Disclaimer: I have no clue if what I'm proposing is realistic or not, but: Perhaps the federal government should step in and gradually step down the level of subsidies given to farmers in California and gradually increase subsidies given to NEW farmers in other, more water rich parts of the country. This would have the effect of moving farms to more sustainable locations in the country. Sure, the types of crops produ…
What would happen if the gov't did nothing? 1. Water would become more scarce in California. Not everyone would get what they need. 2. Price of produce would go up, since there is a smaller supply. 3. We'd start to import more produce (either from outside the country or other states) because the price is the same or lower than the new, higher CA price. 4. Other farmers, who don't grow what CA grows, would start to be…
The straightforward solution is to internalize the externality via a progressive tax on water usage. Then, as you said, the free market can regulate itself.
Note: I'm not a fan of taxation, but it can be a good solution to managing externalities.