ECON 406: Applied Environmental and Natural
Resource Economics
Lecture 3. Benefit-Cost Analysis, Present Value, Valuation Techniques
Levi Edwards
Spring 2023
Levi Edwards
ECON 406: Applied Environmental and Natural Resource Economics
Spring 2023
1 / 18
Intro
Actions have both costs and benefits. If the benefits exceed the costs
(positive net benefit), than the action is worth pursuing. If instead
the costs exceed the benefits (negative net benefits or, net cost), then
the action is not desirable.
First Equimarginal Principle. Social net benefits are maximized
when the social marginal benefits from an allocation equal the social
marginal costs.
Levi Edwards
ECON 406: Applied Environmental and Natural Resource Economics
Spring 2023
2 / 18
Issues in Benefit Estimation
Primary vs. Secondary Effects: Public policies have both primary
and secondary effects–should we include both in our BCA?
Accounting Stance: At what scale are we undertaking the analysis?
For instance, a policy may be worth pursuing from the point of view
of a given city or locality–but may not be from the point of view of
the country as a whole.
With and Without Principle: The principle that benefits and cost
which would have accrued irrespective of the chosen policy should be
ignored.
Tangible vs. Intangible Benefits: Tangible benefits are those that
can be reasonably assigned a monetary value, whereas intangible
benefits are those that can’t. While you cannot directly include an
intangible benefit in a cost-benefit analysis in the same way that you
can a tangible one, you can test to see if the results are sensitive to
changes in the magnitude of this intangible benefit.
Levi Edwards
ECON 406: Applied Environmental and Natural Resource Economics
Spring 2023
3 / 18
Approaches to Cost Estimation
There are two main ways of estimating costs–the survey approach,
and the engineering approach.
Survey Approach: You can ask individuals who bear the costs of a
policy what those costs are–e.g. costs imposed on polluters due to
govt. regulation. Problem: may not have an incentive to be truthful.
Engineering Approach: Use general engineering information to
catalog the possible tech that could be used to meet a given
regulatory objective in the least cost way. Problem: Unique
circumstances can make these hypothetical costs differ from those of
actual firms.
Can also use a combined approach that collects info re: employed
tech from firms and then derive the actual costs implied by that tech.
Levi Edwards
ECON 406: Applied Environmental and Natural Resource Economics
Spring 2023
4 / 18
Comparing Benefits and Costs Across Time
Static efficiency criterion considers only the magnitude of benefits and
costs, but not their timing. This is okay, so long as time is not an
important factor in the analysis.
Time is however an important factor when considering exhaustible
energy resources such as oil, and renewable resources such as forests
and fisheries.
How do we compare net benefits received in different time periods?
By comparing the present value of those net benefits.
Levi Edwards
ECON 406: Applied Environmental and Natural Resource Economics
Spring 2023
5 / 18
Present Value
The present value of a one-time net benefit received n years from now
is:
Bn
PV (Bn ) =
.
(1 + r )n
The present value of a stream of net benefits {B0 , B1 , ..., Bn } received
over a period of n years is:
PV (B0 , B1 , ..., Bn ) =
n
X
i=1
Bi
.
(1 + r )i
We refer to the process of calculating present values as discounting,
where r is the discount rate.
Levi Edwards
ECON 406: Applied Environmental and Natural Resource Economics
Spring 2023
6 / 18
Dynamic Efficiency
An allocation of resources across n time periods is said to be
dynamically efficient if it maximizes the present value of net
benefits (NPV) that could be received from all the possible ways of
allocating those resources over the n periods.
n
X
Bt − Ct
NPV =
(1 + r )t
t=0
Levi Edwards
ECON 406: Applied Environmental and Natural Resource Economics
Spring 2023
7 / 18
Example
Suppose a project will impose an immediate cost of $4,000,000, but
the $5,500,000 benefit will not be earned until 5 years out. Is this
project a good idea?
Answer depends on the discount rate.
If r = 0.05, then NPV =
If r = 0.1, then NPV =
Levi Edwards
$5,500,000
(1.05)5
$5,500,000
(1.1)5
− $4, 000, 000 = $309, 394 > 0
− $4, 000, 000 = −$584, 933 < 0
ECON 406: Applied Environmental and Natural Resource Economics
Spring 2023
8 / 18
Choosing the Discount Rate
Should governments use market interest rates as for discounting–or a
lower rate?
Using a lower rate can address inter-generational equity concerns–i.e.
a lower rate means greater weight is given to future generations. But
is this appropriate for benefit-cost analysis? Distributional concerns
are distinct from efficiency concerns, so maybe a lower rate not
justified on these grounds.
If governments have a great deal of say in the discount rates they
employ, they can manipulate policy by choosing the “right” discount
rate. If governments use market rates, not as easy to manipulate
policy in this fashion.
Large literature on this topic...just scratching the surface here.
Levi Edwards
ECON 406: Applied Environmental and Natural Resource Economics
Spring 2023
9 / 18
Cost Effectiveness Criterion
Sometimes, the necessary valuation to conduct a benefit-cost analysis
isn’t available, or is unreliable.
In such cases, the policy may be chosen by some non-efficiency
criterion, and the means of enacting that policy may be chosen by
economic analysis.
Typically several means of achieving a specified objective are
available, but each means differs in its structure of costs.
Second Equimarginal Principle. The least-cost means of achieving
an environmental target will have been achieved when themarginal
costs of all possible means of achievment are equal.
Levi Edwards
ECON 406: Applied Environmental and Natural Resource Economics
Spring 2023
10 / 18
Types of Valuation
There are two types of valuation: market valuation and non-market
valuation.
Market Valuation: Monetization of environmental goods based on
market prices.
Nonmarket valuation: The practice of monetizing goods and
services for which there are no market prices.
Levi Edwards
ECON 406: Applied Environmental and Natural Resource Economics
Spring 2023
11 / 18
Types of Value I
Economists typically decompose the economic value conferred by
environmental resources into three components: use value, option
value and nonuse value.
Use value reflects the value from direct use of the resource. For
instance, the fish harvested from sea, timber harvested from the
forest, or the scenic beauty conferred by a natural vista. Note that
“use” does not necessarily mean that the resource is “used up” (i.e.
viewing a vista)
Levi Edwards
ECON 406: Applied Environmental and Natural Resource Economics
Spring 2023
12 / 18
Use Value
Market values: Some attribute of the environment is of value in the
production of a good exchanged in private markets.
Agriculture: soil, water, crops
Forestry: trees, soil, water, forest products
Fisheries: fish populations, other plant/animal populations
Levi Edwards
ECON 406: Applied Environmental and Natural Resource Economics
Spring 2023
13 / 18
Types of Value II
Option value reflects the value people place on the future ability to
use the environment.
Nonuse value reflects the fact that some people would be willing to
pay to preserve or improve existing environmental resources, without
any personal intent to use the resource now or in the future.
▶
▶
Bequest value is the willingness to pay to ensure a resource is available
for your children and grandchildren.
Existence value is the willingness to pay to ensure that a resource
continues to exist.
Total willingness to pay is then:
TWP = Use Value + Option Value + Nonuse Value
Levi Edwards
ECON 406: Applied Environmental and Natural Resource Economics
Spring 2023
14 / 18
Valuation Methods
The researcher’s main goal is to estimate the total willingness to pay
for a good or service
There are two main ways to estimate the value of resources: revealed
preference and stated preference methods.
Stated preference methods use survey techniques to elicit willingness
to pay for a marginal improvement or for avoiding a marginal loss.
Revealed preference methods are based on actual observable choices
that allow resource values to be directly inferred from those choices.
Levi Edwards
ECON 406: Applied Environmental and Natural Resource Economics
Spring 2023
15 / 18
Stated Preference: Contingent Valuation I
A direct stated preference method is that of contingent valuation
At its core, contingent valuation consists of asking respondent what
value they would place on an environmental change or on preserving a
resource in its present state.
The survey creates a hypothetical market and asks respondents to
consider a willingness-to-pay question contingent on the existence of
this market.
Levi Edwards
ECON 406: Applied Environmental and Natural Resource Economics
Spring 2023
16 / 18
Stated Preference: Contingent Valuation II
This approach suffers from a variety of biases, however.
Strategic bias: Respondents may possess strategic incentives to
misrepresent their preferences
Information bias: Respondents may not possess the requisite
information to make an informed choice. They may be ignorant of the
relevant alternatives, etc.
Starting-point-bias: The range of values or options given to
respondents may alter their reported willingness-to-pay
Hypothetical bias: Responses may be biased due to contrived or
artificial nature of the choice. That is: it is not a choice at all, but an
imagined scenario
Differences between WTP and WTA
Levi Edwards
ECON 406: Applied Environmental and Natural Resource Economics
Spring 2023
17 / 18
Stated Preference: Choice Experiments
Similar to contingent valuation in that also survey-based.
Asks respondents to choose among alternate bundles of goods or
attributes, rather than stating a willingness to pay.
Levi Edwards
ECON 406: Applied Environmental and Natural Resource Economics
Spring 2023
18 / 18