Cost-Benefit Analysis March 23, 2017 MSSM Program Columbia University Satyajit Bose

Announcements Topic Choices: Group presentation schedules posted. Multifamily solar Vertical forests California High Speed Rail Fairtrade certification Cheesecake Factory caloric reduction Group presentation schedules posted. Outlines due Apr 2. (No grade, just feedback). Please schedule feedback appointment (4/3 to 4/7) for Outlines.

Announcements General Advice for Outline: Take-home exam tomorrow. Review detailed instructions for Outlines on Canvas Identify audience and write with the appropriate tone and language Work on identifying data sources for quantification early in the process Search Econlit and use a variety of sources Eliminate typos Take-home exam tomorrow. Today: Revealed Preference

Components of Value Use Value Nonuse Value In surveys, values are assigned to environmental goods when there can be no obvious use value. Existence value, altruistic value or bequest value

Indirect Estimation Measuring demand without markets and without utility functions: Revealed preference or market methods. (use values only) Hedonic price models Household production models (travel cost, defensive expenditure) Stated preference methods (use and non-use values) Contingent valuation methods Experimental markets Political referenda Benefits transfer

Source: EPA

Source: Ernst & Young. Total Value: Impact Valuation to Support Decision-making. 2016

Revealed Preference Methods Can only cover what has been done, not what would be done under specified conditions Greatest success in measuring value placed on: Use of recreational resources. Perceptible differences in air quality.

Market Analogy Method This method uses data on similar goods in the private market to estimate the implicit “price” or the demand curve for publicly provided goods. Ideally, construct a demand curve (rather than estimate price or expenditure) for the publicly provided good

The Trade-Off Method Use the opportunity cost as a measure of value: Example: Time saved valued at after-tax wage rate Example: value of statistical life measured by the wages people demand for increases in fatality risk

Value of Time Saved Without market imperfections (people can choose the # of hours of work and there is no unemployment), the wage rate equals the marginal value of time. Adjustments: Benefits and taxes Enjoyment of work Wage rate may differ from marginal social product

Moment of Silence “Let us have a moment of silence for all those Americans who are stuck in traffic on their way to the gym to ride the stationary bicycle.” – Rep. Earl Blumenauer

Intermediate Good Method If a project produces an intermediate good that is not sold in a well functioning market, then its value can be imputed by determining the value added to the “downstream activity”: Annual Benefit = Net income of downstream activity (with project) – Net Income of downstream activity (without project)

Asset Valuation Method If impacts are capitalized into asset prices (requires that asset markets be functioning perfectly), then changes in asset values measure impact.

Hedonic Price Method Is a revealed preference method of evaluating environmental goods Many goods are composite bundles of attributes Hedonic pricing attempts to infer the value of specific attributes by observing prices of many different bundles It attempts to address the omitted variable and selection biases inherent in the asset price method. Assumes: Demand for a market good is dependent on the quantity of the (inseparable) environmental good, e.g. houses and air quality Consumers are optimizing utility, even though we do not observe utility There is sufficient variety in levels of the environmental good to allow useful estimation Is relevant only for small changes in the attribute

Example Price of Homes with wetlands = constant term + 1 × acreage + 2 × square footage + 3 × wetland dummy + error term

Example: Mahan et al. (2000) Estimate the value of wetland amenities Data on 14,000 actual house sales in Portland, Oregon Data on proximity to wetland, size and type of wetland for each house.

Example: Mahan et al. Explain house prices in Portland, deriving thereby an estimate of the marginal value of access to wetlands, as reflected in house prices K control variables (# of rooms, living area, age of the house etc.) Fit the following equation:

Household Production Models The household production model is a form of revealed preference environmental valuation. The model assumes that consumers combine a non-market good or bad with a market good to produce a synthetic good that yields utility. Defensive expenditure or averting models refer to models where consumption of a market good counteracts the effects of a non-market bad. Travel cost models refer to models where consumption of a market good must be combined with the non-market good to facilitate enjoyment of the non-market good.

Travel Cost Method Inspired by Hotelling (1947) Recognizes that the full price paid by persons for a visit to a recreational site is admission fee PLUS the costs of traveling to and from the site.

Travel Cost Method Select sample of households within the market area of the site. Survey sample to determine numbers of visits to the site, all costs involved in visiting the site, costs of visiting substitute sites, incomes, and other control variables. Specify a functional form for the demand schedule and estimate it using the survey data. Compute consumer surplus.

Travel Cost Example

Defensive Expenditure Method A defensive expenditure is an expenditure in response to something undesirable, such as pollution. The change in expenditures can be used as a measure of the cost of the change in pollution. Observed defensive expenditure provides a lower bound on the willingness to pay to avoid the bad.

Criticisms of Revealed Preference Methods Equates market values with values Strongly influenced by the distribution of income Selection Bias: usually, visitors or averters comprise the sample difficult, if not, impossible to control for risk aversion Dynamic Aspects: Averting behavior has many dimensions, e.g. not moving to a hurricane-prone area Travel Cost: Computing costs are not trivial: the value of time marginal vs. average costs Zonal Travel Cost: low data requirements but unable to capture heterogeneity of consumers (beyond distance from site) Individual Travel Cost: expensive data requirements