Conference Agenda

In this paper, we investigate optimal regulation to manage a groundwater extraction problem. Specifically, we analyse the dynamic interaction between a set of farmers and a water agency within a leader–follower differential game played à la Stackelberg. We assume that the water agency, acting as the leader, selects two policy instruments, a water tax and a (non-tradable) water threshold, to control groundwater withdrawals and preserve the aquifer. In particular, we consider that farmers are asked to pay a tax proportional to their individual withdrawals and an additional charge when the extraction level exceeds the water threshold. Farmers, as followers, determine their optimal extraction levels given the water agency’s policy. We compare scenarios in which the regulator controls both the tax and the threshold with more restrictive cases where the regulator can only set one of the two, and we examine the implications for social welfare, farmers’ profits, and groundwater preservation. Our results show that the joint use of a linear–progressive tax scheme strictly dominates linear taxation in terms of aquifer preservation and social welfare whenever the progressive regime is feasible. Moreover, among constrained policy regimes, allowing feedback adjustment of the water threshold performs close to the fully flexible benchmark and outperforms the case in which only the tax can be adjusted.