Valuation 8: Defensive expenditures (HPF) Revealed preference methods Defensive expenditures Damage costs Defensive expenditures: A simple model An example: Urban ozone

Last week Contingent choice modelling and its variants Steps and design stages for choice modelling Some econometrics Application to green product choice

Revealed preference methods People make choices within markets: prices paid and quantities purchased Derive values people place on environmental amenities and disamenities from purchase decisions Stated preference methods: intended behaviour; non-use values Four commonly used methods: TCM, HPM, defensive expenditures and damage costs

Revealed preference methods -2 MethodRevealed Behaviour Conceptual Framework Types of Application HedonicProperty purchased or choice of employment Demand for differentiated goods Property value and wage models Travel CostParticipation in recreation activity and site chosen HPF, weak complements Recreation demand Defensive Expenditures Expenditures to avoid illness or death HPF, mostly substitutes Morbidity /mortality Cost of Illness Expenditures to treat illness Treatment costs Morbidity

The Household production function approach A household combines an environmental good/bad with market goods to produce and „experience“ that directly provides utility To enjoy a national park people must visit the park and this costs money To defend against an environmental bad such as traffic noise money is spent on insulation The household production function (HPF) approach involves investigating changes in the consumption of commodities that are substitutes or complements for the environmental good of interest

Defensive expenditures Measures the “demand” for environmental bads A rational consumer buys self-protection up to the point where the marginal cost of additional measures exceeds the marginal benefits from the reduction Averting inputs include air filters, water purifiers, noise insulation and other defensive or self- protection inputs; these are substitutes In all these cases an individual combines quantities of a public bad with a quantity of a market good to produce what actually gives utility

Excurse: Damage costs The method estimates the resource cost associated with environmental change, rather than WTP –Does not include any estimate of consumer surplus or marginal prices In the health context: cost of illness approach This is the sum of direct and indirect costs associated with illness, injury, or death Direct costs (out-of pocket expenses) –Diagnose, treat, rehabilitate, or support ill or injured persons Indirect costs (the value of output that is not produced) –Mainly foregone earnings

Defensive expenditure: A simple model Noise pollution (P) from a nearby road –higher Ps are worse The individual is only interested in the level of quiet within the house (Q) –higher Q is better The homeowner buys noise insulation and other equipment to reduce the level of noise within the house Defensive expenditure: D(Q,P) to achieve Q for a given P

The homeowner’s problem The homeowner’s problem to choose between conventional goods (X) and Q is: Outdoor noise does not enter the utility function, it is outside of the control of the individual Q X Y=X+D(Q,P) U 0 =U(X,Q) U 1 =U(X,Q) Y X* Q* D(Q*,P)

A simple model (2) Suppose the level of noise (P) increases slightly –consumer has to spend more to achieve same noise level If income increases –The level of utility is the same –Compensating surplus What happens if income is not adjusted? –Lower level of utility –Substitution effects: Q drops Defensive expenditure < true marginal WTP

The effect of a change in pollution Q X Y=X+D(Q,P 2 ) U2U2 U1U1 Q2*Q2* Y=X+D(Q,P 1 ) Q1*Q1* P 2 > P 1

Algebraically Suppose we change P slightly by  P The consumer adjusts the choice of Q and X Defensive expenditure changes by  D and indoor noise levels by  Q  D=D(Q+  Q, P +  P)-D(Q,P) =D(Q+  Q, P +  P)-D(Q, P +  P)+ D(Q, P +  P)-D(Q,P) =D Q  Q+D P  P D Q =[D(Q+  Q, P +  P)-D(Q, P +  P)]/  Q D P =[D(Q, P +  P)-D(Q,P)]/  P The marginal WTP to avoid a change in P  D/  P =D Q (  Q/  P)+D P Generally:  D/  P <D P

An example: Urban ozone Significant extension to previous model –pollution level enters directly into the utility function Study by Dickie and Gerking (1991) Estimate the demand for ozone pollution for two cities in the metropolitan area of Los Angeles –Burbank and Glendora Compare the results to out-of-pocket medical expenses (damage costs) associated with elevated ozone in each of the two cities

Burbank and Glendora Suppose Burbank Glendora New Standard Old Standard

The basis of the analysis Both cities have a significant amount of air pollution What is the WTP for an average resident of each city to reduce the maximum ozone level during a year to either 12 or 9 pphm? The analysis is based on people’s willingness to purchase health care to compensate for the health-related damage from ozone pollution Ozone causes coughing and other breathing difficulties

The modelling approach Utility is a function of market goods (X), health (H) and exposure to air pollution (A) Defensive expenditure (M) depends on health (H), air pollution (A) and the individuals health status (R) We write this as a health production function which tells us how much health will result if M is spent on medical care The budget constraint is defined on the basis of time available to generate income

The modelling approach (2) The indirect utility function giving maximum utility attainable is If we could observe utility we could statistically estimate the equation Dickie and Gerking compensate this by observing whether people visit a doctor If they do, there must be a utility gain from visiting and V 1 (M>0) > V 0 (M=0) They use a random probability model and estimate the probability to visit a doctor The binary choice problem is M>0 if V 1 - V 0 > 0 and M=0 if V 1 - V 0 = 0

The data Sample of 256 residents of the two cities All are household heads with full-time jobs Married white males with compromised respiratory functions are oversampled Respondents were asked about –long-term health status –contacts with the medical care delivery system –socio-economic/demographic and work environmental characteristics –typical out-of-pocket expenses incurred for a visit to their doctor –commuting and waiting time required to see their doctor Each contact with a respondent was matched to daily measures of ambient air pollution concentrations

The results

Conclusion Estimates are lower bounds As expected, out-of-pocket medical expenses are much lower Earlier studies on defensive expenditures found much smaller values –$0.04 to $4.00 per year per person –Other regions –Lower ozone levels –No oversampling of respiratory impaired CV studies found similar values The broad range of WTP estimates poses an awkward situation for policy makers