Transcript Chapter 5

The Economic Approach to
Environmental and Natural
Resources, 3e
By James R. Kahn
© 2005 South-Western, part of the Thomson Corporation
Part I
Theory and Tools of
Environmental and Resource
Economics
3e
Chapter 5
Environmental Decision
Making: Criteria and Methods
of Assessment
© 2004 Thomson Learning/South-Western
Introduction
 This chapter shows how the economic value
measures discussed in Chapter 4 can be used to test
the “economic efficiency” of a potential decision or
outcome.
 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.
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Decision-Making Criteria
 The development of a set of criteria on which
to base public policy decisions is difficult.
 Everyone agrees on a few key criteria, for
example, economic efficiency.
 However there is general disagreement about
what other criteria should be considered.
 The following is a suggested list of relevant
criteria.
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Decision-Making Criteria
 Economic efficiency
 Equity
 Sustainability
 Environmental Justice
 Ecological impact/environmental
stewardship
 Ethics
 Public participation
 Advancement of knowledge
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Economic Efficiency
 Economic efficiency has to do with
maximizing the difference between the social
benefit and social cost of an economic
activity, policy, or project.
 Economic efficiency is usually measured in
one of two different ways:
Net economic benefit – preferred by economists and
explored in Chp. 4;
Gross domestic product – preferred by international
development and lending agencies.
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Economic Efficiency – Net Economic
Benefit
 As the information presented in Chapter 4
indicated, the demand curve represents
marginal willingness to pay and the supply
curve represents marginal opportunity cost
of production.
 Net economic efficiency subtracts total
opportunity cost from total willingness to
pay and is represented by the area under the
demand curve and above the supply curve
for a particular good or service.
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Economic Efficiency – Gross Domestic
Product
 Gross Domestic Product is a measure of the
total value of all goods and services
produced in an economy.
 Because expenditures become income, GDP
is also a measure of national income.
 GDP is not a measure of social welfare
because it does not measure other
dimensions of the quality of life, such as
health, environmental quality, social justice,
freedom from crime, etc.
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Economic Efficiency – Gross Domestic
Product
 GDP also fails as a measure of economic efficiency.
 It does not consider the opportunity costs of
producing the good or service.
 This failure means that GDP would rise because of a
rise in HIV/AIDS due to the increased expenditure on
health care costs.
 Net economic efficiency would not rise because this
measure includes the opportunity cost of using
those monies in next best option.
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Economic Efficiency – Pareto Criterion
 What constitutes an improvement in economic
efficiency?
 One option is the Hicks-Kaldor criterion, or the
criterion of potential Pareto improvement.
 Pareto improvement – resources are reallocated in
such a fashion that some people are better off and
no one is worse off.
 Potential Pareto improvement – is reallocation
whereby the gain of people who are helped is larger
than the losses of those made worse off. If the
gainers could compensate losers, the gainers would
still be better off.
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Equity
 Potential Pareto improvement does not
consider equity issues.
 The equity criterion for evaluating policy
considers how costs and benefits are
distributed among members of society.
 These distributional impacts could be within
a country, across international borders, or
across generations.
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Intracountry Equity
 Both environmental degradation and environmental
policy create consequences for reducing or
increasing the differential in the quality of life that
may exist across subgroups of a country’s
population.
 In the past environmental quality was perceived as a
luxury good, ill afforded by lower income individuals.
 The negative impact of environmental degradation
on agrarian life and urban environments has lead to
a change in this view.
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Equity Across Countries
 Some environmental problems such as global
warming require international cooperation.
 In the area of preservation of shrinking
environmental resources, lower-income countries
bear the burden of preserving these for the higherincome countries.
 Many policy makers in lower-income countries think
they should be compensated for their preservation
efforts.
 There is also the potential link between poor
environmental quality and lower standards of living.
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Equity Across Generations and
Sustainability
 Intergenerational equity is important because
many of the decisions regarding resource
use today may generate important
environmental costs for future generations.
 The process of discounting future costs and
benefits can exacerbate this problem.
 An alternate criterion of sustainability is
based on improving the condition of the
current generation without compromising the
ability of future generations to meet their
needs and improve their quality of life.
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Equity Indicators
 Income is one component of equity.
 Two different measures are the primary tools for
considering the inequality of the distribution of
income, the Lorenz curve and the Gini coefficient.
 Figure 5.2 contains an example of a Lorenz curve.
 The curve illustrates the percentage of income
received by a given percentage of the population.
 Equity is illustrated by the diagonal line bisecting the
origin. Along this line the two percentages are
equal.
 Inequity in income distribution is illustrated by a
curved line.
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Equity Measures - Lorenz Curve
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Equity Measures – Gini Coefficient
 The farther the Lorenz curve is skewed away from
the diagonal line, the more inequitable the income
distribution.
 This curve can be transformed into a single variable,
the Gini coefficient.
 The Gini coefficient is calculated by taking the area
between the diagonal line and the Lorenz curve and
dividing by the entire area under the diagonal line.
This value is then multiplied by 100.
 The Gini coefficient can range from 0 to 100, where
greater numbers are associated with greater
inequity.
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Equity Measures – Gini Coefficient
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Equity -Environmental Justice
 Studies have suggested that certain segments of the
population face disproportionate exposure to
environmental risk.
 In the US, minorities, especially those of low income
living in rural areas, face greater exposure to
carcinogenic and mutagenic hazardous chemicals.
 In developing countries, with giant cities, levels of
air pollution as well as exposure to toxic waste
surpass that of developed countries.
 Environmental justice is an issue in rural areas
where high levels of pesticide use by large
plantation owners impacts villages downwind.
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Ecological Criteria
 There is no consensus on how to develop
measures for quality and functionability of an
ecological system.
 The first question is how to define a
desirable state of an ecosystem.
Ecosystem health – measures a system’s ability to
provide a flow of ecological services.
Ecosystem integrity – measures the closeness of
the system to a hypothetical reference system that
is completely undisturbed by human activity.
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Ecosystem Health
 Difficult to define what would constitute a
healthy ecosystem in terms of the flow of
ecological services.
 Schrader-Frechette (1998) argues that
ecosystem health can be measured with an
extension of the traditional ecological risk
paradigm.
 She discusses the “wholistic” health
approach.
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Ecosystem Health
 Shrader-Frechette notes that many proponents of
the concept believe it to be related to at least 3
ecosystem characteristics:
 An ecosystem’s ability to maintain desirable vital signs.
 An ecosystem’s ability to handle stress.
 An ecosystem’s ability to recover after perturbations.
 She notes that there are no nonnormative value-free
ways to operationalize this concept.
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Ecosystem Integrity
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Ecosystem Integrity
 Cairn’s definition is difficult to operationalize
because the definition has nine components,
each of which is multidimensional.
 For many urbanized, industrialized, or highly
agriculturalized areas, the concept of
ecological integrity might be inappropriate.
 The concept of ecosystem health may be the
better choice.
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Operational Indicators of Environmental
Quality
 At least 4 methods have been suggested to
develop operational indicators:
The use of “representative” environmental
variables.
The use of a “green” GDP.
The development of satellite accounts for National
Income and Product Accounts.
The development of indices of sets of environmental
variables.
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Representative Environmental Variables
 Measures of individual types of pollution
have been used where the trend in these
variables somehow reflected the trend in
environmental quality.
 This concept is similar to using output in the
steel industry as a proxy for GDP.
 While using the spotted owl as an indicator
species for the Pacific old-growth forests
might be appropriate, it would be very
difficult to identify an indicator species for as
diverse a system as the Amazon.
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Green GDP
 Many economists have argued that
disastrous consequences for the
environment result when macroeconomic
policy is based on growth of GDP.
 While net domestic product (NDP) subtracts
the depreciation of human-made capital from
GDP, it does not consider the depreciation of
natural capital.
 If increasing NDP is the primary policy goal,
then the loss of future income from depleted
natural capital is important.
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Green GDP
 The resulting measure would still only take
into account one link between the
environment and social welfare.
 It ignores the direct effect of the health of the
environment on social welfare.
 In addition, macroeconomic approaches tend
to focus on environmental resources that are
part of the economic production process and
less on the resources that contribute to more
basic life support services or amenities.
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Satellite Accounts
 The United Nations Statistical Division
recommends the development of a system of
environmental satellite accounts to monitor
environmental change.
 Environmental costs, benefits, and natural
resource assets, as well as expenditures for
environmental protection, are presented in
flow accounts and balance sheets in a
manner consistent with National Income and
Product Accounts.
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Satellite Accounts
 Satellite accounts represent a disaggregation
of measures of environmental change.
 Satellite accounts could serve as inputs for
developing indicators of environmental
change but not as independent sets of
indicators.
 The development of independent indicators
to examine the trade-offs and overall trends
in environmental change would require a
large number of measures.
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Aggregate Indices
 The US Environmental Protection Agency’s
Environmental Monitoring and Assessment Program
(EMAP) attempts to develop overall indicators for
individual ecosystems.
 In the case of estuaries, EMAP develops a series of
over 20 indicators, but creates an aggregate index
by summing the indicators based on water clarity,
the benthic index, and the presence of trash.
 There is equal weighting for each individual
indicator.
 Alternatives to equal weighting include normalizing
each variable by dividing by its largest value and/or
choosing weights based on expert opinion.
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Ethics
 Ethical dimensions are particularly important and
particularly difficult to quantify.
 Does the firm or agency have an ethical obligation
for environmental stewardship independent of the
impact on social welfare?
 Should decision-making have an anthropocentric or
biocentric approach?
 “Deep ecology”, developed by Arne Ness, rejects
management of the environment. All components of
an ecosystem, as well as the ecosystems
themselves, have an intrinsic value and an inherent
right to exist.
 Ethics can be treated as constraints to the decisionmaking process.
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Public Participation
 This is a very different type of decision-making
criterion because it relates more to process than
outcome.
 Fairness and appropriateness of process of arriving
at the outcome are also considered to be important.
 A good public participation process begins with
identifying stakeholders.
 A process must be developed where people feel free
to voice their concerns.
 Skilled moderating is needed.
 All results of the process must be communicated to
the public at large.
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Public Participation
 Unlike the old-style public participation process of
“decide-announce-defend”, most environmental
agencies now begin the public participation process
early in the decision-making process.
 Four major techniques have been used to
incorporate public participation:
 Incorporate information about stakeholder preferences in
the decision-making process.
 Allow stakeholders to negotiate a solution amongst
themselves.
 Allow stakeholders to arrive at a solution through roleplaying.
 Empower a representative group of stakeholders to hear
the evidence and make a decision, jury style.
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Advancement of Knowledge
 This criterion is extremely diverse and has
multiple attributes.
 Care must be taken to include advancement
of knowledge in the decision-making
process.
 This is best done in a qualitative fashion,
because experts can evaluate the importance
of potential gains in knowledge associated
with a project or decision.
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The Use of Multiple Criteria in Decision
Making
 How do policy makers take multiple decisionmaking criteria and jointly employ the criteria
so as to inform the actual decision?
 If too much aggregation is done across
criteria, then a lot of the information that is
contained in the different criteria will be lost.
 Cost-benefit analysis is one approach which
has been frequently employed and is even
legally required of governmental agencies in
many countries.
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Cost-Benefit Analysis
 The most important concept is that cost-benefit
analysis is NOT a decision-making tool; it is only an
information organizing tool.
 There is no single correct answer to a cost-benefit
analysis exercise.
 Different assumptions about future states of the
world or key analytical parameters will have a big
impact on the final outcome.
 The analysis should produce a suite of numbers
reflecting the sensitivity of the analysis to alternative
analytical assumptions.
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Cost-Benefit Analysis
 Cost-benefit analysis should be a dynamic
analysis, investigating costs and benefits far
into the future, where future costs and
benefits are discounted.
 The simplest version of a discounting
formula is PV = FV(1/(1+r))t,
 where PV is present value, FV is future value,
r represents the discount rate and t is the
time period.
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Cost-Benefit Analysis
 The objective of cost-benefit analysis is to identify
the alternative project, plan, or policy that has the
greatest net present benefit, which will therefore
maximize economic efficiency.
 A critical aspect of the analysis is the choice of the
appropriate discount rate.
 The market rate of interest is not appropriate
because it includes inflation rates and risk
components.
 Many analysts argue that the rate used should be the
real, risk-free rate of interest.
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Cost-Benefit Analysis
 The choice of discount rate is critically important
because it represents the relative importance of the
future.
 Even small differences in discount rate can become
very important.
 This is illustrated in Table 5.3, where the present
value of a future stream of income decreases by 90
percent with a 1 percent change in the discount rate.
 This difference in value is much less at greater
distances in the future where the value in the distant
future is unimportant.
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Cost-Benefit Analysis
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Cost-Benefit Analysis
 Displacement theory suggests that the appropriate
discount rate to use is one that reflects the
opportunity cost of government intervention or the
rate of return on private investment which was not
made.
 However, it is important to recognize that no
individual investment can grow faster than GDP for
long periods of time.
 As such, the discount rate should be no greater than
the long-term real rate of growth of GDP.
 Sensitivity analysis should be performed to
determine the sensitivity of present value measures
to alternative choices of discount rates.
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Cost-Benefit Analysis
 The first step in implementing any costbenefit analysis is to determine what should
be evaluated.
 The analyst must identify the credible
alternatives to the proposed project and
include them in the cost-benefit analysis.
 In defining alternatives, the analyst must
consider political feasibility, technical
feasibility, and economic feasibility.
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Cost-Benefit Analysis
 The next step is to list the costs and benefits
to make sure that all relevant issues are
considered.
 Care must be taken to factor in
environmental costs, both on-site and offsite.
 In some cases religious, cultural, and
historical significance must be taken into
account.
 Indirect costs must also be considered.
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Cost-Benefit Analysis
 In general, benefits are easier to measure
than costs.
 It is important to recognize alternative
solutions in the measurement of the benefit
of one project.
 It is also important to recognize both private
and social benefits associated with a project.
 It is important to recognize the difference
between the creation of new benefits and the
transfer of benefits from one area to another.
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Cost-Benefit Analysis- Multiple Scenarios
 It is important to build different scenarios
when conducting a cost-benefit analysis.
 These different scenarios need to consider
differing assumptions or predictions about
the future states of the world.
 Among these are:
Rates of population growth
Rates of growth in GDP
Level of global climate change
Rate of technological innovation
Change in environmental policy.
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Cost-Benefit Analysis-Decision Rules
 Each scenario should also be evaluated
using different discount values.
 Various decision rules can be made to allow
qualitative comparison and determination of
which projects are best.
 Examples of decision rules include:
Choose the project that is in the top ranking in the
most states of the world.
Choose the project that is in the top two categories
in the most states of the world.
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Cost-Benefit Analysis – Missing Values
 One of the major problems with cost-benefit analysis is how to
deal with missing values.
 It is not appropriate to use a value of zero.
 If the missing value is associated with environmental costs,
then it is possible to conduct an analysis without the costs and
then consider how the answer might change with those costs
factored in.
 Alternative approaches to comparing projects with missing
information include:
 The dominance method choose the option that is best across multiple
scenarios;
 Estimate how big the missing value would have to be to change the
outcome.
 Provide general impressions of the unmeasured environmental
benefits.
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Multiple Decision-Making Criteria
 One way to incorporate multiple criteria within decision making
is to use a public participation process.
 All the alternatives can be scored according to the criteria and
the public can be used to choose.
 If there is more than one decision-making criterion, then the
decision-makers must assign different weights.
 One method is to assign weights through informal discussion
of the merits of each.
 Formal weights can be assigned through a consensus among
decision-makers.
 A more quantitative approach is to use conjoint analysis.
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Marginal Analysis
 Cost-benefit analysis is a good tool for
choosing between a set of discrete
alternatives.
 Marginal analysis is useful when a choice
must be made about which level to choose
from a potentially infinite spectrum.
 As discussed in Chapter 3, marginal damage
functions and marginal abatement functions
can be used to identify the optimal level of
pollution.
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Marginal Damage Functions
 A marginal damage function specifies a relationship
between an incremental unit of emissions and the
damages the emissions generate.
 As Figure 5.5. illustrates, this relationship is actually
a complex series of cause-and-effect relationships.
 The first set examines how pollution emissions
generate concentrations of pollution in the
environment.
 The next set considers how exposure occurs.
 The next considers the impact of exposure.
 The next considers the damages which result and
finally, the resulting change in social welfare.
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Marginal Damage Function and Policy
Analysis
 It quite unlikely that it will be possible to
completely identify the set of marginal
abatement cost functions and marginal
damage functions for a particular problem.
 Even so, knowledge of the properties of a
particular damage function can help identify
policy goals.
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Summary
 The science in support of environmental policy
decisions has made important strides.
 Various research and analytical tools can help
narrow the decision set and further guide the
decision process.
 While not always used correctly, cost-benefit
analysis has proven to be a useful tool in organizing
information about economic efficiency.
 The most important need in terms of making better
decisions is the need to develop better indicators
related to the nonefficiency related decision-making
criteria.
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