1. Valuation 2 and 3: Demand and welfare theory
What is so special about environmental goods?
Theory of consumer demand for market goods
Welfare effects of a price change: Equivalent variation versus compensating variation
Consumer demand for environmental goods
Welfare effects of a quantity change: Equivalent surplus versus compensating surplus
Theory and practise

2. Last week Price and Value Total Economic Value Why and what to value?
Uses of economic valuation

3. Why valuation?
We must make choices about how to manage the human impact on natural systems
Greater use of a particular environmental service or greater protection of a specific natural system results in less of something else (trade-off)
To make the most of scarce resources we must compare what is gained from an activity with what is sacrificed by undertaking that activity
Why? To assess the net impact of changes

4. What is so special about environmental goods and services?
In economics the criterion for assessing the net impacts („benefits“ and „costs“ ) is the well-being of the members of society
Well-being is defined as the individuals‘ preferences for goods
Preferences are typically represented through demand functions
Changes in well-being can be inferred by changes in prices or quantity
Problem with environmental goods: no markets exist
Individuals have preferences nevertheless
Changes in well-being are derived by individuals’
max. willingness to pay for gains or (WTP)
min. willingness to accept compensation for losses (WTA)
Prices and marginal WTP or WTA are equivalent

5. Consumer demand theory: Market goods
Consider a consumer who has a utility function
This consumer maximises the utility of a bundle of goods x, with prices p, and income M
This solves to the ordinary or Marshallian demand function
Substituting the expression for xi gives the indirect utility function
this gives you the highest level of utility attainable, given prices p and income Y

6. Consumer demand theory -2
Roy‘s identity relates x and v:
That is, the derivative of indirect utility with respect to the ith price yields the ith demand function, after normalising by the marginal utility of income

7. Constructing an ordinary demand functionx2 p1 I3 I2 I1
x1(p1,p2,y), demand for x1 C
Budget constraint C A A B B x1 x1

8. Consumer demand theory -3
An alternative to generate a demand curve is to keep utility constant instead of income
Here the consumer is assumed to minimize total expenditure to achieve a given level of utility at price level P
This solves to the compensated or Hicksian demand function
This gives the quantity demanded as a function of price and utility
Income is of no consequence; as prices change, expenditures are adjusted to maintain constant utility.

9. Consumer demand theory -4
Demand for the ith commodity is the derivative of the expenditure function to the price of i

10. Constructing a compensated demand functionx2 p1 I1
hx1(p1,p2,U1), demand for x1 C C A A B B
Budget constraint x1 x1

11. Ordinary and compensated demand
We derived ordinary and compensated demand functions
Ordinary demand functions bundle income and price effects together
Compensated demand function do not have this problem, but look at price effects alone
To evaluate the effect of a governmental policy that changes relative prices we want to examine the price effect only
Typically, economists estimate ordinary demand functions, as utility cannot be observed

12. Income and price effectsx2
e/p21 A
Price effect
e/p22 B
Income effect C I1 I0 D M x1

13. Surplus from ordinary and compensated demand
If AB is an ordinary demand function like x1(p1,p2,M):
Consumer Surplus= ABCD-BCDE=ABE A
If AB is a compensated demand function like hx1(p1,p2,U1) the area under the curve correspond to changes in constant utility expenditures E B
p*1 D C
x*1 x1

14. Ordinary and compensated demand - 3
hx1(p1,p2,U0)
Compensated demand
hx1(p1,p2,U1) A B
x1(p1,p2,M)
Ordinary demand x1

15. Ordinary and compensated demand - 4
Properties of both demand functions are related
We observe ordinary demand functions, but we are interested in compensated demand functions – the latter can be derived from the former if agents are rational, and even then it involves many steps including integration

16. Welfare effects of price changes
Consider price fall P*  P#
Willingness to pay (WTP) to secure price fall is known as compensating variation (CV)
Willingness to accept compensation (WTAC) to forego price fall is known as equivalent variation
There are gains and loss, so four measures (EV)
Price decreases
WTP to secure a gain (CV)
WTAC to forego a gain (EV)
Price increases
WTP to prevent a loss (EV)
WTAC to tolerate a loss (CV)

17. Welfare measures
Compensating variation is the quantity of income that compensates consumers for a price change, that is, returns them to their original welfare
Equivalent variation is an income change that yields the same utility change as the price change
Both terms can be defined using the expenditure function

18. Ordinary and compensated demand: Welfare effects
Compensated variation: ABEG
Consumer Surplus: AEFB
Equivilent variation: ADFB
=> If p decreases CV<DCS<EV
hx1(p1,p2,U0)
Compensated demand
hx1(p1,p2,U1) E A D
p01 F
p11
x1(p1,p2,M) B G
Ordinary demand
x01
x11 x1

19. Consumer demand theory: Environmental goods
Often demand for environmental commodities is only indirectly observed
People change their behaviour in response to changes in the environment, but do not purchase environmental quality directly
We‘ll repeat the analysis above, but now assume that only n-1 goods are directly traded; the nth good (named q) is the environmental commodity of interest

20. Restricted demand The environmental good q affects individuals utility
This consumer maximises the utility of a bundle of goods X, with prices P, and income M
This leads to restricted ordinary demand functions
and a restricted indirect utility
Again, Roy‘s identity relates x and v

21. Restricted demand - 2 The dual of the problem: Minimising expenditure
This leads to the expenditure function function
The Hicks-compensated demand function for changes in prices is
The Hicks-compensated inverse demand (marginal WTP) for changes in q is
Rearranging the equation yields the compensating demand for q

22. Restricted demand - 3 But...
we can determine how expenditures change with q for some price of good x and implicitly defining a demand function for q only if we assume weak complementarity
That is, if the demand for good x drops to zero, then demand for good q goes to zero as well and marginal changes in q no longer affect expenditure
Example: if swimming is too expensive, water quality is irrelevant

23. Restricted compensated demand
Choke price
The income equivalent or marginal WTP for a change in q: ABC B C
p*1
hx1(p1,q0,U1), initial demand for x1
hx1(p1,q0 +Dq ,U1), demand for x1 after increase in q D x1

24. Welfare effects of quantity changes
Measures of „surplus“ instead of „variation“ when consumers are not free to vary the quantity of q
In case of quantity changes, compensating and equivalent surplus are defined as
U0 results from (P,q0,M)

25. Measures of changes in welfare for an environmental good
Expenditure on private good x, M D
ES/px
If q0 increases to q1, income has to
be reduced by CS/p to keep the same utility B M
M=pxx A
CS/px U3 U2 C U1 q0 q1
Quantity/quality of environmental good q

26. WTP and WTAC
If the good is relatively unimportant ES and CS are roughly the same
If environmental goods are relatively scarcer than market commodities, one may expect the compensating variation/surplus (WTP) to be smaller than the equivalent variation/surplus (WTAC) for improvements
Differences between WTP and WTAC are mainly due to income effects
People view gains and losses differently
WTP is limited to an individual‘s income, WTAC is unbounded
Confirmed by empirical studies, but not uncontested
Implies that surveys, policies need to be carefully designed
Income effects are small only if the good is of little value relative to your overall wealth

27. Theory and practice
Horowitz and McConnell collect 208 observations of WTP and WTAC from 45 studies
For all studies, the average ratio WTAC/WTP is 7.2 (0.9)
However, for public or non-market goods, the ratio is 10.4 (2.5)
For ordinary goods, it is 2.9 (0.3)
For money, it is 2.1 (0.2)

28. Methods for measuring demand
Indirect methods (use values)
Surrogate market where we observe expenditures on a related goods
Infer information on the trade-off between money and the environmental good
Hedonic pricing
Household production function approach
Direct methods (use and non-use values)
Hypothetical/constructed market
Contingent valuation: “value contingent on there being a market”
Choice modelling