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But why would the upstream town be interested in governing what they dump?

Clearly someone/something has to assert the value that downstream towns have the right to unpolluted water. And won't that be the higher level government preventing the upstream town from asserting their rules and values?

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Yes actually. I'm not opposed to any government above a highly-local level. The point of government is basically to fix externalities and run defense/diplomacy. For rivers we do in fact need co-ordinated governance to prevent people from polluting others' water downstream.

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