Most of the effort being expended to revise western water policy concerns the maintenance of instream waters to the exclusion of traditional diversionary interests. Absent from the economics literature is a theoretical treatment addressing the interface between diversionary and instream water uses. At issue is the potential for refining market operations to accomplish efficient allocation in the presence of both diversionary and instream uses. Optimization methods are employed to examine this issue in a highly generalized framework. If a specific structure is adopted, markets and other incentive-based policies are demonstrated to be capable of efficient water allocation.