1. 1 5. WHAT ARE THE KEY BENEFIT/COST MEASUREMENT METHODS FOR NATURAL RESOURCE & ENVIRONMENTAL ISSUES? SPRING 2002 Larry D. Sanders Dept. of Ag Economics Oklahoma State University

2. 2 INTRODUCTION u Purpose: to understand alternative ways to measure value of natural resource/environmental management options u Learning Objectives: 1.To understand how Benefit Cost Analysis (BCA) operationalizes utilitarian concepts of ethical social policy making with money as a common measure. 2.BCA includes time & future generations by searching for present value of net benefits. 3.There are several methods to apply BCA to nonmarket goods, although ethical values & cultural considerations are not likely to be quantified.

3. 3 Overview of Benefit/Cost Analysis (BCA) u BCA provides a method to compare an array of alternative public policy choices u If B>C for a given policy, it says that for every $1 of project expense, more than a $1 of benefits would be generated by the project u If there are several alternative projects to resolve a problem, the project with the greatest net benefits would be preferred, assuming to ethical/cultural reasons to the contrary

4. 4 Overview of BCA (continued) u For BCA to work: –“apples & oranges” measured by money –nonmarket goods/services measured by money –proxy measures are sought if no market exists u Alternatives to BCA: –public vote (democracy) –those in power decide –use a noneconomic decision rule (social, cultural, religious, etc.)

5. 5 BCA (continued) u Mix BCA w/others –BCA used to guide/educate public/decision makers –Integrated environmental assessment »economics plus ecological/social/political/ethical factors

6. 6 BCA compared to others u BCA –may be scientific, objective, & equitably applied –requires time/resources to conduct/evaluate –ethical questions –nonmarket goods problematic –interdependencies problematic u Noneconomic –may be “easy” to do –ethical questions (majority rule; future generations, etc) –subject to manipulation

7. 7 Efficiency is central to economic assessment... u Minimize waste (of resource, profits, time) u Ecosystem must be valued in monetary terms to be included in efficient solution u “Efficient policy option” selects alternative which generates most social utility relative to status quo u Kaldor-Hicks: PDV = or > status quo u Pareto Criterion: no other policy can make some better off without making anyone worse off u B/C ratio: policy w/greatest benefit per $ of cost & B/C > 1

8. 8 Cost-Benefit Analysis & Economic Measures u Project evaluation, typically over time u Choice of Discount Rate Key –Higher rate lowers future value of b, c –Risk-free real market rate of interest may be preferred social discount rate (sdr) –Choice for sdr individuals value future u Potential for Abuse –Assumptions & who decides are critical –May run counter to Native American Ethic, “Deep Ecology”, Leopold land ethic, etc.

9. 9 Dynamic Efficiency u Rapid development of resource drives price down u Future price rapidly increases u Hi future P suggests incentive to reduce current production, thus raising current P & potentially reducing future P u Dynamic Efficiency: maximum present discounted value (PDV)

10. 10 “Optimal” Environmental Quality Level u Opportunity Costs to reduce externality increase as pollution levels approach zero –Marginal Abatement Cost Function (MAC) u Damage (real & perceived) to physical/natural environment –Marginal Damage Function (MD) u Optimal Level: MD = MAC u Economics provides analytical tools; society provides the goals (sometimes thru market, sometimes thru public action)

11. 11 Marginal Damage/Marginal Abatement Damages & Costs ($) Pollution Level Marginal Damage Function=MD Marginal Abatement Cost Function = MAC Total Damage Total Abatement Cost

12. 12 Economic Incentives to Improve Natural Resource/Environmental Quality u Marketable Pollution Permits –Trade permits in market to equate MC across polluters –Initial distribution »history, auction, lottery »equity & geographic concerns u Bonding Systems u Liability Systems u Pollution Subsidies

13. 13 Natural Resource/Environmental Valuation u Determined by people & willingness to make trade-offs u Producer & Consumer Surplus u Nonmarket valuation--use & non-use value

14. 14 Non-market Valuation Techniques u Direct--hypothetical questions on willingness to pay/sell (wtp/wts) –Contingent Valuation Method (CVM) »open/closed-ended w/specific mechanism –Conjoint Analysis »preferences among bundles of characteristics u Indirect (revealed preference)--people’s decisions reveal preferences & value –Hedonic Pricing/Wages –Travel Cost Method (TCM)

15. 15 Economic Returns --Rent Applications (cont.) u Land Values: In theory, current market value = present value of expected future land rents = worth of current investment held at acceptable interest rate –Discounting determines present worth of expected rental returns; negative premium on waiting –Present Value = Future Value / (1+rate) –Future Value = Present Value x (1+ rate) –“rate”: appropriate discount rate »social discount rate? »Risk-free real market rate of interest? t t