Population growth is increasing the scarcity of freshwater for irrigation and accelerating its replacement with non‐freshwater sources such as treated wastewater and brackish water. Although these substitutes may be less productive agronomically, their supply is usually more stable. We develop a structural econometric framework to assess the substitution between fresh‐ and non‐fresh water as it is inferred from water‐use decisions of farmers under increasing block‐rate water pricing. We employ the model to village‐level panel data from Israel, in which 50% of the freshwater allotments were replaced during the 1990–2010 period by treated‐wastewater quotas, using a non‐freshwater/freshwater volumetric exchange rate of 1.2. Based on our estimation results, the hypothesis that the marginal rate of substitution between the two water sources is equal to one cannot be rejected. Simulations suggest that the Israeli quota‐exchange policy has increased both agricultural production value and farming profits.