Price
Chapter 3
The Benefits and Costs of Environmental Protection
Quantity
Our roadmap for Chapter 3:
1) Evaluate cost of environmental protection, C(X)
2) Evaluate benefit of environmental protection, B(X)
3) Use them to evaluate policies
Types of costs associated with environmental protection
1.
Private compliance costs: costs paid by private companies to comply with an environmental
regulation
• Examples: capital costs for pollution control equipment, cost of changing to cleaner inputs
• Challenging to measure since this is private information and firms have an incentive to report overestimates
of these costs
2.
3.
4.
Government sector costs: public expenditures to achieve compliance
• Examples: training, monitoring and reporting, permitting, litigation
Social welfare costs: changes in consumer and producer surplus
• Example: electric utility raises rates to pay for pollution control equipment
• don’t forget the substitution effects!
• How far do these ripple effects go?
Transitional effects: cost of shifting from the unregulated to regulated equilibrium
• Example: temporary job losses
• Economists suggest these are small relative to other costs but are focus of much of polititcal debate
Opportunity Cost
• Opportunity cost: the highest-valued alternative
that must be forgone when a choice is made. It is
the evaluation of a trade-off.
Total cost
Cost
(billion $
per year)
Saving twice as many (50% total) will require
5 times as much money - $25 billion per year.
60
25
5
0
Saving 25% of all endangered species will
cost $5 billion dollars per year.
To save three times as many (75%) costs
12 times as much - $60 billion per year.
25
50
75
100
Endangered species
saved (%)
Where do you stop???? What about babies??
What about education? What about food?
What
about water? What about the military?
4
Marginal
Opportunity Cost
• The shape of the Production
Possibilities Frontier illustrates
the relative cost of moving
productive resources from one
activity to another.
• The marginal opportunity cost is
the amount of one good or service
that must be given up to obtain
one additional unit of another
good or service.
Marginal
Opportunity Cost
"Evaluating tradeoffs among ecosystem services to
inform marine spatial planning." Lester, Sarah E.,
Christopher Costello, Benjamin S. Halpern, Steven
D. Gaines, Crow White, and John A. Barth. Marine
Policy 38 (2013): 80-89.
Convex cost function assumptions lead to this PPF but
others are possible; especially when dealing with
ecosystem services
Marginal
Opportunity Cost
Preferred bundles
Concave PPF: Individuals will roughly
agree about their preferred levels of
ecosystem services
Convex PPF: Individuals will prefer all
or nothing outcomes
Individual A’s utility a function Individual B’s utility a function
of two ecosystem services:
of two ecosystem services:
𝑈(𝑆𝑒𝑟𝑣𝑖𝑐𝑒 1, 𝑆𝑒𝑟𝑣𝑖𝑐𝑒 2)
𝑈(𝑆𝑒𝑟𝑣𝑖𝑐𝑒 1, 𝑆𝑒𝑟𝑣𝑖𝑐𝑒 2)
Bottom up approach
Disadvantage: restrictive
assumptions about how
individuals, firms, and the
economy as a whole
responds to a policy
Advantage: draws from a
wide range of engineering
costs
Top down approach
Cost
($/CO2e)
Price increase
from carbon tax
emissions
Potential gigatons per year
Emission decrease
from carbon tax
Ln electricity sales
Evaluating the Benefits
• Valuing environmental resources is challenging (and thus interesting)
for a couple of reasons:
1. Unlike for private goods where we can estimate demand curves from readily
available data, no markets exist for many environmental and other public
goods (e.g., there is no market from which consumers can buy clean air).
2. Even if markets exist, we know that market information doesn’t quite give
us the correct demand curve.
Total Economic Value and Total Willingness to Pay
• Economists have decomposed the total economic value conferred by
resources into three main components:
• Use Value: the value people place on direct use of a resource.
• Option Value: the value people place on maintaining future resource use.
• Non-use Value: values people obtain from a resource without actually using it
directly.
• These categories of value can be combined to produce the total willingness
to pay (Total WTP):
•
Total WTP = Use Value + Option Value + Nonuse Value
Types of Non-use Value
• Most of us will never visit the tropical rainforests of South America.
However, we might nevertheless place value on rainforest
preservation. What “types” of nonuse values might people have?
• Value the environmental quality (e.g. carbon sequestration) and habitat it
provides (“ecosystem services”).
• Care about the well-being of those that directly use the resource (“altruism”).
• Place value on resource being available for future generations (“bequest
value”).
• Simply value that the resource exists (“existence value”).
The Concept of “Option” and “Existence” Values
• “I begin by considering an extreme case of a commodity, the purchase of which is fairly infrequent and
uncertain, and production of which cannot be readily reinitiated at any cost once it has been halted and
inputs devoted to other uses. The commodity is a visit to a particular National Park, such as Sequoia…”
“The fact that a revenue of a private operator is limited, as a practical matter, to user charges prevents his
capturing the option demand of the non-user. It follows that the inability of the operator to make a profit
does not necessarily imply the economic inefficiency of the firm. If he had the power to tax, he could
supplement user charges with charges for the option services being generated...”
• Weisbrod, Quarterly Journal of Economics (1964)
• “When the existence of a grand scenic wonder or a unique and fragile ecosystem is involved, its
preservation and continued availability are a significant part of real income of many individuals...” “There
are many persons who obtain satisfaction from mere knowledge that part of wilderness North America
remains, even though they would be appalled by the prospect of being exposed to it…”
• Krutilla, American Economic Review (1967)
A Philosophical Digression
• An economic concept of value is only relevant if human value is the only one that
matters (humans as value holders)
• Naess critique:
 Environment has intrinsic value that is independent of human interests
 Humans valuing the environment makes no more sense than the environment valuing humans
 Humans should only use environmental resources when necessary for survival
 Since economic valuation does not deal with survival it contribute little to environmental
management
• With no valuation environment is given a default value of zero in calculations that
guide policy
• Emerging concepts such as natural capital indicate that natural scientists are starting to buy
in.
The Economic Concept of Value
• Economists have a distinction definition of value based on the ideals of
rationality and consumer sovereignty
• Rationality – an individual consistently knows what he or she wants and needs
In a market setting: If an individual prefers grapes to bananas, rationality requires
her to consistently select grapes
In a nonmarket setting: If an individual prefers wetland quality to a new truck,
rationality consistently requires her to consistently rank wetland quality over a truck
• Consumer sovereignty – an individual is best able to make choices that affect his or
her own welfare
Types of Economic Valuation
• Based on this foundation of rational sovereignty, individuals are assumed to be able to value
changes in environmental services in one of two ways despite their absence from the market
• Willingness to pay (WTP): If a change in environmental services causes a person to believe they are
better off, they should be willing to pay some money to secure this improvement
• Willingness to accept (WTA): If a change in environmental services causes a person to believe they are
worse off, they should be willing to accept some compensation to allow this deterioration
• Economists believe these estimates represent an individual’s value for environmental goods and
services
• These values should be the same but we know better
• Are individuals willing to accept income for environmental damage?
• Do individuals view gains and losses in environmental quality equally?
Non-Market Valuation Methods
• Because there are no markets or imperfect markets for many
environmental goods, we have to rely on so-called “nonmarket”
valuation techniques. There are two types of techniques:
• Stated Preference Methods: techniques that elicit values for environmental
and other goods by asking questions regarding people’s WTP for changes in
the provision of goods.
• Revealed Preference Methods: techniques that measure values for
environmental and other goods as revealed by related behavior.
Non-Market Valuation Methods
• Stated and revealed preference methods may rely on direct or
indirect indications of value:
• Indirect method: a valuation method that infers resource values rather than
estimating it directly.
• Direct method: a valuation method that estimates resource values directly.
Non-Market Valuation Methods
• The choice of the technique depends on the answers to some important
questions:
• Is there a limited time frame and budget?
• Revealed preference usually cheaper and quicker.
• Common for government agencies to use benefit transfer, which involves the application of
estimates from other studies to the issue being studied.
• Are nonuse values important?
• Since people do not reveal nonuse values through their behavior, we must rely on stated
preferences.
• Are we valuing an existing or proposed policy?
• Valuing a proposed policy favors stated preference methods if proposed change is beyond
scope of existing data.
Stated Preference Methods
• Two related approaches:
• Contingent Valuation: a survey method used to ascertain willingness to pay for
services or environmental amenities by having respondents make a direct tradeoff
between a policy and an amount of money.
• (Discrete) Choice Experiments: a survey method that derives willingness to pay for
services or environmental amenities by having respondents choose between policy
options where each policy has a specified set of attributes and a price.
• Three main differences:
• The type of question used to estimate value.
• By utilizing techniques of experimental design, and varying the levels of attributes across policy options and
respondents, choice experiments generate values for a large number of possible policy choices.
• Relatively fewer conditions needed for contingent valuation to reveal true preferences.
Stated Preference Methods
• Surveys involve three main components:
1. A detailed description of the proposed policy action, including what types of
benefits (e.g., better air quality, better health) will accrue from the policy as well as
the means for meeting the policy objectives (e.g., stricter regulations on power
plants).
2. Questions that elicit respondents’ values. This includes a description of how
responses will be used in the policy process.
3. Questions about the respondents’ characteristics (e.g., age, income), and
preferences relevant to the services being valued, and use of the services.
• Survey design and sampling methods are essential.
• Need to get responses from a representative population and need to have a high
survey response rate.
• Focus groups and pre-tests are used to make sure surveys are well-understood,
unbiased, and enough information is provided.
Stated Preferences: Value Questions
• Although other types are used, most commonly the value question in
a contingent valuation survey is framed as an advisory referendum.
For example:
We now would like you to consider carefully the following Proposal....<description of proposed policy action>
We have found that some would vote for the proposal and others would vote against it. Both have good
reasons why they would vote that way. If the proposal passed, you would have to pay $40 per year, through a
fee in your utility bill. If you had a chance to vote on this Proposal, how would you vote?
YES (for)
NO (against)
• A YES vote implies WTP ≥ $40; a NO vote implies WTP < $40.
• Costs are varied across respondents to identify mean/median WTP.
Systematic over- or under-statement
of true WTP or WTA
There are many types of bias associated with stated preference studies:
• Strategic bias: With strategic bias the respondent provides a biased answer in order to influence a particular outcome or to free ride on the
contributions of others.
Example: How much would you be willing to pay to avoid taking a final?
• Information bias: With information bias respondents forced to value attributes which they have little or no experience.
Example: How much would you be willing to pay to prevent habitat loss in India?
• Starting-point bias: This type of bias arises in dichotomous-choice or payment card applications when the respondent uses the values
provided as a guide for his/her own individual value.
Example: Would you be willing to pay $100 to avoid taking a final?
• Hypothetical bias: This type of bias arises due to the respondent being confronted by a contrived rather than actual set of choices.
Example: Would you be willing to pay $100 to avoid taking a final if you know that I
will not
actually collect the money?
• Payment vehicle bias: With payment vehicle bias respondents are influenced by the context of the question.
Example:
How much would you be willing to pay to prevent water pollution in the TN River?
How much would you be willing to accept to allow water pollution in the TN River?
Assessing the Reliability of Stated Preference
There are two general ways to asses the reliability of stated preference
approaches:
1. Test-retest procedures involve conducting a survey on a particular
resource change and population of winners/losers, then repeating
the same survey on a different sample from the same population
some time later
2. Convergent validity compares stated preference estimates for a
particular environmental good with estimates gained from other
valuation methods
Revealed Preference Methods
• Travel Cost Method (TCM): method that can infer the value of a recreational resource by using information
on what it costs to get to and to use the site.
• The travel cost method arose out of need to compare the value of recreation uses with other land and
water uses in 1940's and 1950's.
• Hedonic Pricing Method: involves the use of statistical analysis (e.g., linear regression analysis) to
explain the price of a good or service as a function of the good’s components.
• Underlying assumption: at people place value on a good or service based on the values of the good’s
characteristics.
Key difference: hedonic pricing measures market equilibria, and is just going to tell us about the
equilibrium “price” of characteristics and not their demand functions.
Travel Cost Method: Intuition
“The people who use any particular area for outdoor recreation will incur various costs in doing so –
perhaps small ones, perhaps large ones. These costs will be made up on many items, some in cash,
some in time, others of a more subjective kind. If they continue to use an area, then it is a
reasonable assumption that their satisfactions are as great as their costs, possibly greater in some
instances. But, for the marginal user or for the marginal visit by a habitual user, the total costs just
equal his estimate of total satisfactions. Were it otherwise, he would have increased his visits or
decreased them... had entrance fees been raised to a substantial figure, this would have raised the
total cost of the recreation experience, and surely would have affected the amount of use made of
this area.”
- M. Clawson, Methods of Measuring the Demand for and Value of Outdoor Recreation, 1959
Travel Cost Method: Intuition
Atlanta
Nashville
Knoxville
Cades Cove
(Increasing distance)
Suppose the average person in Knoxville takes 2 trips per year. What do we expect for someone
from Nashville? Someone from Atlanta?
$
Atlanta
Nashville
Knoxville
Trips
Constructing the Travel Cost or “Price” Variable
• What types of costs does one occur in visiting a recreation site?
• Out of pocket expenses
• Automobile, train, or plane expenses
• Admission charges
• Other
• The opportunity cost of time: visitors must take time to travel to visit a site, and this time could be
devoted to work in order to increase their income.
• How could we estimate the value of time?
• The typical approach is to observe how people tradeoff their time with other expenses. For instance, if
people willingly choose to save $2 in exchange for a 15 minute longer bus ride, but are not willing to do
so for a 30 minute longer ride, we may conclude that they value their time between ____________ an
hour.
• The general consensus of the transportation economics literature is that people value
their time somewhere in the region of 20-50% of their gross wage (Small, 1992).
The Individual TCM
• Sample surveys are used to collect information on trips to recreation sites, costs, and
socioeconomic characteristics of individuals. (obtaining a representative sample is crucial)
• The demand function looks like that for market goods.
• Travel Cost (“price”) is on the vertical axis.
• Number of trips (“quantity”) is on the horizontal axis.
• Demand also depends on income, the prices of substitute and complementary goods, variables that
reflect preferences, etc.
• A demand function for trips for the “average” individual is estimated from the survey data using
statistical techniques such as linear regression analysis.
• The area under the demand curve and above the average individual’s travel cost is the average
individual consumer surplus. To aggregate to the population, we just take the average consumer
surplus in the sample and multiply by the total number of visitors.
Valuing Changes in Site Quality: Graphical Analysis
• A quality improvement should shift the demand curve for trips (shift from D1 to D2). The welfare change for
the quality improvement is the difference in consumer surplus.
• Note that surveys often include contingent behavior questions that ask about changes in trip behavior for site
quality changes in order to estimate demand functions for varying quality levels (since quality may not vary much
naturally).
$
TCave
D2
D1
trips
Valuing Changes in Site Quality
A quality improvement should shift the demand curve for trips (shift from D1 to D2). The welfare
change for the quality improvement is the difference in consumer surplus. Note that surveys often
include contingent behavior questions that ask about changes in trip behavior for site quality
changes in order to estimate demand functions for varying quality levels (since quality may not vary
much naturally).
$
Consumer Surplus
at initial quality
TCave
D1
Q1
trips
Valuing Changes in Site Quality
A quality improvement should shift the demand curve for trips (shift from D1 to D2). The welfare change
for the quality improvement is the difference in consumer surplus. Note that surveys often include
contingent behavior questions that ask about changes in trip behavior for site quality changes in order to
estimate demand functions for varying quality levels (since quality may not vary much naturally).
$
Consumer Surplus
at new quality
TCave
D2
D1
Q1
Q2
trips
Valuing Changes in Site Quality
A quality improvement should shift the demand curve for trips (shift from D1 to D2). The welfare change for
the quality improvement is the difference in consumer surplus. Note that surveys often include contingent
behavior questions that ask about changes in trip behavior for site quality changes in order to estimate
demand functions for varying quality levels (since quality may not vary much naturally).
$
Change in
Consumer Surplus
TCave
D2
D1
Q1
Q2
trips
TCM: Example Study
“The Effect of Acidification Damages on the Economic Value of the Adirondack Fishery to New York
Anglers” (Mullen and Menz, Amer. J. Agri. Econ., 1985)
• “According to recent counts, the Adirondack region contains 2,877 individual lakes and ponds encompassing
some 282,154 surface acres, with an additional 31,805 miles of streams”
• More than 3/4 open to public fishing at no charge.
• Potential outdoor recreational experience for 55 million
• Acidification first reported in 1976, 52% of sites with a pH less than 5 and 90% of these devoid of fish life.
• Conducted a travel cost survey of visitation “before” acid rain problem (43% response or 11,087 anglers).
•
•
•
•
•
Only used NY residents, accounting for more than 90% of angler days.
Measured distance from residence to recreation site.
Out of pocket travel costs estimated to be $0.10 per mile.
Travel time valued at 35% of average hourly county wage.
Travel time calculated by round trip distance assuming 50 mph.
TCM: Example Study
• Study conceptualized trip demand (angler visits) for one site as a function of travel cost, prices for
other sites, environmental quality, and socioeconomic variables.
• Loss to anglers from acidification damage is approximated by shifting the demand curve to reflect
lower environmental quality (pH=5).
• Annual loss to NY anglers estimated to be more than $1 million in $1976.
• Based on their assumptions, what is the travel cost estimate for someone who visits a site 50 miles
away and lives in a county with an average hourly wage of $5?
• Out of pocket: $0.10/mile * 100 miles = $10
• Time costs:
• Time = 100 miles / (50 miles / hour) = 2 hours
• Time costs are then 2 hours * [0.35*$5] = $3.50
• Travel Costs = $13.50
TCM: Numerical Example
Suppose that the estimated individual trip demand function for
a lake is given by:
Trips = 40 – 2*(Travel Cost) + 10*(Water Quality)
Question 1: If the typical level of “Water Quality” is 1 and the
average consumer travel cost is $20, what is the consumer
surplus for the average individual?
CS(A): ½*(10)*(25-20) = 25S(B): ½*(20)*(30-20) = 100
CS(B) – CS(A) = 100 – 25 = $75 per individual
TCM Example
Trips = 40 – 2*(Travel Cost) + 10*(Water Quality)
Let’s graph it: Trips = 40 – 2*(Travel Cost) + 10*(1)
Trips = 50 – 2*(Travel Cost)
{Travel Cost = 25 – ½ Trips}
$
CS (initial) = ½ (10)(25-20) = $25
25
Ave TC=20
DWQ=1
10
50
Trips
TCM: Numerical Example
Suppose that the estimated individual trip demand function for
a lake is given by:
Trips = 40 – 2*(Travel Cost) + 10*(Water Quality)
Question 2: What is the value of a policy that would increase
water quality to 2 units?
CS(A): ½*(10)*(25-20) = 25S(B): ½*(20)*(30-20) = 100
CS(B) – CS(A) = 100 – 25 = $75 per individual
TCM Example
Trips = 40 – 2*(Travel Cost) + 10*(Water Quality)
Let’s graph it: Trips = 40 – 2*(Travel Cost) + 10*(2)
Trips = 60 – 2*(Travel Cost)
{Travel Cost = 30 – ½ Trips}
CS (new) – CS (initial) = 100 – 25 = $75
$
30
CS (new) = ½ (20)(30-20) = $100
Ave TC=20
DWQ=1
20
DWQ=2
60 Trips
Hedonic Pricing Methods
• What determines the price of a house?
•
•
•
•
The supply and demand conditions of the housing market
Housing characteristics
Neighborhood characteristics
Environmental amenities?
• What determines a worker’s wage?
•
•
•
•
Labor market conditions
Worker characteristics
Job characteristics
Job-related risks?
• If housing costs more in areas with better environmental quality, or if workers are paid
more for taking on greater risk, this information can be used to infer nonmarket values.
Choice Implies Value?
• Consider two properties for sale that are identical except for the fact
that one is located next to a nice park and the other one is not.
• Can we expect that potential buyers are willing to pay more for the house
close to the park? Can we expect that the seller will demand more for the
house close to the park?
Property 1
Property 2
Next to Park?
Yes
No
Actual Sales Price
250,000
245,000
• What “price” does the market place on proximity to a park?
Hedonic Property Value Method
• Hedonic property value method: a valuation technique that allows the value of an environmental
amenity to be determined from differences in the values of property exposed to different levels
of the amenity.
• As a simple example, suppose we want to estimate the relationship between House Price (P),
square footage (S), population density (N) and air quality (Q):
P = B0 + B1S + B2N + B3Q
• The coefficients (i.e., the “B”s) can be estimated using a statistical technique called linear
regression analysis. The function specifies a linear relationship between P and Q. However, in
empirical studies the relationship is sometimes non-linear. Also, it is clear that many, many more
characteristics need to be controlled for.
Hedonic Price Function
• Analogous to our depiction of demand and supply functions, after
estimating the coefficients, we can hold other factors constant and
depict the relationship between housing price and, say, air quality.
Housing Price (P)
• Suppose that a higher value of Q reflects better air quality:
slope = B3 > 0
෠ ∆𝑃 .
Implicit price (𝑃)=
∆𝑄
෠
Benefits (per household) = 𝑃×Q
෠
Change in Benefits (per household) = 𝑃×Q
Air Quality (Q)
Hedonic Property Method: Example Study
“Hog Operations, Environmental Effects, and Residential Property Values” (Palmquist, Roka and
Vukina, Land Economics, 1997)
• The study area included nine counties in North Carolina, an area which has had tremendous expansion in
hog production but still has diverse levels of hog production and animal concentrations.
• Data collected on 237 home sales. For each transaction, data were collected on house characteristics (lot
size, bathrooms, effective age, date of sale, type of garage, deck, fireplace), general neighborhood indicators
(population density, income, commute time) and swine population.
• Created three manure (yuck!) variables, which are indices that combine the number and size of operations
within a certain distance to the house:
• 0-1/2 mile; 1/2 mile to 1 mile; 1 to 2 miles.
• The higher the concentration, the higher the index (e.g., “0” indicates no concentration)
Hedonic Property Method: Example Study
• “The estimates from a hedonic model show that proximity of hog operations has a statistically
significant and negative impact on property values. the results also show that monetary damages
decrease with the increased distance from the swine production facility to the house. The results
further indicate that expansion of swine production in an area where hog concentration is already high
will have smaller negative effects on surrounding property values than when expansion occurs in low
hog density regions.”
• Median house associated with a manure index of .725 (1/8 of sample is at or below this) has a value of
$63,272. The same house with a manure index of 50.025 has a value of $60,557.
• Median house with an index of 33.107 will experience a $2,889 decline in value if another hog
operation opens within ½ mile. A $346 decline if the same operation opens within ½ to 1 mile.
Benefit-cost analysis (BCA)
• Means of evaluation based on economic efficiency
• Compares monetized benefit and cost estimates to decide whether a policy
should be undertaken based on specific decision rules
• Decision rules
1.
•
2.
•
Maximize NPV criterion: resources should be committed to those uses maximizing
the present value of net benefits received
identifies efficient allocation
Positive NPV criterion: an activity or policy should be undertaken whenever the
present value of net benefits is greater than zero
Policy is beneficial but not necessarily efficient
Decision rules
Consider a policy to harvest an old
growth forest based on each of these
decision rules
• Rule 1
$
• Total benefits = A+C
• Total costs = C
• Net benefits = A
MB
This highlights difference between
designing optimal policies and
choosing the best among existing
policies
B
A
C
• Rule 2 & 3
• Total benefits = A+C+D
• Total costs = C+D+B
• Net benefits = A-B
MC
D
Acres harvested
$
Total
Benefit
A
Total
Cost
Rule 1
Rule 2&3
A Political Basis for BCA
• Reagan’s Executive Order 12291 (year 1981): “the benefits should outweigh the costs” and that “of all the
alternative approaches to the given regulatory objective, the proposed action will maximize net benefits to
society”.
• E.O. covered all major regulations having more than $100 million effect on the economy.
• Clinton’s Executive Order 12866 (1993):
• “reasoned determination that the benefits of the intended regulation justify its costs”.
• “…include both quantifiable measures (to the fullest extent that they can be usefully estimated) and
qualitative measures of the costs and benefits that are difficult to quantify.”
• “Select those approaches that maximize net benefits (including potential economic, environmental,
public health and safety, and other advantages; distributive effects; and equity) unless a statute
requires another regulatory approach”.
• Many major environmental laws (e.g., Clean Water Act, National Ambient Air Quality Standards) preclude
weighing benefits and costs.
• Only three major environmental policies -- The Toxic Substances Control Act (TSCA), the Federal
Insecticide, Fungicide, and Rodenticide Act (FIFRA), and the 1996 Amendments to the Safe Drinking
Water Act (SDWA))-- explicitly require that benefits and costs be weighed in setting standards.
• Clean Air Act and Clean Water Act define health-based environmental standards that are not
necessarily intended to maximize net benefits but benefit-cost analyses are routinely used as
supplemental justification for the continuance of these policies.
“Unless A Statute Requires Another Regulatory Approach”
• Many major environmental laws (e.g., Clean Water Act, National
Ambient Air Quality Standards) preclude weighing benefits and costs.
• Of the major environmental policies, only three -- The Toxic Substances
Control Act (TSCA), the Federal Insecticide, Fungicide, and Rodenticide Act
(FIFRA), and the 1996 Amendments to the Safe Drinking Water Act (SDWA))-explicitly require that benefits and costs be weighed in setting standards.
• Note that while, for example, the Clean Air Act and Clean Water Act define
health-based environmental standards that are not necessarily intended to
maximize net benefits, benefit-cost analyses are routinely conducted for
these programs and are used as supplemental justification for the
continuance of these policies.
Structure of BCA
1. Identify and monetize (when possible) potential costs and benefits of
proposed policy.
2. Adjust cost and benefit estimates to account for the realization of costs
and benefits over time (discounting).
3. Take into account uncertainties over outcomes or values (expected
values).
4. Compare adjusted estimates using an evaluative criterion
Example: Hells Canyon
• Hells Canyon on the Snake
River between Oregon and
Idaho is the deepest canyon
on the North American
continent and also one of the
last places for a hydroelectric
dam
• Consider the following
alternatives:
1.
2.
Hell’s Canyon dam which will
provide hydroelectric power
and lake recreation
Hells Canyon Preservation
which will provide amenity
benefits, wildlife and fisheries
habitat, and recreation
Hells Canyon Example
Years
0.00
Project 1: Hells Canyon Dam
Costs (thousands of $)
Construction
Recurring costs
Benefits
Electricity Revenue
Lake Recreation
Net
NPV @ 5%
Project 2: Hells Canyon Preservation
Cost (thousands of $)
Elec opportunity cost
Benefits
Ammenity
Net
NPV @ 5%
1.00
2.00
3.00
4.00
5.00
700.00
700.00
700.00
700.00
700.00
0.00
60.00
3000.00
60.00
3000.00
60.00
3000.00
60.00
3000.00
60.00
3000.00
60.00
-9940
-9940
2360
2248
2360
2141
2360
2039
2360
1942
2360
1849
0
1500.00
1500.00
1500.00
1500.00
1500.00
800.00
950.00
1150.00
1350.00
1550.00
1650.00
800
800
-550
-524
-350
-317
-150
-130
50
41
150
118
Total
10000.00
278
-12
Problems: Discount rate sensitivity
Years
0.00
Project 1: Hells Canyon Dam
Costs (thousands of $)
Construction
Recurring costs
Benefits
Electricity Revenue
Lake Recreation
Net
NPV @ 5%
NPV @ 10%
Project 2: Hells Canyon Preservation
Cost (thousands of $)
Elec opportunity cost
Benefits
Ammenity
Net
NPV @ 5%
NPV @ 10%
1.00
2.00
3.00
4.00
5.00
700.00
700.00
700.00
700.00
700.00
0.00
60.00
3000.00
60.00
3000.00
60.00
3000.00
60.00
3000.00
60.00
3000.00
60.00
-9940
-9940
-9940
2360
2248
2145
2360
2141
1950
2360
2039
1773
2360
1942
1612
2360
1849
1465
0
1500.00
1500.00
1500.00
1500.00
1500.00
800.00
950.00
1150.00
1350.00
1550.00
1650.00
800
800
800
-550
-524
-500
-350
-317
-289
-150
-130
-113
50
41
34
150
118
93
Total
10000.00
278
-994
-12
25
Problems: Distribution of costs and benefits
Consider 3 different policies to
reduce emissions of CO2
• Efficient reduction is 20
• Policy 2 is clearly preferred to 1
because it provides larger net
benefits
• Policy 1 and 3 have same net
benefits…
• NB(1) = (A+D) - D = A
• NB(3) = (A+B+C+D+E+F+G) –
(D+E+F+G+H) = A
…but policy 1 puts more costs on
society while policy 3 puts more
costs on sources
$
MCC
Policy 3
Policy 1
Policy 2
A
B
E
C
F
H
G
MDC=MB
D
10 15 20
30
Emission
reduction
(%)
Problems: Need to value human life
• Instead of valuing human life economists attempt to value a reduction
in probability of premature death
• Often this is the largest portion of benefits from pollution reduction
policies
• Implied values for reduction of environmental risks ranges from $3 to
$7 million
• Is this immoral?
Problems: Uncertainty & Irreversibility
When a policy has benefits and costs that accrue in the future there is
some uncertainty about what these values may be
In this case it may be useful to calculate the
expected (i.e. average) value?
• Expected value: weight each outcome by
the probability it occurs, and sum them
up to get the expected value.
• For example, suppose there is a 50%
chance the NPV is $1 million, 25% that
the NPV is $-1 million, and 25% that the
NPV is 3 million. What is the expected
NPV?
probability
50%
25%
-1
1
3
NPV
(millions $)
Problems: Uncertainty & irreversibility
• But expected value doesn’t
distinguish between policies with
different levels of uncertainty
probability
• Combine this with the fact that
some policies are irreversible
• If a policy has more uncertainty
and is irreversible should it be
more heavily scrutinized?
Policy 2
Policy 1
Expected
NPV
Example: Harvesting old growth
Option 1
• Old growth forest could be clear cut
today producing timber with known
net revenue T0
• It will then be converted to
agriculture tomorrow with known
net revenue D1
• Present value of clear-cutting today
is
D1
D = T0 +
1
(1 + r )
Example: Harvesting old growth
Option 2
• Do not clear-cut today amenity
values A0 in t=0
• However in the future amenity
and timber values are uncertain
• Two possible future states
1.
2.
Market price for timber has
increased so timber revenues
T11>A11 with probability π
International timber boycott
causes timber prices to fall below
amenity A12>T12 with probability 1π
• Expected present value of
preservation today is

T11 + (1 −  ) A12 
P = A0 +
(1 + r )1
Example: Harvesting old growth
• Timber clear-cutting and conversion to agriculture will
occur if D>P and preservation will occur if P>D
• You will be indifferent between the two policies when
D=P
D1
T11 + (1 −  )A12
T0 +
= A0 +
1
1
(1 + r )
(1 + r )
D1
T11 + (1 −  )A12
T0 +
− A0 =
1
1
(
)
(
)
1+ r
1+ r
 
Net value of cutting forest
today less forgone
amenity value today
Option value of
preservation today
BCA: A Critical Appraisal
• In 1972 Robert Haveman conducted a study focusing on comparing the before and after estimates of Army Corps
of Engineers water projects. He finds:
• Nearly 50% of the projects displayed realized costs that deviated by more than +/- 20% from projected costs. (In more recent
studies, evidence is that costs tend to be overestimated due to failing to account for technological change.)
• Overestimation of benefits. Largely due to assuming important factors are not changing (e.g. crop prices, shipping rates, etc.)
• Ackerman et al. (2004) looked back at three regulatory decisions, seen as major successes, and asked “what would
have happened if benefit/cost analysis, based on the information available, had been the determining factor in the
decision?”
• Removal of lead from gasoline: would not have passed because the effects of high lead levels in blood were not known in
early 1970s.
• Protecting the Grand Canyon from dams: would not have passed as nonmarket values would not have entered in analysis in
1960s.
• Regulation of vinyl chloride exposure in the workplace: would not have passed as low values of life used in 1974 would have
required 1 in 7 workers to have had to die for regulation to pass.
Alternatives to BCA
1.
Safe Minimum Standard (Toman 1992)
•
•
2.
Set a safe minimum standard which would prevent current generations from performing irreversible harm on the env.
How do we set this standard?
Democratic Process (Sagoff 1988, 1993)
•
•
3.
Property rights treatment of env. offenses: pollution is treated as a legal nuisance or trespass instead of a social cost
Env. conservation is treated as a policy of protecting places
Generational Env. Debt (Azar and Holmberg 1995)
•
•
4.
GED: measure of the total amount of environmental damage that past and present generations have caused that will affect future generations
Present generation should restore specific damage until the marginal benefits of restoration equals the marginal cost of restoration
Multicriteria Analysis (MCA)
•
•
•
5.
Set up systems of objectives then minimize sum of deviations or realized levels from target levels
In comparison to BCA analysis MCA enlists a broader type of criteria instead of just economic efficiency
Can account for different types of appraisal criteria for projects with multiple objectives
Cost Effectiveness Analysis (CEA)
•
6.
Minimize economic and environmental costs of achieving objective
Environmental Impact Analysis
•
•
•
Only considers environmental costs
Makes no attempt to convert environmental impacts to monetary units
Can be difficult to compare to other monetary impacts