# **1 Introduction**

Water scarcity is one of the fundamental challenges facing developing country agriculture, one that is only expected to be exacerbated by climate change. In India, by far the world’s largest user of groundwater, millions of borewells have sprung up in recent decades (Shah, 2010). While groundwater exploitation has allowed increased agricultural intensification, a boon to the rural poor (Sekhri, 2014), unregulated drilling has also raised concern about the sustainability of this vital resource (e.g., World Bank, 2005). India’s main policy related to groundwater has been its effort to promote water-saving technologies such as drip and sprinkler irrigation, targeted particularly at small farmers.<sup>1</sup> For such farmers, however, the benefit of water-saving technology depends on their ability to expand water sales to neighboring cultivators, in other words on the the efficiency of groundwater markets.<sup>2</sup> To explore the implications of water-saving technology in a setting where there are contracting distortions, we build and structurally estimate a model of south India’s groundwater economy incorporating three salient features: First, given high irrigation conveyance losses, groundwater transactions tend to be highly localized, typically involving bilateralmonopolistic contracts between a well-owner and a water-buyer on adjacent land (see Jacoby et al., 2004). Second, during the dry ( _rabi_ ) season, agricultural production relies almost exclusively on borewell irrigation, the supply of which is, at least in part, unpredictable.<sup>3</sup> Third, planting requires upfront and irreversible outlays. Insofar as a water-buyer has a single borewell from which to purchase irrigation, his standing crop effectively becomes an investment specific to that trading relationship.

In our setting, bilateral transactions between well-owners and neighboring farmers take one of two forms: spot contracts, in which groundwater is sold on a per-irrigation basis throughout the season, and long-term (i.e., seasonal) contracts, which specify ex-ante the price and area irrigated over the entire season. We develop a model in which spot contracts are fully state contingent and thus ex-post efficient, but, due to the classic hold-up problem, ex-ante inefficient. In particular, planting incentives of water-buyers are distorted. Long-term contracts, by contrast, are assumed immune from hold-up, but lead to ex-post

> 1The National Mission on Micro Irrigation, initiated in 2006, is perhaps the largest subsidy program of its kind in the world. When combined with complementary subsidies recently offered by several states, including Andhra Pradesh, smallholders may be eligible to defray up to 90% of a system’s cost.

> 2Due to the high degree of land fragmentation, groundwater markets are pervasive in India . The 2011-12 India Human Development Survey (Desai and Vanneman, 2011) indicates that, of the 83% of agricultural households nationwide that do not own a borewell, 37% purchase irrigation (groundwater).

> 3During the wet ( _kharif_ ) season, groundwater is typically used as a buffer against insufficient rainfall or shortfalls in surface water flows rather than as the sole source of irrigation.

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