The Economic Approach to Environmental and Natural Resources, 3e By James R. Kahn © 2005 South-Western, part of the Thomson Corporation

Theory and Tools of Environmental and Resource Economics 3e Part I Theory and Tools of Environmental and Resource Economics 3e

Valuing the Environment Chapter 4 Valuing the Environment © 2004 Thomson Learning/South-Western

Introduction This chapter pursues the question of how we should identify our environmental objectives. One aspect of this process is the measurement of both the value of environmental resources and the value of changes in the level of environmental quality. This is essential information when comparing the benefits of environmental policy against the costs of obtaining those benefits.

What is value? First, the economic view of “value” is anthropocentric. This means value is determined by people and not by either natural law or government. Second, value is determined by peoples’ willingness to make trade-offs. When an individual spends money on one good, there is less available for other goods.

What is value? For market goods, the inverse demand curve represents a marginal willingness to pay function. Each price on the curve represents a marginal willingness to pay for a specific quantity of the good. The area under the curve at each price/quantity combination represents the total willingness to pay.

Marginal Willingness to Pay Function

Marginal Cost Function Marginal willingness to pay does not measure the total benefit associated with producing a good. Resources used to produce the good could be used to produce other goods that would benefit society, these benefits must be subtracted from total value to yield net value. Total resource costs can be examined with the aid of the marginal cost function.

Marginal Cost Function The relevant resource cost associated with a specific output level is given by the area under the marginal cost function at that output level. This area represents the opportunity cost of these resources (the productivity of these resources in their next most productive use).

Marginal Cost Function

Net value Net value for a market good is equal to the sum of consumers’ surplus and producers’ surplus. Consider the following example where the impact of air pollution on the productivity of agriculture causes less economic output per acre. This impact is represented by a leftward shift in the MC function and a resulting change in net value equal to area ABCD.

Net value for a market good

Net value for a market good The measurement process for determining the change in net value is much more complicated. In the previous example, farmers may elect to plant a different crop or change quantity of planted acreage in response to the changing productivity. Economic models consider the connectivity of markets when determining changes in net value. An example of this type of analysis is presented in Table 4.1, which looks at the impact on consumer and producer surplus from increases and decreases in different types of pollution.

Net value for a market good

Value and Non-market Goods While money is one thing that people give-up or trade-off to obtain goods, it is not the only thing. Time and other opportunities are sacrificed in order to obtain both market and non-market goods. Examining these trade-offs can serve as a basis for valuing non-market goods.

Value and Non-market Goods Non-market goods may have both direct use and indirect use values. Direct use values are associated with tangible uses of environmental resources, such as use in manufacturing processes, recreational activities, or when environmental quality affects human health.

Value and Non-market Goods Indirect use values are those associated with more intangible uses of the environment, such as aesthetic benefits or satisfaction derived from the existence of environmental resources. Indirect use values are also called passive use and nonuse values. Indirect use values include existence value, bequest value, altruistic value, option value and the value of ecological services.

Indirect Use Value – Bequest Value Bequest value refers to the fact that an individual values having an environmental resource or general environmental quality available for his/her children or grandchildren to experience. It is based on the desire to make current sacrifices to raise the well-being of one’s descendents.

Indirect Use Value – Existence Value Existence value refers to the fact that an individual’s utility may be increased by the knowledge of the existence of an environmental resource even though the individual has no current or potential direct use of the resource. An individual may never have opportunity to see a whale but places value on preserving the species.

Indirect Use Value – Altruistic Value Altruistic value occurs out of one individual’s concern for another. A person values the environment not just because that person benefits from the environmental quality but because the person values the opportunity for other people to enjoy high environmental quality.

Indirect Use Value – The Value of Ecological Services Ecological services include nutrient cycling, atmospheric processes, carbon cycling, clean air, clean water, and biodiversity. Since people do not always understand the link between ecological services and their well-being, it makes the valuation process more difficult.

Techniques for Measuring the Value of Non-market Goods The three major categories for measuring the value of non-market goods include: Revealed preference techniques, which look at decisions people make in reaction to changes in environmental quality. Stated preference techniques, which elicit values directly through survey methods. Benefits-transferred techniques, which look at existing studies for value of analogous environmental change.

Revealed Preference Approaches Hedonic pricing techniques are based on the theory of consumer behavior that suggests that people value a good because they value the characteristics of that good rather than the good itself. An examination of how the price of the good varies with change in the levels of these characteristics can reveal the prices (value) of the characteristics.

Revealed Preference Approaches- Hedonic Pricing Techniques Assume that all the characteristics of houses and neighborhoods are the same throughout the city. Houses with higher air quality would have higher prices. This positive relationship can be represented by the following equation: H = a + bQ, where H is housing price, Q is air quality and “b” tells the researcher how many units H will increase with each unit of air quality.

Revealed Preference Approaches- Hedonic Pricing Techniques In reality prices of houses are dependent on many different characteristics, all of which need to be reflected in the calculation of the impact of air quality on the price of housing. The regression analysis can be expanded to include many right-hand side variables and can be estimated in a fashion that represents non-linear relationships among the variables. Two types of variables have traditionally been included as explanatory variables in the hedonic housing price functions. Characteristics of the house itself Characteristics of the neighborhood

Revealed Preference Approaches- Hedonic Price Studies

Revealed Preference Approaches- Hedonic Wage Studies The hedonic wage approach is based on the idea that an individual will choose the city in which he or she resides in order to maximize his/her utility. The individual will consider wages and a host of other positive (educational or recreation opportunities) and negative (crime, pollution) factors. Wages adjust to compensate people for different city characteristics.

Revealed Preference Approaches- Hedonic Wage Studies Suppose a person has two job offers, one in a cold weather city and the other in a warm weather city. Suppose each job offers the same salary. If the person chooses the warm weather job, and others do too, the labor pool will increase in the warm weather city and wages will fall. The reverse happens in the cold weather city. The difference between the wages in the warm weather city and the cold weather city compensates people for the disutility of living in the cold weather. This compensating differential can be used to look at value placed on environmental amenities or risk.

Revealed Preference Approaches- Travel Cost Model The travel cost model is a method for valuing environmental resources associated with recreational activity and was first proposed by Harold Hotelling in 1947. The basic premise is that travel cost to a site can be regarded as the price of access to the site. Multiple observations on travel cost and quantity of visits can be used to estimate a demand curve.

Revealed Preference Approaches- Travel Cost Model Once a demand curve has been estimated, the value of the site to an individual can be estimated by computing consumer surplus for each individual in the survey, calculating an average consumer surplus and then multiplying by the estimated number of recreationists. The travel cost demand curve is often expanded to include other explanatory variables such as age, income, family size, education level, and other socioeconomic variables.

Revealed Preference Approaches- Travel Cost Model

Revealed Preference Approaches- Travel Cost Model In order to measure how the travel cost demand curve shifts as environmental quality shifts, the travel cost demand curve must be estimated with quality as an explanatory variable. There are methodological issues which remain unresolved concerning the appropriateness of the travel cost model. These include: How to incorporate the opportunity cost of travel time. How to properly account for substitutes (multiple sites). How to account for a variety of sampling biases. How to properly measure recreational quality and relate this to environmental quality.

Stated Preference Techniques Stated preference techniques solicit values directly by asking individuals hypothetical questions. Contingent valuation is the most widely used stated preference valuation technique. This method ascertains value by asking people their willingness to pay for a change in environmental quality.

Stated Preference Techniques- Contingent Valuation The questions used in contingent valuation can take both open-ended and close-ended form. In open-ended questions, respondents are asked to state their maximum willingness to pay. In close-ended questions, respondents are asked to say whether or not they would be willing to pay a particular amount. The questions must also specify the mechanism by which payment will be made. Consider the following:

Stated Preference Techniques- Contingent Valuation

Stated Preference Techniques- Contingent Valuation Information is provided about cause and effect. The payment vehicle is clearly stated and is appropriate to the particular problem. Care must be taken so that the contingent valuation exercise does not become a referendum on the payment vehicle, for example the choice to raise taxes.

Stated Preference Techniques- Contingent Valuation Although the contingent valuation method has been widely used for two decades, there is considerable controversy over whether it adequately measures people’s willingness to pay. These arguments are based on informational issues and on the fact that people may be indicating their value of something other than the particular environmental issue.

Stated Preference Techniques- Contingent Valuation The informational issue revolves around the fact that people do not have practice valuing environmental issues so they are not certain what they are willing to pay. A second issue revolves around the fact that the expressed willingness to pay may be biased because the respondent wants to feel good, be thought of as a good person, or signal importance of the issue but not actual willingness to pay. A different problem is the potential link the respondent makes between the question and other issues, for example reduced pollution and reduced health risks. This may result in double counting. Finally, some researchers believe there is a fundamental difference between hypothetical decisions and actual decisions.

Stated Preference Techniques- Conjoint Analysis Conjoint analysis is a technique employed by researchers in marketing, transportation, psychology, and increasingly economics for determining individual preference across different levels of characteristics of a multi-attribute choice. Consumers are asked to state which of two hypothetical goods they prefer, each having a stated level of different characteristics. These choices can be made in a pair-wise fashion or by ranking a number of alternatives. Statistical techniques are used to establish a relationship between characteristics and preference.

Stated Preference Techniques- Conjoint Analysis As long as one of the characteristics is price, it is possible to use the preference function to derive the willingness to pay for changes in the levels of characteristics. Conjoint analysis can be viewed as a hedonic price technique, where hypothetical price substitutes for actual market price. Conjoint analysis could be used to value forest quality and the importance of various forest characteristics by defining characteristics of age of trees, diversity of trees, diversity of other organisms, etc.

Stated Preference Techniques- Conjoint Analysis Conjoint analysis can be used to directly value alternative national environmental policies by asking respondents to compare alternative scenarios. One advantage of conjoint analysis over contingent valuation is that it does not ask respondents to make a trade-off between environmental quality and money. It asks respondents to state a preference between two choices. This eliminates some of the biases associated with contingent valuation.

Stated Preference Techniques- Benefit Transfer Approaches The process of estimating values using revealed preferences or stated preferences approaches can be quite expensive. Benefit transfer refers to the process of taking values from studies that were previously completed in other areas, and applying them to the area where the new decision must be made. Although benefit transfer is not a “scientific methodology” it is associated with hypothesis testing and formal confidence intervals and there is a set of alternative methodologies that can be employed to maximize the quality of information.

Stated Preference Techniques- Benefit Transfer Approaches It is important to use a reference study that is congruous. If many reference studies are available, the process becomes much easier. The appropriate reference study can be chosen, or a weighted average of the values can be employed, where weights are chosen according to similarity between the reference study and the problem at hand.

Non-willingness to Pay Based Value Measures Three cost-related techniques fall into this category. Avoidance cost- the cost people incur to avoid the negative consequences of an environmental change. Replacement cost – the cost of recreating what was lost to environmental change. Restoration cost – the cost of repairing the environmental damage. Problems: Is the restored/replaced environment equivalent? Is the value lower because it is no longer authentic?

Summary Even though the economist’s definition of value is not universally accepted, it can make a substantial contribution to the decision-making process. Revealed preference approaches can help measure direct use values. Stated preference approaches can estimate indirect use values.