In mid-March, the The Guardian ran the headline: “ Drought-stricken California only has one year of water left, Nasa scientist warns .” Similar headlines ran throughout the US and led to a national discussion among policymakers about the seemingly dire situation facing the state of California. A few weeks later, California Governor Jerry Brown imposed mandatory water-rationing guidelines requiring cities and towns to reduce usage by 25 per cent. The current water crisis in California serves as an excellent opportunity to revisit two key insights from economics—the role of prices and the distortionary effects of subsidies.Competitively determined market prices reflect the relative scarcity of resources. This means that, as a resource becomes scarcer, its price tends to rise. This price increase has two important effects. Firstly, it provides a disincentive for people to consume as much of the resource as they previously did. Secondly, the higher price incentivises suppliers to either bring more of the resource to the market or innovate and find substitutes which can be offered to consumers who are looking for low-cost alternatives.In order for this process to work, however, it requires that prices be allowed to rise as resources become increasingly scarce to signal to consumers and producers that they should change their behaviour. As the example of California illustrates, this is often not the case, as prices are often controlled by government fiat. In California, water prices are capped by government-imposed law such they are unable to rise above the cost of delivery and many homes do not even have metered water . This means that when supply and demand conditions change, such that the price of water should be above the cost of delivery, providers are unable to adjust the price to reflect these realities. The result is a water shortage. Writing about the situation in California, Kathryn Shelton and Richard McKenzie note : “When the annual rainfall is well below the state’s historical average, as has been the case for years, a ‘water problem’ can become a ‘water crisis’—especially when governments do not allow water prices to rise.”Since the price citizens pay for water does not reflect its true scarcity, they continue to consume water as if it were plentiful. If, instead, the price of water were determined competitively by supply and demand conditions, this would lead people to automatically ration water usage without government intervention. For example, as the price of water increased fewer people would wash their cars or water their lawns.The ongoing water crisis in California also illustrates how government subsidies can exacerbate the distortionary effects of price controls. Subsidies are intended to reward recipients for engaging in a particular behavior, perhaps if those behaviours are perceived to have additional positive social benefits. Federal government subsidies are prevalent in the US agricultural industry, and the state of California is one of the top recipient states. These subsidies are intended to incentivise several behaviours including farming certain crops, protecting the environment, and investing in infrastructure and machinery to reduce water consumption.Agricultural subsidies have an impact on water usage in a variety of ways. Some of these effects are predictable and obvious. For example, the subsidies provided to farmers to grow certain crops leads to more farming of those crops which, in turn, leads to more water usage. In a water-thirsty state, water-intensive crops are grown purely because farmers are subsidised to grow them. If water were priced properly, crops that needed a lot of water would be grown in wetter states and more drought-tolerant crops would be grown in California. This would be far more efficient and ensure that water was reserved for more valuable uses. The Economist reports , for example, that agriculture accounts for 80 per cent of water use in California but only 2 per cent of economic activity and that farmers grow thirsty crops such as rice and alfalfa using heavily subsidised irrigation systems. California, does not have a comparative advantage in rice production any more than, if New York State provided subsidised green houses, that state would have a comparative advantage in growing bananas.Subsidies for improved farming infrastructure and equipment intended to reduce water usage have not been successful. Consider, for example, the Environmental Quality Incentives Program. Implemented in 1996, the programme provides subsidies to farmers who invest in infrastructure and equipment to reduce water usage. However, a study found that many of the subsidy recipients actually used more water than they had prior to the implementation of the programme because recipients used the savings generated by the equipment to expand their farming operations in other areas which increased the farmers’ overall usage. The end result was the exact opposite of the stated intention of the programme.A drought due to reduced rainfall is an act of nature beyond the control of man. However, a water shortage is the result of humanly devised policies which neglect the basic logic of economics. Whether we are discussing water or other resources, the central question that must be answered is: what is the best means of allocating scarce resources?To date, policymakers in California have relied on government command and control to allocate water resources. This has failed, as the combination of government-imposed price caps, subsidies and regulations has led to a persistent water shortage. Each intervention into the market has led to subsequent interventions to address the unintended consequences of previous policies, as illustrated by the most recent government mandate to reduce water usage. The Californian experience offers important lessons when considering how other natural resources are allocated.An alternative approach focuses on removing policies which block the reallocation of resources in response to changes in natural conditions. Ideally, prices would reflect actual supply and demand conditions so that a drought would result in higher prices. Similarly, subsidies and regulations which incentivise the over-use of resources would be removed. This approach is the most effective means of achieving the dual goals of conserving natural resources while satisfying human wants. If water is in short supply, pricing ensures that it is used for its most important ends first (for example, basic household needs). Those economic activities that can be dispensed with (for example, large green lawns, lush golf courses) will tend to be the first to go. At the same time, the price mechanism is essential in ensuring that water-intensive activity takes place where water is in greater supply and drought-tolerant activity takes place in dry states. Refusing to price water, whilst subsidising businesses to pursue activities that use more water, is a recipe for turning a drought into a disaster.Christopher J. Coyne is the F.A. Harper Professor of Economics at George Mason University.Rachel L. Coyne is a Senior Research Fellow at the F.A. Hayek Program for Advanced Study in Philosophy, Politics, and Economics at the Mercatus Center at George Mason University.They are the editors of the IEA monograph Flaws and Ceilings – price controls and the damage they cause