A classic case of market failure with a hydro/economic externality is illustrated in the “Buy and Dry” of agricultural to urban water markets. An irrigation district, supplied by a canal, sells its water right to a distant city; water deliveries through the canal decrease or cease and the aquifer sustained by canal seepage declines. The groundwater pumper, even though she holds an adjudicated right, is damaged. Whom does she sue—the farmers that sold the water, the city that purchased it, or the state that allowed the transaction?

Lacking legal recourse, the groundwater user could seek redress through a water market. Here the market fails. The amount of water conveyed down the canal is determined solely by the demand and adjudicated right of the surface water users. A market failure is defined as a wedge or disparity between social and private benefits. The private beneficiaries are the surface water users because the water supplied through the canal is priced. The groundwater users, the recipients of the positive externality of canal seepage, wishing to dodge paying for seepage water, do not have their values for water represented in the price mechanism of a market. The market fails in that the amount of water conveyed down the canal is less than the social optimum—the sum of both surface water and groundwater users.

The market failure is perpetuated when water is sold to the city. When the marginal benefit of groundwater pumpers are excluded from the calculus in the water sale, the quantity of water sold to the city will be greater and priced less than the social optimum. Inviting the groundwater users into the sale negotiations would correct the failure by internalization of groundwater user benefits. However, from the canal user’s perspective, the groundwater pumpers have been the beneficiaries of free water since construction of the canal. The costs of canal operation and maintenance, the costs of canal and storage construction, purchase of water from various suppliers, and damages resulting from warm water wells have been borne entirely by the surface water users. Further, inclusion of the groundwater users would not be in the city’s interest. With the groundwater users represented at the sale, the socially optimal amount of water sold to city will decrease and the price the city pays for water will increase. Groundwater users fall through cracks of a failed legal system and market that does not address hydrologic externalities.