Chapter 8
Assessing Costs for
Environmental Decision Making
1. Environmental Costs: Conceptual Issues
• ___________________: the change in costs
arising from policy-induced improvements in
environmental quality
costs after the policy is implemented –
existing level of environmental expenditures
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Modeling Incremental Costs
• Find baseline TSC before policy
• Find TSC after policy is implemented
• Subtract baseline from new TSC
– TSC can be found as area under MSC
• Recall MSC = MACMKT + MCE
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MSC and TSC of Abatement
MSC = MACMKT + MCE
MSC ($millions)
MSC = 4 + 0.75A
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TSC
0
A1
A (abatement %)
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The areaModeling
of the trapezoid
Incremental Costs
= the average of the bases x height
= ½ x (19+22.75) x (25-20) = 104.375
MSC ($millions)
MSC = 4 + 0.75A
MSC = MACMKT + MCE
22.75
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Incremental costs =
$104.375 million
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0
20
25
A (abatement %)
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• Economic costs include
– Explicit (or monetary) costs
– Implicit (or nonmonetary) costs
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Explicit Costs
• Administrative, monitoring, and enforcement
expenses incurred by the public sector plus
compliance costs incurred by all sectors
– Capital (or fixed) costs
• Fixed spending on plant, equipment,
construction… for pollution abatement
– Operating (or variable) costs
• Variable costs of operating and maintaining
abatement processes
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Implicit Costs
• Value of nonmonetary effects that negatively
affect society’s well-being
– Examples:
diminished product variety, time costs of
searching for substitutes, reduced convenience…
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2. Estimating Explicit Costs
• Two methods
– Engineering Approach
– Survey Approach
• Common to use a combination approach
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Engineering Approach
• Estimates abatement spending based on leastcost available technology
• Relies on __________ in abatement methods
• Drawbacks
—difficult to use for proposed policy due to
uncertainty
about price movements, availability of raw materials…
—likely understates true costs because it
assumes all firms are cost-effective
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Survey Approach
• Derives estimated abatement expenditures from a
sample of polluting sources via _________
• A more direct means to obtain abatement cost
• Drawbacks
– polluters have an incentive to exaggerate costs
to officials to increase the probability that the
proposed regulation will be rejected
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3. Cost Classifications
• By economic sector
– Shows cost distribution across public and
private sectors
• By environmental media
– Shows how costs vary across air, water, and
solid waste abatement activities
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Chapter 9
Benefit-Cost Analysis in
Environmental Decision Making
1. Benefit-Cost Analysis in Practice
Making ________ adjustments
• Benefits and costs must be adjusted to
account for how their values change over
time
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Time Adjustments
• Purpose
– Benefits and costs do not accrue to society at
the same time
– Benefits and costs often accrue in the future
• Two types of adjustments
a. Present value determination
= Discounting
• accounts for the opportunity cost of money
= Adjusting for inflation
b. Inflation correction =Deflating
• accounts for changes in the general price level
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a. Present Value Determination
• Discounts a __________ (FV) into its _______
______ (PV) by accounting for the opportunity
cost of money (its highest valued alternative use,
which is the rate of return (r) on investment)
• Explains why money loaned in the present must
be paid back in the future with interest
O. C. of money = r = rate of return = interest rate
1. People prefer to consume now rather than later.
2. $100 could be invested to yield a 10% return. The
O.C. of $100 is $10.
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• General formula PV = FV[1/(1 + r)t] where:
• [1/(1 + r)t] is the _______________
• t is number of time periods
• r, the discount rate, is the only variable
-called the social discount rate in public policy
-should reflect the social opportunity cost of
funds
• PV determination is the means by which future
environmental benefits and costs are adjusted
r = the discount rate = the social discount rate
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b. Inflation Correction
• Adjusting for movements in the general price level
– Converting a real variable today to its future
nominal value to account for expected inflation
• Nominal valueperiod x+t= Real valueperiod x  (1 + p)t,
–where p is the expected inflation rate
– Converting a nominal value to its real value
• Real valueperiod x = Nominal valueperiod x + t /(1 + p)t
• Known as deflating
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• Present value of benefits in real terms (PVB)
over all t periods
= S(bt/(1+rs)t)
• bt: real benefits
bt = Bt / (1+p)t
• Present value of costs in real terms (PVC) over
all t periods
=S(ct/(1+rs)t)
ct = Ct / (1+p)t
• ct: real costs
Adjust for inflation; then discount
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2. Benefit-Cost Analysis in Policy
• Step 1: Determine if an option is feasible
• Step 2: Select from among feasible options
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Step 1:
Determining Feasibility
• Use the benefit-cost ratio
– If PVB/PVC > ___ option is feasible
OR
• Use the present value of net benefits (PVNB),
which equals (PVB – PVC)
– If PVNB > ____  option is feasible
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Step 2:
Select Among Feasible Options
• Decision rule: To achieve allocative efficiency
– Maximize PVNB = S(bt - ct)/(1+rs)t for all t
periods, among all feasible alternatives
• Decision rule: To achieve cost-effectiveness:
– Minimize PVC = S(ct/(1+rs)t) for all t periods,
among all feasible alternatives that achieve a
predetermined benefit level
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3. Reservations About the Use of Benefit-Cost
Analysis
• Measurement Problems
– Estimation is particularly problematic due to
intangibles
– Implicit costs
• Equity Issues
– Distribution of benefits and costs may be
highly skewed
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4. Federal Government Support
• Reagan’s Executive Order 12291
– Explicitly called for maximizing net benefits
(allocative efficiency) and choosing the leastcost alternative (cost-effectiveness)
– Detail of potential benefits and costs to be
given in a Regulatory Impact Analysis (RIA)
– Applicable to any “major rule,” i.e., a
regulation expected to have an annual
impact of at least $100 million
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• Clinton’s Executive Order 12866
– Explicitly refers to adopting/proposing
regulations for which benefits justify costs
(allocative efficiency) and designing
regulations in most cost-effective manner
– Applicable to any “significant regulatory
actions,” including those expected to have
an annual impact of at least $100 million
– Detail to be given in an Economic Analysis
(EA)
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• Bush’s Executive Order 13258
– Makes only minor amendments to Clinton’s
Executive Order 12866
– Extends the use of economic criteria in
policy design and evaluation through an
Economic Analysis
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5. Regulatory Impact Analysis (RIA):
Lead in Gasoline
• Estimated incremental benefits included health
effects and nonhealth effects, such as increased
fuel economy
• Estimated incremental costs were estimated
using an engineering cost model of the refinery
industry
• The resulting PVNB over the 1985-1992 period
(excluding blood pressure effects) was estimated
to be $5.9 billion and supported the proposed
new lead standard
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Extra information:
Opportunity Cost for Individuals
The money we pay for a good/service is a
part of its cost;
The total cost of any choice is everything we
must give up.
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Opportunity Cost—What is given up
when taking an action
Arises from the scarcity of time or money
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Example:
In one hour, Charlie can fix 4 flat tires or type
200 words. His opportunity cost of fixing 4
flat tires is ___________.
200 words
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The opportunity cost of any activity can be
measured by the value of the best
alternative to that choice.
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Example:
You are spending a couple of hours reading
Chapter 1. Instead of reading, you could be
doing many other things: watching TV, go
shopping, earning extra money tutoring high
school students… Assume that tutoring is your
best alternative.
The opportunity cost of reading Chapter 1 is
extra money which could be earned by tutoring
________________________________________.
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Opportunity cost includes:
(a) Explicit Cost—Dollars actually paid
out for a choice
(b) Implicit Cost—Value (forgone
income) of something (time)
sacrificed when no direct payment is
made
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You are considering attending a concert.
Ticket price: $35
Cost of driving and parking: $20
In order to attend the concert, you will have to take
time off from your part-time job (5 hours, $6 per
hour).
Your opportunity cost of attending the concert
= explicit cost
+ implicit cost
= monetary cost + forgone income
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($35 + $20) + ($6 x 5)
=________________________
=_____________
$55 + $30
=______
$85
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Comments on “opportunity cost”:
• Most accurate and complete concept of
cost
• The one we should use when making our
decisions
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TIME VALUE OF MONEY
The idea that money available at the present time is worth
more than the same amount in the future due to its potential
earning capacity. This core principle of finance holds that,
provided money can earn interest, any amount of money is
worth more the sooner it is received.
Everyone knows that money deposited in a savings account
will earn interest. Because of this universal fact, we would
prefer to receive money today rather than the same amount
in the future.
For example, assuming a 10% interest rate, $100 invested
today will be worth $110 in one year ($100 multiplied
by 1.10). Conversely, $110 received one year from now is
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only worth $100 today ($110 divided by 1.10).
Solving for FV:
The Formula Method
• After 1 year:
FV1 = PV(1 + r) = $100*(1.10) = $110.00
• After 2 years:
FV2 = PV(1 + r)2 = $100*(1.10)2 = $121.00
• After 3 years:
FV3 = PV(1 + r)3 = $100*(1.10)3 = $133.10
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Solving for PV:
The Formula Method
Solve the general FV equation for PV:
PV = FVt /(1 + r)t
PV = FV3 /(1 + r)3
= $133.10/(1.10)3
= $100
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