COLLECTIVE ACTION THROUGH CONTRACTING
It is useful to clearly restate the essential features of the economic problem facing potential irrigators in the arid West before exploring how formal property rights developed to solve that problem in a setting where political and informal institutions had largely failed to do so. The rugged, arid terrain of the West made upfront investment in irrigation infrastructure a prerequisite for agriculture. The capital intensity of this infrastructure, the large public benefits it ultimately provided, and the potential for free-riding made irrigation investment a classic collective-action problem. Information problems, a vast federal estate, and a large number of heterogeneous agents arriving over a wide time frame reduced the government’s capacity to provide irrigation works initially and largely precluded the development of informal, community-based irrigation projects. Instead, individuals turned to property rights as a coordinating device.
In reflecting on Ostrom (2011), Hanemann (2014) emphasizes the role that property rights played in providing an alternative solution to this problem, detailing the importance of having legal property in providing access to credit. Leonard and Libecap (2016) also study the role of property rights in promoting investment, focusing on the role of first possession as reward for socially valuable search and investment (a similar argument has been made in the context of patents). Another critical benefit of prior appropriation not emphasized by Hanemann (2014) or Leonard and Libecap (2016) was that it transformed irrigation works from a non-excludable into an excludable club good, providing a foundation for the market-based development of water resources in the West.
The economic theory of club goods first developed by Buchanan (1965) provides a convenient analytic framework for understanding how property rights can serve as a basis for collective action to develop socially beneficial projects like infrastructure. Buchanan proposed club goods as a more flexible approach to categorizing collective action problems than the strict private vs. public good dichotomy popularized by Samuelson (1954). In the original taxonomy, public goods like national defense are non-rivalrous (everybody gets the same amount) and non-excludable, whereas private goods like shirts are rivalrous (a shirt can only be worn by one person at a time) and excludable (it easy to prevent the theft of shirts).
Buchanan’s innovation was to recognize the existence of club goods such as swimming pools which are partially rivalrous and partially excludable. As Buchanan notes,
The interesting cases are those goods and services, the consumption of which involves some “publicness,” where the optimal sharing group is more than one person or family but smaller than an infinitely large number. The range of “publicness” is finite. The central question in the theory of clubs is that of determining the membership margin, so to speak, the size of the most desirable cost and consumption sharing arrangement. (Buchanan 1965, 1)
This framework is useful for analyzing irrigation works because, as noted, the optimal group size for an irrigation project was greater than one but nevertheless faced an upper boundary based on the profitability of ditch investment and the amount of land and water that could be put to productive use in a given area.
The key economic question in the theory of clubs is determining the optimal club size and associated delivery size for a particular good. Taking the amount of the good as fixed and assuming a particular distribution of the club good (such as equal sharing), the optimal club size is found by setting the marginal benefit of a new member (their contribution to the cost of production) equal to the marginal cost of that new member (the reduction in existing members’ consumption). For a given production function, sharing rule, and good size, the optimal club size is uniquely determined. Under these conditions, we would expect private clubs to form and provide goods that are “public” among their members but are not enjoyed by nonmembers. Classic examples include homeowner’s associations, private swimming pools, and (of course) irrigation companies.
Even under the restrictive conditions outlined above, provision of club goods requires the ability to exclude nonmembers. Indeed, Buchanan saw exclusion as essential:
If individuals think that exclusion will not be fully possible, that they can expect to secure benefits as free riders without really becoming full-fledged contributing members of the club, they may be reluctant to enter voluntarily into cost-sharing arrangements. This suggests that one important means of reducing the costs of securing voluntary co-operative agreements is that of allowing for more flexible property arrangements and for introducing excluding devices. (Buchanan 1965, 14)
While Buchanan explicitly recognizes the fact that his analysis ignores the costs of excluding outsiders and securing internal agreement, both are fundamental to determining whether clubs are a viable mechanism for collective action. At the same time, Buchanan’s emphasis on the importance of property as a means for exclusion points the way to a cost-minimizing mechanism for both exclusion and coordination.
The emergence of prior appropriation water rights illustrates how property rights can provide a key means of exclusion to facilitate the formation of economic clubs while also serving as a basis for internal agreement among club members. Prior appropriation water rights are historically unique in that they are explicitly quantified and assigned a priority based on when they were established (Leonard and Libecap 2016).9 These two distinctive features of prior appropriation address the two critical needs associated with the formation of clubs—allocating rights via first possession solved a complicated exclusion problem, while quantifying water rights provided a heretofore unavailable means of contracting over claims to surface water.
The challenges for informal cooperation presented by the inter-temporal arrival of new claimants also posed a problem for the formation of economic clubs. Ultimately, exclusion is only economically meaningful if agents have the de facto ability to preclude others from the rents associated with a particular good or resource. The unquantified share-based riparian water rights dominant in the eastern United States did not provide claimants with de jure protections for their investments because any new arrival would be allowed “reasonable use” of the river (Leonard and Libecap 2016). With large numbers of potential entrants and a fluctuating distribution of land ownership, location-based enforcement costs were high because new claimants could intercept existing users’ water before it ever reached them by locating upstream. This was exacerbated by the fact that land claims—the basis for a riparian water right—were also in flux as the West was settled. While preexisting land holdings had been a low-cost margin along which to demarcate property to water in the eastern United States, this was not a viable option in the West.
Faced with high enforcement costs for unquantified, land-based water rights, claimants on the Western frontier turned to an alternative, lower-cost dimension along which to define claims: time. Demarcating rights to water based on the timing of the claim may have initially emerged simply due to convenience; rights to land, timber, and minerals were all officially allocated via first possession, and claimants began using the same mechanism to assert quantifiable rights to water (Umbeck 1977, 1981; Libecap 1978; Kanazawa 1996). These claims lacked formal legal status initially, but the system was adopted in a de facto way by users across a variety of different settings.
Whether or not it was adopted out of convenience, first possession turned out to be just the sort of “excluding device” needed to support the formation of clubs envisioned by Buchanan (1965). Fixing claims based on their initial timing formed a low-cost basis for exclusion because in most cases it was apparent which claims were established earlier or later than others. Moreover, new claimants at any given time did not have to worry about the threat of potential entry because they had prior access to the water. This made agents willing to invest in costly ditch construction and made them more willing to enter into contracts with one another (Leonard and Libecap 2016).
Fixing claims based on time also lowered coordination costs once subsequent claimants did arrive because they could take existing claims as given in their own decision of where and how much to invest. Though transactions costs were certainly not zero, first possession claims to water were a way of establishing an initial distribution of quantifiable property rights that could then serve as a basis for negotiation and exchange vis-a-vis Coase (1960). Positive transaction costs may have impaired an efficient outcome in the sense of the first-best, but the existence of some form of property rights facilitated agreements that would not have been possible otherwise.
Crifasi (2015) provides a litany of examples of coordination, investment, and contracting that occurred throughout the Colorado Front Range even before first-possession water rights had been legally recognized. Often, claimants who formed a ditch company would pool their individual claims into one large claim and then allocate water among themselves on a proportional basis. This reduced the cost of enforcing their collective claim relative to outsiders and secured their joint interest in the success of the project. Even though water rights were not formal legal property rights initially, claimants legally incorporated their ditches and issued shares (Crifasi 2015). This provided a mechanism for securing capital necessary for investment before water rights were legally recognized as collateral. As Hanemann (2014) makes clear, this was a dominant feature of the economic problem of irrigating, making the clubs that formed as ditch companies a novel solution.
Water clubs in the form of ditch companies carried with them other advantages in addition to access to capital. By formally incorporating, users were able to avoid post-contractual opportunism that often plagued informal agreements about water deliveries and rights-of-way for constructing ditches (Crifasi 2015). Incorporation created a “backdoor,” so to speak, to formal legal recourse for claimants. While irrigators could not initially take legal action over their informal water claims, they could hold one another accountable for breach of contract associated with the internal rules and responsibilities of a ditch company (Hanemann 2014). Settlers’ willingness to incorporate around first possession claims thus provided a mechanism for reducing the organizing costs that worried Buchanan (1965).
While de facto first-possession claims allowed for a remarkable degree of coordination, they were subject to at least a potential threat of encroachment by new claimants because they lacked formal legal protection. When encroachment did eventually come, it led competing individuals and ditch companies to “leap frog” one another by constructing new irrigation works further and further upstream. With lack of legal means to enforce their first possession claims, users resorted to a spatial competition over access to water. In one particular instance, a group of frustrated irrigators with junior, downstream claims led by Rubin Coffin destroyed the head gate of the Left Hand Ditch Company, which had previously diverted much of the available water along St. Vrain Creek near Boulder, Colorado (Crifasi 2015). The destruction of physical property gave the Left Hand Ditch Company a basis for legal action. As it worked its way up to the Colorado Supreme Court, the resulting court battle would become the test case for the legal status of first- possession claims to water.
The Colorado Supreme Court was clearly sensitive to the need for secure property rights to provide incentives to invest. As Chief Justice Samuel Elbert explained:
It has always been the policy of the national, as well as the territorial and state governments, to encourage the diversion and use of water in this country for agriculture; and vast expenditures of time and money have been made in reclaiming and fertilizing by irrigation portions of our unproductive territory. Houses have been built, and permanent improvements made; the soil has been cultivated, and thousands of acres have been rendered immensely valuable, with the understanding that appropriations of water would be protected. Deny the doctrine of priority of superiority of right by priority of appropriation, and a great part of the value of all this property is at once destroyed. (Rocky Mountain News, January 2, 1878, as quoted in Crifasi 2015, 175)
The court rejected riparian rights in favor of the more secure, excludable first-possession claims that emerged first as de facto rights and had gradually become generally acknowledged. By providing a clear, legal recognition of first possession, the case became the basis for the “Colorado Doctrine” of water rights that would later become known as prior appropriation across the West (Schorr 2005; Crifasi 2015).
The formal recognition of appropriative water rights unleashed the market process as a mechanism for discovering more efficient forms of organization for irrigation. Hanemann (2014) notes that the asset specificity associated with land and water use in the West created challenges for traditional market relationships identified by Williamson (1975, 1985). This was solved through “vertical integration combining both sides of the transaction within a single entity. In an irrigation context, this means that the water supplier and land-owner become the same entity” (Hanemann 2015, 15). Indeed, this was exactly the strategy adopted by the wave of ditch companies that formed in the wake of Coffin v. Left Hand Ditch Company.
Though contracts and investment had already begun on the basis of informal first possession claims, the formal recognition of appropriative water rights allowed the market process to develop more fully than was previously possible. Formal codification involved quantification and recording of claims via flow measurement devices at head gates located along each stream. Measuring and recording claims provided a more standard method of quantification and created a registry of claims by priority, lowering the costs of learning about prior claims and enforcing existing claims. State enforcement of appropriative claims also provided greater certainty for outside investors who were crucial sources of capital (Hanemann 2014) while allowing claimants themselves to devote less effort to enforcement and more to solving the important information problems associated with developing agriculture in an arid climate.
Entrepreneurs recognized profit opportunities from solving the information problem facing new migrants while also ameliorating the asset specificity problem. Once property rights to water were legally recognized, the market solution was straightforward:
The business model for corporate ditch building in Colorado was quite elegant in its simplicity. First, private investors, railroad companies, or other corporate developers would acquire a large block of undeveloped land. . . . Once the land passed to private hands, engineers developed plans and claimed the necessary water rights. They would then incorporate a ditch and sell enough shares to build the ditch while reserving sufficient stock to irrigate lands they owned. Elsewhere developers would sell the land and then rent the water to farmers. Using these tactics, irrigation companies profited by bringing new settlers to Colorado. (Crifasi 2015, 184)
While Hanemann (2014) emphasizes the widespread failure of many such ventures, much of the existing irrigation infrastructure servicing cities like Boulder was initially constructed by a private ditch company and later acquired by municipal authorities.
The development of irrigation companies as clubs that could price membership allowed the market process to shape the course of water development early on in the movement west. As noted by Lavoie (1986), the market process generates information through entrepreneurial discovery. This was true in two important ways in the irrigation context. First, led by the profit motive, irrigation companies on Colorado’s Front Range developed new techniques for irrigating lands previously thought un-irrigable and dramatically expanded the very definition of irrigable land. Second, successes and failures of irrigation companies of varying sizes, locations, and organizational types laid the groundwork for the water management institutions that allowed western irrigation to flourish over the next century.
The earliest American settlers in the rugged west began by irrigating the easily-reached “bottom-lands” near streams, but these lands were relatively scarce and soon exhausted. With the ability to acquire land cheaply and sell at a premium once water was provided, engineers had a strong incentive to find ways to irrigate the wide, flat bluffs that often lay above streams. Faced with large potential gains and a burgeoning market for joint land and water claims, entrepreneurs discovered that lands above the stream channel could be irrigated if the initial diversion was constructed farther upstream and made to slowly work its way above the bluffs. As soon as the earliest of these endeavors was successful, large-scale irrigation companies copied the technique and the land that could be brought under irrigation expanded dramatically not just in Colorado but across the rugged terrain of the West (Crifasi 2015).
Property rights to water also facilitated market-driven evolution of institutions for water management. The problems of club formation raised by Buchanan (1965) become more complex if the production function is not known, the amount of the club good is endogenous, or the shares enjoyed by club members are not equal. These were precisely the conditions in the
West. It was not obvious ex ante where or how irrigation works should be constructed. Nor was the efficient scale of irrigation development known. Finally, the inter-temporal nature of arrival coupled with heterogeneity in land endowments and crop choice meant that equal sharing was not a foregone conclusion. Put this way, the problem of irrigation development is determining the optimal number of users of a given irrigation works, the size of the irrigation works, and coordinating deliveries for each of the users.
While early ditch companies and cooperative arrangements had begun groping toward a solution to this economic problem, the growth of a broader market for bundled land and water rights was fundamental to the continued evolution of irrigation institutions. These institutions developed spontaneously through the market process a la Hayek (1964, 167) and were later emulated by local governments that formed irrigation districts. The joint necessity for both land and water in producing agricultural output meant that institutions for managing water use had to match to spatial extent of the associated land use. Ditch companies had initially formed around capitalintensive investment and focused more narrowly on water but later gave way to irrigation companies that bundled land and water claims and developed rules for the use of water on all relevant land.
As Hanemann (2014) and others are quick to point out, many irrigation companies ultimately failed. It is a mistake to characterize these failures as a failure of prior appropriation itself. On the contrary, the ability to price water rights based on priority, coupled with observation of the actual deliveries of water over time, led to rights that were not profitable to be retired. Leonard and Libecap (2016) document a bias in the timing of water claims that led claimants to over-claim water along a given stream because more claims are generally established during periods of unusually high flows, resulting in “calls” on water during more average years.10 In other words, the failure of ditch companies that claimed more water than was actually available is a form of market correction, not a systemic failure of markets.
Even in settings where ditch and irrigation companies eventually faded away, their initial formation and activities laid the groundwork for contemporary water users. Early ditch companies were responsible for developing infrastructure that is still in use today because many of these initial projects became the basis for municipal water supplies and were ultimately purchased by local governments (Crifasi 2015). As noted earlier, the large number of entrants and the information problems they faced precluded either governments or informal communal arrangements from constructing these irrigation works themselves. Moreover, early entrepreneurial efforts to bundle land and water claims led to the development of mutual irrigation companies, an early form of the irrigation districts that dominate the West today (Hanemann 2014).