Agriculture is the main water-using sector in Southern European Countries, such as Spain and Italy. Innovative institutional solutions for reducing water use or increasing its efficiency are pursued by recent legislation concerning water, in particular by the Water Framework Directive (WFD). Even if not explicitly considered by the directive, water markets may be seen as a kind of instrument responding to the guiding principles of the upcoming water regulation. The issue of water markets is very much debated in the water economics literature and particularly in the agricultural water literature. Water markets refer to a mechanism of water allocation based on the exchange of rights on water use. Water markets are proposed and supported by economic theory on the ground that they produce an efficient allocation of water resources. Criticisms to water markets may derive both on the ground of economic efficiency itself (for example due to higher transaction costs and expenditure for wider water transport systems) and on equity considerations (for example the concentration of water on the more efficient farms that would specialise in intensive production, while the others would retain less intensive crops). The objective of this paper is to test to what extent water markets may contribute to the improvement of the efficiency of water use. The analysis is based on a linear programming model applied at basin level, comparing the situation with and without market and including transaction costs proportional to the amount of water exchanged. The model simulates the behaviour of different farm types, derived from cluster analysis on a sample of farms in each area. The model is tested in two areas in Southern Italy and Spain. The paper confirms that water markets have the possibility to improve water use efficiency. However, the exchanges are very much affected by the amount of transaction costs, even for transaction costs relatively low. In the case of Lower Ter, gross margin increase due to markets may be as high as 30% which is rather a considerable amount. Instead, the highest increase in Foggia is only about 10%, a result that may be regarded as hardly relevant. In Foggia the benefits of the water market collapse only when transaction costs are between 0,1 and 0,2 EUR/m3 (that may be regarded as a fairly high amount). On the contrary, Lower Ter is more sensitive to transaction costs and 0,075 EUR/m3 are enough to cause the market to shut down whatever the water quota. When potential improvements occur, an additional issue arises, i.e. the institutional acceptance of market criteria for water allocation purposes. The general attitude in Europe still appears against such a solution. However, the changing economic context (agricultural markets, demographic trends) tend to decrease rigidities about water exchange, particularly among farmers.
