted principles and are subject to social scrutiny. If the commenters meant that an initial allocation of use rights is arbitrary since it does not emerge from the functioning of a market, I would concur. This perspective was posited by Arrow (1951). Yet initial allocations of new wealth occur all the time, as evidenced by the distribution of stock options in start-up firms as well as the on-going establishment of new market-based regulatory programs. The commenters next question my implicit logic that market-based programs that succeed at the level of firms and municipalities can also succeed at the level of households and small businesses. This, they claim, is a potential "fallacy of composition" since sufficient expertise may not reside at the household and small-business level to engage in such a market. The choice whether to purchase or rent a home, condominium, or townhouse, or to rent a room in someone else's home, involves orders of magnitude more money, greater risk, and greater complexity of implementation than the simple voluntary transactions called for in this proposal. Yet we trust all adults capable of living on their own to make housing decisions for themselves, and they do. Who could be more expert at making market-based decisions than people living in a market-based society? While it is true as the commenters point out that drivers of cars do not participate in southern California air pollution markets, that was a design choice made by the South Coast Air Quality Management District. There is no reason why drivers (some of whom currently trade stock options by cell phone during their commutes) could not participate in an appropriately-designed air pollution market. If individuals can effectively evaluate competing claims found on pharmaceutical containers, made by automobile salespersons,' and buried in investment prospectuses, engaging in occasional water transactions will be a snap. The commenters then raise two related points concerning use-rights trading and transaction costs. The