Recap from Lecture 1- CBA
• CBA is an economic tool for government policy and
investment project analysis, used for efficient
allocation of scarce resources
• CBA is carried out by aggregation of benefits from and
costs of a policy/project over individuals that are
affected and over time (life of the policy/project)
• Incorporate environmental impacts (both positive and
negative) of policies/projects within CBA to ensure
efficient allocation of environmental and economics
resources
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Recap from Lecture 1-TEV
• Environmental goods are public goods
(non-rival and non-excludable)
• They are not traded in the markets and
hence they do not have readily available
prices that can be used in CBA
• Value of environmental goods have a
broader definition: Total Economic Value
(TEV)
2
Recap from Lecture 1-TEV
Total Economic Value:
• Use Values: Related to values derived from using the
environmental good
– Direct use value: Value that come from the consumptive use of the
environmental good
– Indirect use value: Value of functions of the environmental good
– Option value: values of conserving the option of making use of the
environmental good in the future even though no current use is made of it.
• Non-use values: Unrelated to the value of current or planned
use of the environmental good
– Bequest value: Value of knowing that future generations will benefit from
the environmental good
– Altruistic value: Value of knowing that other individuals in this generation
benefit from the environmental good
– Existence value: Value of knowing that the environmental good exists even
if no one in this generation or in the future generations will ever use it.
3
TEV of a Wetland
USE VALUES
Direct Use Value
Indirect Use
Value
fish
nutrient retention
agriculture
flood control
fuelwood
storm protection
recreation
groundwater
transport
recharge
wildlife harvesting external
energy
ecosystem
support
micro-climatic
stabilisation
shoreline
stabilisation, etc.
NON-USE VALUES
Option Value
potential future
uses (as per
direct and
indirect uses)
bequest value
altruistic value
existence value
related to biodiversity
and cultural heritage
future value of
information
Barbier et al. 1997
4
Recap from Lecture 1
• TEV can be estimated using environmental
valuation methods.
These are
– Revealed Preference Methods
• Hedonic Pricing Method
• Travel Cost Method
– Stated Preference Methods
• Contingent Valuation Method
• Choice Experiment Method
5
Reading List
• Hanley N., Shogren, J. and White, B. (2001) An Introduction
to Environmental Economics, Oxford University Press,
Oxford.
– Chapters 2, 3 and 4
• Pearce, D.W and Turner, K. (1990) Economics of Natural
Resources and the Environment, Harvester Wheatsheaf,
London
– Chapters 9 and 10
• Kolstad, C.D.(2000) Environmental Economics, Oxford
University Press, Oxford
– Chapters 4 (pp.68-74), 15, 16, 17 (pp.344-350) and 18
• Perman, R., Ma, Y., McGilvray, J., and Common, M. (2003)
Natural Resource and Environmental Economics, Longman,
Harlow, 3rd Edition
– Chapters 11 and 12
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Valuing Environmental Goods
• Deciding to use the environmental goods one way or
other entails a cost.
• Is it worth sacrificing environmental goods to obtain
market goods?
• Economists measure TEV in terms of willingness to
pay (WTP) or willingness to accept (WTA)
• Compare maximum WTP for the environmental good
with the market value of the goods for which the
destruction of the environmental goods is required.
• Or compare minimum WTA compensation for the loss
of environmental resources with the market value of
the goods for which the destruction of the
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environmental goods is required.
Valuing Environmental Goods
• WTA and WTP differ in terms of:
– Income: WTP is limited by one’s income and WTA is
unbounded. One is richer when one owns the item and is
being compensated for it, than one must pay to obtain it.
– Property rights: If one has the property right to an
environmental good, then the appropriate concept is WTA.
If one does not have the property rights then use WTP.
Many environmental gods are public goods, sometimes
current allocation is taken as the property rights, that is
improvements in environmental quality is measured as
WTP and reductions in environmental quality is measures
as WTA.
• The concepts of WTP and WTA for an environmental
good can be explained using IC.
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Hedonic Pricing Method (HPM)
• HPM is used to estimate the economic values of an
environmental good that directly affect prices of
marketed goods.
• It is most commonly applied to variations in property
prices to estimate the value of local environmental
goods.
• It can be used to estimate economic benefits or costs
associated with:
– environmental quality, including air pollution, water
pollution, noise, soil quality, water quality, erosion, drainage,
proximity to waste sites
– environmental amenities, such as aesthetic views (sea, lake,
forest) or proximity to recreational sites (e.g. coast, open
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space)
HPM – Main assumption
• HPM is based on Lancaster’s characteristics
theory of value (Lancaster, 1966). That is
people value the characteristics of a good,
or the services it provides, rather than the
good itself.
• Thus, property prices will reflect the value
of a set of characteristics, including
environmental characteristics, that people
consider important when purchasing a
property.
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HPM – Main assumption
• The price of a property is related to its characteristics,
the characteristics of the neighbourhood and community,
and environmental characteristics.
• Thus, if non-environmental factors are controlled for,
then any remaining differences in price can be attributed
to differences in environmental quality.
• For example, if all characteristics of properties and
neighbourhoods throughout an area were the same,
except for the level of air pollution, then houses with
better air quality would cost more. This higher price
reflects the value of cleaner air to people who purchase
houses in the area.
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HPM – Data requirement
• To apply the hedonic pricing method, the
following information must be collected:
– A measure or index of the environmental amenity of
interest (e.g. for air pollution measurements of SO2,
SO3, H2S, H2SO4 etc. or for distance to hazardous waste
sites distance in km)
– Cross-section and/or time-series data on property prices
and property and household characteristics for a welldefined market area that includes homes with different
levels of environmental quality, or different distances to
an environmental amenity.
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HPM - Analysis
• The data are analysed using regression analysis.
• Regression analysis: A statistical process for fitting a
line through a set of data points. It gives the intercept
and slope(s) of the “best fitting” line. Thus it tells how
much one variable (the dependent variable) will change
when other variables (the independent, or explanatory,
variables) change.
• In the first stage of HPM, regression analysis is used to
estimates the hedonic price function, which relates the
price of the property to its characteristics and the
environmental characteristic(s) of interest. Thus, the
effects of different characteristics on price can be
estimated.
13
HPM - Analysis
• The regression results indicate how much property
values will change for a small change in each
characteristic, holding all other characteristics
constant.
• That is differentiating the hedonic price function
with respect to any one of the characteristics yields
the implicit price function (implicit because it is
revealed to us indirectly through the amounts people
are prepared to pay for the whole property of which
the particular characteristic is only a part).
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HPM- Analysis
• In the second stage of HPM, the demand function
(marginal WTP) is identified. To identify the demand
function information. There are two ways information
on individuals’ demand (marginal WTP) for a good at
different prices
– either observe individuals’ demand for a good in one
market when the price of the good changes over time
– or observe individuals’ demand for a good in different
markets where the good is traded at different prices.
• In general, the only way we can identify the marginal
WTP curve is to have observations on households
with the same characteristics facing different implicit
prices.
15
HPM- Advantages
• HPM is relatively straightforward and uncontroversial
to apply, because it is based on actual market prices
and fairly easily measured data.
• Property markets are relatively efficient in responding
to information, so can be good indications of value.
• Property records are typically very reliable.
• Data on property sales and characteristics are generally
readily available through many sources.
• If data are readily available, it can be relatively
inexpensive to apply.
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HPM- Limitations
• The scope of environmental benefits that can be
measured is limited to environmental goods and
services that are related to property markets.
• The method will only capture people’s willingness to
pay for perceived differences in environmental
attributes, and their direct consequences. If people
aren’t aware of the linkages between the environmental
attribute and benefits to them or their property, the
value will not be reflected in property prices.
• The method assumes that people have the opportunity
to select the combination of features they prefer, given
their income. However, the housing market may be
affected by outside influences, like taxes, interest rates,
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or other factors.
HPM- Limitations
• Transaction costs in the property market are varied
and not inconsiderable consisting of items such as
the time spent searching for properties, expenses on
lawyers and surveyors, taxes and the costs of
moving possessions from one property to another.
Given the prevailing market prices, a household may
want to live in a property with a different set of
characteristics than their current residence. However,
if the transaction costs are sufficiently high, they
may negate the benefits of moving. The household
will stay where it is and the housing market will
remain out of equilibrium.
18
HPM-Limitations
• One of the fundamental assumptions of the
HPM is that households have perfect
information. If households are not aware of
the prices and characteristics of all the
properties in the market then it is likely that
the prices that they pay for properties, and
by definition the implicit price they pay for
different characteristics, will vary from sale
to sale.
19
HPM- Limitations
• The method is relatively complex to implement and
interpret, requiring a high degree of statistical
expertise.
• The results depend heavily on model specification.
• Large amounts of data must be gathered and
manipulated.
• The time and expense to carry out an application
depends on the availability and accessibility of data.
If data must be gathered and compiled, the cost of an
application can increase substantially.
20
HPM- Limitations
• Only use values of environmental goods can
be estimated by HPM. HPM cannot
estimate non-use values and hence the TEV
of the environmental goods. Need to use
other methods in addition to HPM to
estimate the non-use values in order to find
out the TEV of an environmental good.
21
HPM - Example
• Hypothetical Situation:
EPA wants to measure the benefits of an open space
conservation programme in a region where open land
is rapidly being developed.
• Why Use the Hedonic Pricing Method?
The hedonic pricing method was selected in this case
because:
1. Housing prices in the area appear to be related to
proximity to open space.
2. Data on real estate transactions and open space
parcels are readily available, thus making this the least
expensive and least complicated approach.
22
HPM- Example
• Alternative Approaches:
If the open space of concern is used mainly
for recreation, the travel cost method might
be used (Lecture 3). Alternatively, surveybased methods, like contingent valuation or
contingent choice, might be used (Lectures
4 & 5). However, these methods would
generally be more difficult and expensive to
apply.
23
HPM- Example
• Application of the Hedonic Pricing Method:
Step 1:
The first step is to collect data on residential property
sales in the region for a specific time period (usually
one year). The required data include:
– selling prices and locations of residential properties
– property characteristics that affect selling prices, such as lot
size, number and size of rooms, and number of bathrooms
– neighborhood characteristics that affect selling prices, such as
property taxes, crime rates, and quality of schools
– accessibility characteristics that affect prices, such as
distances to work and shopping centers, and availability of
public transportation
– environmental characteristics that affect prices
24
HPM - Example
• In this case, the environmental characteristic of
concern is the proximity to open space.
• The researcher might collect data on the amount
and type of open space within a given radius of
each property, and might also note whether a
property is directly adjacent to open space.
• Often, this type of data may be obtained from
computer-based GIS (geographical information
systems) maps.
• Data on housing prices and characteristics are
available from municipal offices, multiple listing
services, and other sources.
25
HPM- Example
Step 2:
Once the data are collected and compiled, the next
step is to statistically estimate a function that
relates property values to the property
characteristics, including the distance to open
space.
The resulting function measures the portion of the
property price that is attributable to each
characteristic. Thus, the researcher can estimate
the value of preserving open space by looking at
how the value of the average home changes when
the amount of open space nearby changes.
26
HPM- Example
• How Do We Use the Results?
The results can be used to evaluate EPA
investments in open space
conservation. For example, specific parcels
may be under consideration for
protection. The hedonic value function can
be used to determine the benefits of
preserving each parcel, which can then be
compared to the cost.
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HPM- Case study I
• Values of Environmental Amenities in Southold,
Long Island
• Opaluch, James J., Thomas Grigalunas, Jerry
Diamantides, Marisa Mazzotta, and Robert
Johnston. 1999. Recreational and Resource
Economic Values for the Peconic Estuary System.
Report prepared for the Peconic Estuary Program,
Suffolk County Department of Health Services,
Riverhead, NY by Economic Analysis, Inc.
28
HPM- Case study I
• The Situation
The town of Southold, Long Island, New York has
coastlines on both the Peconic Bay and Long
Island Sound. Compared to the rest of Long
Island, it is a relatively rural area, with a large
amount of farmland. However, population and
housing density are rapidly increasing in the town,
resulting in development pressures on farmland
and other types of open space.
29
HPM- Case study I
• The Challenge
The Peconic Estuary Program is considering
various management actions for the Estuary
and surrounding land areas. In order to
assess some of the values that may result
from these management actions, a hedonic
valuation study was conducted, using 1996
housing transactions.
30
HPM- Case study I
• The Analysis
The study found that the following variables that are
relevant for local environmental management had
significant effects on property values in Southold:
– Open Space: Properties adjacent to open space had, on
average, 12.8% higher per-acre value than similar properties
located elsewhere.
– Farmland: Properties located adjacent to farmland had, on
average, 13.3% lower per-acre value.
– Major Roads: Properties located within 20 meters of a major
road had, on average, 16.2% lower per-acre value.
– Wetlands: For every percentage point increase in the percent
of a parcel classified as a wetland, the average per-acre value
increased by .3%.
31
HPM- Case study I
• The Results
Based on the results of this study, managers could,
for example, calculate the value of preserving a
parcel of open space, by calculating the effects on
property values adjacent to the parcel. For a
hypothetical simple case, the value of preserving a
10 acre parcel of open space, surrounded by 15
“average” properties, was calculated as $410,907.
32
HPM- Case study II
• Estimating costs of air pollution using HPM
• Ridker, R.G. and J.A. Henning (1967) “The
Determinants of Residential Property Values
with Special Reference to Property Values”,
The Review of Economics and Statistics,
Volume 49, Issue 2, (May, 1967), 246-257.
33
HPM- Case study II
• Ridker and Henning tested the hypothesis that
air pollution affects property values.
• They used cross-section data on property values
for single family dwelling units in an urban area
(St. Louis metropolitan area) in 1960.
• They regressed property prices on air pollution
(sulfation levels), characteristics specific to the
property (e.g. number of rooms), location
characteristics (e.g shopping and working area
access) , neighbourhood characteristics (e.g.
school quality, crime rates), family income 34
HPM- Case study II
• They found that air pollution is a significant variable in
explaining residential property values
• They found that if sulfation levels were to drop by
0.25mg/100cm2/day, the value of the property could
rise $83-$245
• If sulfation levels dropped by 0.25mg/100cm2/day, total
increase for the St. Louis metropolitan area could be as
much as $82 790 000
• Invested at 10% this sum amounts to a gain over $ 8
million annually, and households would be WTP at
least this amount for the specified reduction in
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pollution levels
HPM- Case study II
• They do not have enough data to carry out a
thorough CBA
• Crude assessment suggest that shift to low
sulphur fuels would cut sulfation in half and
cost $10-$15 million per year
• This cut in sulphation is higher than the
target envisaged (0.25mg/100cm2/day),
however extrapolating to this level would
bring the annual benefit figure to $15
million
36
HPM- Case study II
• In addition, need to consider
– Property values other than those for single family
dwellings would also rise, contributing to the benefit
estimates
– Other benefits besides increase in property values
would also be derived from such a reduction
– To bring about the property value and other benefits,
levels of other pollutants correlated with sulphates
should also be reduced, this would increase cost
estimates
37
HPM – Case study III
• Using HPM to estimate farmland values
• Palmquist, R.B. and L.E. Danielson, (1989)
“A Hedonic Study of the Effects of Erosion
Control and Drainage on Farmland Values”,
American Journal of Agricultural
Economics.
38
HPM – Case study III
• Improvements can be made to farmland (e.g.
clearing or draining the land and controlling
erosion)
• Farmers must decide whether to undertake such
improvements, so they need information on
value and costs of such improvements.
• Government programmes are designed to
encourage/discourage changes in
characteristics of farmland, to evaluate such
programmes decision makers need to know the
benefits of the resulting changes
39
HPM – Case study III
• In this study Palmquist and Danielson use HPM to
estimate the values of drainage and reductions in
erosion potential of land in North Carolina
• They find that draining soil could increase land values
by 34% on average and one ton per acre per year
reduction in potential soil loss would be worth $6.19 in
terms of land prices
• This information can be combined with drainage and
soil protection cost estimates to inform farmers
(investment project) and government (policy-making)
on the net benefits of erosion control and drainage
40