AbstractWater development and allocation to competing uses without well‐defined water quality rights contribute to water use externalities. Federal legislation to address the salinity externalities in the Colorado River Basin comprises a set of arbitrary quality standards and millions of dollars in federal projects. This study specifies economic criteria to empirically determine first‐ and second‐best quality standards and to indicate opportunities for efficiency gains in existing policy. A basin‐wide, nonlinear programming model optimizes river water quality, resource allocation, production levels, and total expenditures for control. Revealed are the economic tradeoffs between water uses, regions, and control strategies.