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Applied Welfare Econ & Cost Benefit Analysis

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1 Applied Welfare Econ & Cost Benefit Analysis

2 Purpose This chapter presents various methods for estimating shadow prices based on observed behavior when markets for the (primary) good, such as human life, do not exist. Considerable progress has been made during the past 30 years to value goods that were previously treated as “intangible”

3 Overview Why do we need a Theory of Environmental Demand?
Welfare Foundations of Demand Theory Contingent Valuation

4 Why do we need non-market valuation?
economic decisions involve a trade-off of resources => we need to be able to ascertain the monetary value placed on environmental goods/bads to calculate the MB of environmental improvements, or the MD of an environmental deterioration We had always assumed that we did know about these!!! But how do we get to know???

5 conventional demand theory?
Conventional demand theory will help us estimate how much people are willing to sacrifice to enjoy a good or service By observing pairs of price and quantity for different individuals or for different markets or the same market at different points in time

6 Why do we need non-market valuation?

7 Why do we need non-market valuation?
PRICE Often the linear functional form is assumed QUANTITY

8 Why do we need non-market valuation?
Once we have estimated a demand function we know About many things… PRICE QUANTITY

9 Why do we need non-market valuation?
conventional demand theory? The problem is that many goods whose markets the project affects are not traded in markets as other goods!!! For example, for many goods related to the natural environment we cannot observe the pairs of price and quantity

10 But, to a certain extent, we can get around the problem of the absence of markets
That is what non-market valuation is for

11 Non-market valuation We can use direct methods (based on market prices somehow) Example: we do not buy and sell clean water, but we buy and sell fish or we pay doctor bills if we get sick from the water or we forego wages when we are sick from the water Or indirect methods (stated preference or revealed preference methods) There are no market prices to use, but we can still get information from what individuals say they would hypothetically pay or do or from what they actually choose to do under different circumstances.

12 Non-market valuation We can use direct methods (based on market prices somehow) …So we use market prices Or indirect methods (stated preference or revealed preference methods) …So we impute market prices

13 Stated versus revealed preference methods
We can ask them => stated preference methods (Contingent Valuation) We can try to infer it from their behaviour in other markets => revealed preference methods The latter include the Travel Cost Method and the Defensive Expenditure Method, both based on the Production Function Approach, and Hedonic Price Methods

14 Stated versus revealed preference methods
Revealed preference methods exploit the idea that some environmental goods/services are related to marketed goods In particular, we may want to find substitutes or complements of those environmental services we want to value

15 Stated versus revealed preference methods
With stated preference methods, we do not need that We simply ask! Example of these methods include contingent behaviour, conjoint analysis, choice experiments, contingent ranking and other complex procedures in constant developing They are all based on asking individuals to state a preference and inferring information from that We will focus on the contingent valuation method

16 MARKET ANALOGY METHOD uses data on similar goods in the private market to estimate the implicit “price” or the demand curve for publicly provided goods.

17 MARKET ANALOGY METHOD Using the Market Price of or Expenditures on an Analogous Good The market price of a comparable good in the private sector provides a good estimate of the value of a publicly provided good if it equals the average amount that users of the publicly provided good would be willing to pay (WTP). Where the government provides a good or service at a lower than market price, the price paid by occupants would generally underestimate the benefit of this service because users would be WTP at least this amount; some might pay more.

18 MARKET ANALOGY METHOD Using Information about an Analogous Private-Sector Good to Estimate the Demand Curve for a Publicly Provided Good Rather than focus on the average amount that users of a publicly provided good are willing to pay, it is conceptually better and easier to think about the demand curve for the good. We can use private-sector data to help map out the demand curve for a publicly-provide good if the goods and their markets are similar. Of course, using expenditures alone underestimates total benefits because it ignores consumer surplus.

19 THE TRADE-OFF METHOD Economists may use the opportunity cost as a measure of its value. For example, time saved could be valued using the after-tax wage rate. Similarly, the trade-off that people make between changes in fatality risk and wages can be used to value a statistical life.

20 The Value of Time Saved The obvious analogous market for time saved is the labor market. In the absence of market imperfections (i.e., people can choose the number of hours they work and there is no unemployment), the wage rate equals the marginal value of time. However, there are some problems in using the wage rate to value time saved…

21 The Value of Time Saved Wages ignore benefits. As benefits are a form of compensation for work, they should be added to wages. People could be working while traveling or waiting and, therefore, time saved would be worth less than the wage rate (plus benefits). It should take account of taxes and, for people who are not working, use the after-tax wage rate (plus benefits).

22 The Value of Time Saved People value different types of time differently. Importantly, many people enjoy traveling. The wage rate may not be appropriate due to rigidities in the market or market failures. For example, people may not be able to easily adjust the number of hours they work. Firms may not pay employees their marginal social product. In conclusion, using the wage rate is only a first approximation.

23 The Value a Statistical Life
Forgone earnings method - This method suggests the value of a life saved equals the person’s discounted future earnings. It generates higher values for young, high-income males than old, low-income females. For retired people, the resultant value of life may be negative. Conceptually, the main problem with this method is that it does not reflect what people are WTP for a small reduction in risk of their death.

24 The Value a Statistical Life
Simple Consumer Purchase Studies – This method estimates the value of life by observing how much people pay for life-saving devices, such as safety belts. If people are willing to pay an extra $300 to reduce the probability that they will die by 1/10,000, then they value life at $3 million.

25 The Value a Statistical Life
Simple Labor Market Studies Similarly, if a person is willing to forgo an extra $3,500/yr to increase the probability that he will not have a fatal on-the-job accident by 1/1,000, then he values his life at $3.5 million (or more). The imputed value of life varies according to the initial risk and the additional level of risk people are asked to assume due to diminishing marginal utility for safety.

26 Problems with Simple Consumer and Wage-Risk Studies
These methods assume workers and consumers fully understand the risks, which they may not. They also assume that people in the studies are representative of the population, while they may not be (sample selection). For example, people who take risky jobs may be may like to take risks which would lead to a relatively small gap in the salary between risky and less-risky jobs. Third, they assume that researchers have accurate measures of the risks. Fourth, the willingness to pay to reduce risk depends on the level of risk. Also, this method assumes that the relevant markets are efficient and all other variables are constant (no omitted variable problem).

If a project produces an intermediate good that is not sold in a well functioning market, then its value can be imputed by determining the value added to the “downstream activity”: Annual Benefit = NI(with project) – NI(without project) where, NI = net income of downstream business. The total benefit of a project can be computed by discounting annual benefits over the project’s life. This method can be used to value improvements in human capital, such as training programs, by comparing the average incomes of those in the program to those who are not.

Some problems with this method are: It assumes the difference in income captures all of the benefits (there may be consumption benefits) It assumes all other variables are held constant (e.g., ability).

The impacts of a project or policy can be imputed from changes in the price for certain capital goods. For example, the “value” of noise can be inferred from comparing the price of a house in a noisy neighborhood to the price of a similar house in a quiet neighborhood. Changes in the market values of firms following a regulatory change can be used to estimate the change in producer surplus of the new regulations (an event study). An advantage of using prices is that information is quickly and efficiently capitalized into prices so that price changes or price differences provide a good estimate of the value of the policy change. Also, appropriate data are often available in machine readable form. 

All of the methods discussed above suffer potentially from the omitted variable problem and self-selection bias.

31 The Hedonic Price Method (HPM)
Finds a link between the environmental good (say air quality) and a market good (say housing) Assumes that house prices depend on characteristics of housing One or more of these may be something for which a conventional market is not available Others are site based (number of bedrooms) and neighbourhood-based (crime rate)

32 The Hedonic Price Method (HPM)
It assumes that any meaningful differences in the characteristics of houses will have been capitalized in the price of the house This method offers a way to overcome problems from omitted variables and sample-selection bias

33 The Hedonic Price Method (HPM)
Three step approach to implementing the method First, estimate regression equation relating house prices to housing characteristics, including environmental characteristic of interest (say it is noise levels, Q1), neighbourhood variables (N) and site variables S: Ph = f ( S1…Sm ; N1…Nn ; Q1…..Qp )

34 The Hedonic Price Method (HPM)
Three step approach to implementing the method Second, find partial effect of Q1 on house prices, Ph. This is the marginal cost of Q1; may vary with level of Ph . Partial effect shows the change in P for the change in Q, P / Q This is the implicit or hedonic price of that characteristic Third, estimate demand curve for Q using (Q,P) pairs and other relevant data (say income)

35 The Hedonic Price Method (HPM)
Problems: Limited applicability: doesn’t work for many environmental goods Data intensive: need lots of info on house sales Segmentation between housing markets; should we estimate more than one equation? Uncertainty: what do people know about current/future levels of environmental quality?

36 The Hedonic Price Method (HPM)
A variant, the hedonic wages model, can be used to measure the effect of varying levels of risk or exposure to environmental bads on wages In equilibrium wage differences will have adjusted to reflect differences in environmental attributes of the job But what if the job market is not really flexible (lack of mobility, or segmentation again, or wage discrimination????)

37 The Hedonic Price Method (HPM)
Again, it assumes that the workers have perfect information about the environmental conditions of the job

38 The Hedonic Price Method (HPM)
People must know and understand the implications of the attribute that is being valued. For example, people should know the level of pollution at the property they buy and know the expected effect of this level of pollution on their health.

39 The Hedonic Price Method (HPM)
Variables should be measured without error (the errors in variables problem). Functional forms should be correct (specification error problem) Market should have enough alternatives so that people can locate at their optimum point on the curve

40 The Hedonic Price Method (HPM)
There may also be multicollinearity problems, e.g., fatality risk and non-fatality risk might be highly correlated. Dropping one variable would lead to an omitted variable problem Markets are assumed to adjust immediately to changes in the attributes of interest and to all other factors.

41 Travel Cost Method relationship between observed visits and the cost of visiting is derived this relationship is used to derive a surrogate demand curve from which consumers' surplus per visit-day can be measured (by integrating under this curve) Avoids the problem that fee is non-existent or the same for everyone

42 Travel Cost Method Travel Cost Method (TCM): one of the oldest approaches to non-market valuation It uses travel costs as a proxy for the price of visiting outdoor recreational sites

43 Travel Cost Method Travel Cost Method is a variant of the household production function approach. It assumes that the household puts together marketed inputs and the site (the national park for example) to produce a visit It exploits the complementarity between the availability of the site and the goods needed to enjoy it

44 Zonal Travel Cost Method
Obtain, with an on-site survey, data on visits to a site (V) from different parts of the surrounding country (zones, i) Park Zone 2 Zone 1 Zone 3

45 Zonal Travel Cost Method
Make the visit rate per capita (Vi /Pi ) a function of travel costs, assumed to depend on both distance and time spent travelling Ci and (from census data or Stats Canada) of socio-economic variables Si: Vi / Pi = F ( Ci, Si ) Predict how visits per capita will fall as travel costs rise => a demand curve can be traced out for each zone, up to the cost at which visits become equal to zero

46 Zonal Travel Cost Method
For multiple sites, estimate Vi / Pi = F ( Ci, Si, Xi ) where Xi is a vector of "prices" (that is, visiting costs) for other, substitute sites. This model may be estimated simultaneously for a group of sites (for example, all public forests within a region)

47 Zonal Travel Cost Method
This is the cost of the trip That would make the number Of visits equal to zero Visits per capita

48 Zonal Travel Cost Method
You can calculate the CS associated with the demand curve Current typical cost of trip form that zone Visits per capita

49 Zonal Travel Cost Method
You can calculate the Change in CS associated with a change in the environmental quality of the site Clean lake Dirty lake Dirty lake Visits per capita

50 Zonal Travel Cost Method
Good if visitors are evenly distributed by zone of origin But not when the visitors come from a few important points of origin For example, if you want to estimate the value of Terra Nova National Park, the idea of concentric zones is not very useful: almost everyone comes form St John’s or Gander!

51 Zonal Travel Cost Method
Good if recreational site is circular, perhaps a national park But not if the site is linear: a beach for example This is because different visitors will travel different distances to access different points along the site

52 Individual Travel Cost Method
Ask individuals about their trips Ask them where they individually travel from and ask them about their individual income, individual age, etc. Try to guess how valuable is their time and whether they can adjust how much they work (example: surgeon versus unemployed)

53 Individual Travel Cost Method
Ask them if they have substitute sites close to home Ask them if they also visited other sites Ask them if they visited the site also for other reasons (visit their families nearby for example)

54 Individual Travel Cost Method
The individual TCM is the most used type nowadays It may involve a general survey: then many of the respondents made zero trips This is expensive and requires statistical methods that handle the excess of zeros

55 Individual Travel Cost Method
It may involve an on-site survey: then all the respondents made at least one trip! This is cheap but requires statistical methods that handle the truncation of the data and the sample selection problems Additionally there is endogenous stratification: you oversample those people who make more trips!

56 Travel Cost Method TCM closely mimics the more conventional techniques used to estimate demand curves relatively inexpensive to apply On-site surveys provide opportunities for large sample sizes, as visitors tend to be interested in participating. The results are relatively easy to interpret and explain

57 Travel Cost Method But…
it assumes that people react to changes in travel costs as if they were prices (while some people actually do like driving to the site!!!) The most simple models assume that individuals take a trip for a single purpose – to visit a specific recreational site Multipurpose trips complicate matters!

58 Travel Cost Method Defining and measuring the opportunity cost of time can be problematic How about the cost of on-site time? Or is that choice endogenous???

59 Travel Cost Method availability of substitute sites will affect values
For example, if two people travel the same distance, they are assumed to have the same value. However, if one person has several substitutes available but travels to this site because it is preferred, this person’s value is actually higher. Some of the more complicated models account for the availability of substitutes

60 Travel Cost Method Those who value certain sites a lot may choose to live nearby => residents will actually end up having low travel costs!!!!! And some more technical problems we are not going to cover

61 Travel Cost Method Does one include the marginal cost of capital goods used at the site?

62 Travel Cost Method The method estimates the WTP for the entire site rather than features of the site It’s possible to value features if people in zones can choose among alternative sites with different attributes – by using the “hedonic travel cost method”, which treats total cost as a function of both distance from zone to the site and the various attributes of the site.

63 Travel Cost Method The method estimates the WTP for the entire site rather than features of the site Using Random Utility Models (RUM) one can also deal with differences across sites, but this is a bit more complex than what we would like to handle here

64 Travel Cost Method TCM assumes weak complementarity between the environmental asset and consumption expenditure (driving, renting a tent, a kayak, etc.) When consumption expenditure is zero, the marginal utility of the public good is also zero => if travelling to a forest becomes so expensive that no one goes, the marginal social cost of a decrease in the quality of that forest is also zero This implies that TCM cannot estimate non-use values!!!

65 Production Function Methods
Many non-marketed goods are used in production as inputs or indirectly used in the sense that ecological functions of and resources were supporting or protecting economic activity Where such values are reflected in market prices and behaviour, revealed preference approaches are appropriate valuation techniques, since they use information about a marketed good to infer the value of a related nonmarketed good

66 Production Function Methods
two-step procedure: First, determine the physical effects of a change (Eg: how much the cleaner water increases the catch by John in the river) Second, value the impact of these changes in terms of the corresponding change in the marketed output (Eg: how much more gains John with the cleaner water due to the increase in catch?)

67 Production Function Methods
the non-marketed good is treated as an input into the economic activity and like any other input, its value can be equated with its impact on the productivity of any marketed output

68 Production Function Methods
$ MC with bad air quality P0 MC with good air quality P1 MWTP for crops Q0 Q1 Agricultural crops

69 Household Production Function Methods
If the household is producing something with the environmental good and other marketed inputs => Household Production Function approach One example was the TCM

70 Defensive or Preventive Expenditures Method
but we also have the Defensive or Preventive or Avertive Expenditures Method It measures peoples' valuation of the non-marketed good by observing how much people are actually spending to prevent its loss or to defend themselves from the consequences of its loss Example: insulation from noise, air purification expenditures, expenditure in water bottles

71 Defensive or Preventive Expenditures Method
A defensive expenditure is an expenditure in response to something undesirable, such as pollution. Example: If smog improves (worsens) you may spend less (more) on having your windows cleaned. The change in expenditures can be used as a measure of the change in pollution

72 Defensive or Preventive Expenditures Method
$ MC with bad air quality MC with good air quality MWTP for air quality Personal air quality

73 Defensive or Preventive Expenditures Method
The method assumes that actual preventive or defensive expenditures are representative of the affected population environmental benefits and costs are perceived and responded to without undue delay preventive and defensive expenditures are effective and worth doing there are no capital constraints and capital market imperfections

74 Defensive or Preventive Expenditures Method
The method assumes that defensive expenditures solve the problem completely Example: an air exchanger will effectively substitute for good air quality

75 Defensive or Preventive Expenditures Method
The method assumes that defensive expenditures solve the problem completely And they are all that counts Example: bad air quality increases expenditure in medicines but the cost of thinking you are going to die must also be considered!!!!

76 Defensive or Preventive Expenditures Method
Not all defensive expenditures are purchased in markets either Example, some people clean their own windows; changes in these “expenditures” should also be included.

77 Keywords stated preference methods Contingent Valuation Method (CVM)
revealed preference methods sample bias

78 Next Reading: Chs. 4-5 in Hanley and Spash (1993), Ch. 7 in F&O, and Chs in Kolstad. Particular examples are cited in the references list and references there…

79 NEXT Stated preference methods: CONTINGENT VALUATION READ CHAPTER 14

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