Transcript Memorial University of Newfoundland

ECON 6012
Cost Benefit Analysis
Memorial University of Newfoundland
Lesson 9 (Chapter 14)
VALUING IMPACTS FROM OBSERVED BEHAVIOR:
INDIRECT ESTIMATION OF DEMAND CURVES
Purpose
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This chapter presents various methods
for estimating shadow prices based on
observed behavior when markets for the
(primary) good, such as human life, do
not exist.
Considerable progress has been made
during the past 30 years to value goods
that were previously treated as
“intangible”
Overview
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Why do we need a Theory of Environmental
Demand?
Welfare Foundations of Demand Theory
Contingent Valuation
Why do we need non-market valuation?
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economic decisions involve a trade-off of resources
=> we need to be able to ascertain the monetary
value placed on environmental goods/bads
to calculate the MB of environmental improvements,
or the MD of an environmental deterioration
We had always assumed that we did know about
these!!! But how do we get to know???
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conventional demand theory?
Conventional demand theory will help us
estimate how much people are willing to
sacrifice to enjoy a good or service
By observing pairs of price and quantity for
different individuals or for different markets
or the same market at different points in time
Why do we need non-market valuation?
PRICE
QUANTITY
Why do we need non-market valuation?
PRICE
Often the linear functional
form is assumed
QUANTITY
Why do we need non-market valuation?
PRICE
Once we have estimated a
demand function we know
About many things…
QUANTITY
Why do we need non-market valuation?
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conventional demand theory?
The problem is that many goods whose
markets the project affects are not traded in
markets as other goods!!!
For example, for many goods related to the
natural environment we cannot observe the
pairs of price and quantity
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But, to a certain extent, we can get around the
problem of the absence of markets
That is what non-market valuation is for
Non-market valuation
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We can use direct methods (based on
market prices somehow)
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Example: we do not buy and sell clean water, but we buy and sell fish
or we pay doctor bills if we get sick from the water or we forego
wages when we are sick from the water
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Or indirect methods (stated preference or
revealed preference methods)
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There are no market prices to use, but we can still get information
from what individuals say they would hypothetically pay or do or
from what they actually choose to do under different circumstances.
Non-market valuation
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We can use direct methods (based on
market prices somehow)
…So we use market prices
Or indirect methods (stated preference or
revealed preference methods)
…So we impute market prices
Stated versus revealed preference methods
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We can ask them => stated preference
methods (Contingent Valuation)
We can try to infer it from their behaviour
in other markets => revealed preference
methods
The latter include the Travel Cost Method
and the Defensive Expenditure Method,
both based on the Production Function
Approach, and Hedonic Price Methods
Stated versus revealed preference methods
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Revealed preference methods exploit the
idea that some environmental
goods/services are related to marketed
goods
In particular, we may want to find
substitutes or complements of those
environmental services we want to value
Stated versus revealed preference methods
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With stated preference methods, we do not need
that
We simply ask!
Example of these methods include contingent
behaviour, conjoint analysis, choice experiments,
contingent ranking and other complex procedures
in constant developing
They are all based on asking individuals to state a
preference and inferring information from that
We will focus on the contingent valuation
method
MARKET ANALOGY METHOD
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uses data on similar goods in the private market to
estimate the implicit “price” or the demand curve for
publicly provided goods.
MARKET ANALOGY METHOD
Using the Market Price of or Expenditures on an
Analogous Good
 The market price of a comparable good in the private
sector provides a good estimate of the value of a
publicly provided good if it equals the average
amount that users of the publicly provided good
would be willing to pay (WTP).
 Where the government provides a good or service at
a lower than market price, the price paid by
occupants would generally underestimate the benefit
of this service because users would be WTP at least
this amount; some might pay more.
MARKET ANALOGY METHOD
Using Information about an Analogous Private-Sector Good
to Estimate the Demand Curve for a Publicly Provided
Good
 Rather than focus on the average amount that users of a
publicly provided good are willing to pay, it is conceptually
better and easier to think about the demand curve for the
good.
 We can use private-sector data to help map out the demand
curve for a publicly-provide good if the goods and their
markets are similar.
 Of course, using expenditures alone underestimates total
benefits because it ignores consumer surplus.
THE TRADE-OFF METHOD
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Economists may use the opportunity cost as a
measure of its value.
For example, time saved could be valued
using the after-tax wage rate.
Similarly, the trade-off that people make
between changes in fatality risk and wages
can be used to value a statistical life.
The Value of Time Saved
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The obvious analogous market for time saved
is the labor market.
In the absence of market imperfections (i.e.,
people can choose the number of hours they
work and there is no unemployment), the
wage rate equals the marginal value of time.
However, there are some problems in using
the wage rate to value time saved…
The Value of Time Saved
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Wages ignore benefits. As benefits are a form
of compensation for work, they should be
added to wages.
People could be working while traveling or
waiting and, therefore, time saved would be
worth less than the wage rate (plus benefits).
It should take account of taxes and, for people
who are not working, use the after-tax wage
rate (plus benefits).
The Value of Time Saved
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People value different types of time differently.
Importantly, many people enjoy traveling.
The wage rate may not be appropriate due to
rigidities in the market or market failures. For
example, people may not be able to easily adjust the
number of hours they work.
Firms may not pay employees their marginal social
product.
In conclusion, using the wage rate is only a first
approximation.
The Value a Statistical Life
Forgone earnings method  This method suggests the value of a life saved equals
the person’s discounted future earnings.
 It generates higher values for young, high-income
males than old, low-income females.
 For retired people, the resultant value of life may be
negative.
 Conceptually, the main problem with this method is
that it does not reflect what people are WTP for a
small reduction in risk of their death.
The Value a Statistical Life
Simple Consumer Purchase Studies –
 This method estimates the value of life by
observing how much people pay for lifesaving devices, such as safety belts.
 If people are willing to pay an extra $300 to
reduce the probability that they will die by
1/10,000, then they value life at $3 million.
The Value a Statistical Life
Simple Labor Market Studies
 Similarly, if a person is willing to forgo an extra
$3,500/yr to increase the probability that he will not
have a fatal on-the-job accident by 1/1,000, then he
values his life at $3.5 million (or more).
 The imputed value of life varies according to the
initial risk and the additional level of risk people are
asked to assume due to diminishing marginal utility
for safety.
Problems with Simple Consumer and WageRisk Studies
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These methods assume workers and
consumers fully understand the risks, which
they may not.
They also assume that people in the studies
are representative of the population, while
they may not be (sample selection).
For example, people who take risky jobs may
be may like to take risks which would lead to
a relatively small gap in the salary between
risky and less-risky jobs.
Problems with Simple Consumer and WageRisk Studies
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Third, they assume that researchers have
accurate measures of the risks (e.g. mining
company secretary versus actual miner!!!).
Fourth, the willingness to pay to reduce risk
depends on the level of risk (diminishing
marginal value of safety) and our policy might
need to measure risk at a different level that
the original study
Also, this method assumes that the relevant
markets are efficient and all other variables
are constant (no omitted variable problem).
INTERMEDIATE GOOD METHOD
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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 = NI(with project) – NI(without project)
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where, NI = net income of downstream business.
The total benefit of a project can be computed by
discounting annual benefits over the project’s life.
This method can be used to value improvements in
human capital, such as training programs, by
comparing the average incomes of those in the
program to those who are not.
INTERMEDIATE GOOD METHOD
Some problems with this method are:
 It assumes the difference in income captures
all of the benefits (there may be consumption
benefits)
 It assumes all other variables are held
constant (e.g., ability).
ASSET VALUATION METHOD
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The impacts of a project or policy can be imputed from
changes in the price for certain capital goods.
For example, the “value” of noise can be inferred from
comparing the price of a house in a noisy neighborhood to the
price of a similar house in a quiet neighborhood.
Changes in the market values of firms following a regulatory
change can be used to estimate the change in producer surplus
of the new regulations (an event study).
An advantage of using prices is that information is quickly
and efficiently capitalized into prices so that price changes or
price differences provide a good estimate of the value of the
policy change. Also, appropriate data are often available in
machine readable form. 
PROBLEMS WITH SIMPLE
VALUATION METHODS
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All of the methods discussed above suffer potentially
from the omitted variable problem and self-selection
bias.
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One solutions is to use the hedonic price method
The Hedonic Price Method (HPM)
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Finds a link between the environmental good (say
air quality) and a market good (say housing)
Assumes that house prices depend on
characteristics of housing
One or more of these may be something for
which a conventional market is not available
Others are site based (number of bedrooms) and
neighbourhood-based (crime rate)
The Hedonic Price Method (HPM)
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It assumes that any meaningful differences
in the characteristics of houses will have
been capitalized in the price of the house
This method offers a way to overcome
problems from omitted variables and
sample-selection bias
The Hedonic Price Method (HPM)
Three step approach to implementing the method
 First, estimate regression equation relating house
prices to housing characteristics, including
environmental characteristic of interest (say it is
noise levels, Q1), neighbourhood variables (N)
and site variables S:
 Ph = f ( S1…Sm ; N1…Nn ; Q1…..Qp )
The Hedonic Price Method (HPM)
Three step approach to implementing the method
 Second, find partial effect of Q1 on house prices,
Ph. This is the marginal cost of Q1; may vary with
level of Ph . Partial effect shows the change in P
for the change in Q, P / Q
 This is the implicit or hedonic price of that
characteristic
 Third, estimate demand curve for Q using (Q,P)
pairs and other relevant data (say income)
The Hedonic Price Method (HPM)
Problems:
 Limited applicability: doesn’t work for many
environmental goods
 Data intensive: need lots of info on house sales
 Segmentation between housing markets; should
we estimate more than one equation?
 Uncertainty: what do people know about
current/future levels of environmental quality?
The Hedonic Price Method (HPM)
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A variant, the hedonic wages model, can be used
to measure the effect of varying levels of risk or
exposure to environmental bads on wages
In equilibrium wage differences will have
adjusted to reflect differences in environmental
attributes of the job
But what if the job market is not really flexible
(lack of mobility, or segmentation again, or wage
discrimination????)
The Hedonic Price Method (HPM)
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Again, it assumes that the workers have perfect
information about the environmental conditions
of the job
The Hedonic Price Method (HPM)
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People must know and understand the
implications of the attribute that is being
valued.
For example, people should know the level
of pollution at the property they buy and
know the expected effect of this level of
pollution on their health.
The Hedonic Price Method (HPM)
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Variables should be measured without
error (the errors in variables problem).
Functional forms should be correct
(specification error problem)
Market should have enough alternatives so
that people can locate at their optimum
point on the curve
The Hedonic Price Method (HPM)
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There may also be multicollinearity
problems, e.g., fatality risk and non-fatality
risk might be highly correlated.
Dropping one variable would lead to an
omitted variable problem
Markets are assumed to adjust immediately
to changes in the attributes of interest and
to all other factors.
Travel Cost Method
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relationship between observed visits and the
cost of visiting is derived
this relationship is used to derive a surrogate
demand curve from which consumers'
surplus per visit-day can be measured (by
integrating under this curve)
Avoids the problem that fee is non-existent or
the same for everyone
Travel Cost Method
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Travel Cost Method (TCM): one of the oldest
approaches to non-market valuation
It uses travel costs as a proxy for the price of
visiting outdoor recreational sites
Travel Cost Method
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Travel Cost Method is a variant of the
household production function approach.
It assumes that the household puts together
marketed inputs and the site (the national park
for example) to produce a visit
It exploits the complementarity between the
availability of the site and the goods needed to
enjoy it
Zonal Travel Cost Method
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Obtain, with an on-site survey, data on visits to a
site (V) from different parts of the surrounding
country (zones, i)
Zone
2
Park
Zone
1
Zone
3
Zonal Travel Cost Method
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Make the visit rate per capita (Vi /Pi ) a function
of travel costs, assumed to depend on both
distance and time spent travelling Ci and (from
census data or Stats Canada) of socio-economic
variables Si:
Vi / Pi = F ( Ci, Si )
Predict how visits per capita will fall as travel
costs rise => a demand curve can be traced out
for each zone, up to the cost at which visits
become equal to zero
Zonal Travel Cost Method
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For multiple sites, estimate
Vi / Pi = F ( Ci, Si, Xi )
where Xi is a vector of "prices" (that is, visiting
costs) for other, substitute sites. This model may
be estimated simultaneously for a group of sites
(for example, all public forests within a region)
Zonal Travel Cost Method
Travel Cost
This is the cost of the trip
That would make the number
Of visits equal to zero
Visits per capita
Zonal Travel Cost Method
Travel Cost
You can calculate the CS
associated with the
demand curve
Current typical
cost of trip
form that zone
Visits per capita
Zonal Travel Cost Method
You can calculate the
Change in CS associated
with a change in the
environmental quality of
the site
Travel Cost
Clean lake
Dirty lake
Dirty lake
Visits per capita
Zonal Travel Cost Method
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Good if visitors are evenly distributed by zone of
origin
But not when the visitors come from a few
important points of origin
For example, if you want to estimate the value of
Terra Nova National Park, the idea of concentric
zones is not very useful: almost everyone comes
form St John’s or Gander!
Zonal Travel Cost Method
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Good if recreational site is circular, perhaps a
national park
But not if the site is linear: a beach for example
This is because different visitors will travel
different distances to access different points along
the site
Individual Travel Cost Method
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Ask individuals about their trips
Ask them where they individually travel
from and ask them about their individual
income, individual age, etc.
Try to guess how valuable is their time and
whether they can adjust how much they
work
(example:
surgeon
versus
unemployed)
Individual Travel Cost Method
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Ask them if they have substitute sites close
to home
Ask them if they also visited other sites
Ask them if they visited the site also for
other reasons (visit their families nearby
for example)
Individual Travel Cost Method
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The individual TCM is the most used type
nowadays
It may involve a general survey: then many
of the respondents made zero trips
This is expensive and requires statistical
methods that handle the excess of zeros
Individual Travel Cost Method
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It may involve an on-site survey: then all
the respondents made at least one trip!
This is cheap but requires statistical
methods that handle the truncation of the
data and the sample selection problems
Additionally
there
is
endogenous
stratification: you oversample those people
who make more trips!
Travel Cost Method
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TCM closely mimics the more conventional
techniques used to estimate demand curves
relatively inexpensive to apply
On-site surveys provide opportunities for large
sample sizes, as visitors tend to be interested in
participating.
The results are relatively easy to interpret and
explain
Travel Cost Method
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But…
it assumes that people react to changes in travel
costs as if they were prices (while some people
actually do like driving to the site!!!)
The most simple models assume that individuals
take a trip for a single purpose – to visit a specific
recreational site
Multipurpose trips complicate matters!
Travel Cost Method
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Defining and measuring the opportunity
cost of time can be problematic
How about the cost of on-site time? Or is
that choice endogenous???
Travel Cost Method
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availability of substitute sites will affect values
For example, if two people travel the same
distance, they are assumed to have the same
value. However, if one person has several
substitutes available but travels to this site
because it is preferred, this person’s value is
actually higher. Some of the more complicated
models account for the availability of substitutes
Travel Cost Method
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Those who value certain sites a lot may choose to
live nearby => residents will actually end up
having low travel costs!!!!!
And some more technical problems we are not
going to cover
Travel Cost Method
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Does one include the marginal cost of
capital goods used at the site?
Travel Cost Method
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The method estimates the WTP for the
entire site rather than features of the site
It’s possible to value features if people in
zones can choose among alternative sites
with different attributes – by using the
“hedonic travel cost method”, which treats
total cost as a function of both distance
from zone to the site and the various
attributes of the site.
Travel Cost Method
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The method estimates the WTP for the
entire site rather than features of the site
Using Random Utility Models (RUM) one
can also deal with differences across sites,
but this is a bit more complex than what we
would like to handle here
Travel Cost Method
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TCM assumes weak complementarity between the
environmental asset and consumption expenditure (driving,
renting a tent, a kayak, etc.)
When consumption expenditure is zero, the marginal utility
of the public good is also zero
=> if travelling to a forest becomes so expensive that no
one goes, the marginal social cost of a decrease in the
quality of that forest is also zero
This implies that TCM cannot estimate non-use values!!!
Production Function Methods
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Many non-marketed goods are used in production
as inputs or indirectly used in the sense that
ecological functions of and resources were
supporting or protecting economic activity
Where such values are reflected in market prices
and behaviour, revealed preference approaches
are appropriate valuation techniques, since they
use information about a marketed good to infer
the value of a related nonmarketed good
Production Function Methods
two-step procedure:
 First, determine the physical effects of
a change (Eg: how much the cleaner water
increases the catch by John in the river)
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Second, value the impact of these
changes in terms of the corresponding
change in the marketed output
(Eg: how much more gains John with the cleaner
water due to the increase in catch?)
Production Function Methods
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the non-marketed good is treated as an
input into the economic activity
and like any other input, its value can be
equated with its impact on the productivity
of any marketed output
Production Function Methods
$
MC with bad air quality
P0
MC with good air quality
P1
MWTP for crops
Q0
Q1
Agricultural crops
Household Production Function Methods
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If the household is producing something
with the environmental good and other
marketed inputs
=> Household
Production Function approach
One example was the TCM
Defensive or Preventive Expenditures
Method
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but we also have the Defensive or Preventive or
Avertive Expenditures Method
It measures peoples' valuation of the nonmarketed good by observing how much people
are actually spending to prevent its loss or to
defend themselves from the consequences of its
loss
Example: insulation from noise, air purification
expenditures, expenditure in water bottles
Defensive or Preventive Expenditures
Method
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A defensive expenditure is an expenditure
in response to something undesirable, such
as pollution.
Example: If smog improves (worsens) you
may spend less (more) on having your
windows cleaned. The change in
expenditures can be used as a measure of
the change in pollution
Defensive or Preventive Expenditures
Method
$
MC with bad air quality
MC with good air quality
MWTP for air quality
Personal
air quality
Defensive or Preventive Expenditures
Method
Defensive or Preventive Expenditures
Method
The method assumes that
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actual preventive or defensive expenditures are
representative of the affected population
environmental benefits and costs are perceived
and responded to without undue delay
preventive and
defensive expenditures are
effective and worth doing
there are no capital constraints and capital market
imperfections
Defensive or Preventive Expenditures
Method
The method assumes that
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defensive expenditures solve the problem
completely
Example: an air exchanger will effectively
substitute for good air quality
Defensive or Preventive Expenditures
Method
The method assumes that
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defensive expenditures solve the problem
completely
And they are all that counts
Example: bad air quality increases
expenditure in medicines but the cost of
thinking you are going to die must also be
considered!!!!
Defensive or Preventive Expenditures
Method
Not all defensive expenditures are purchased
in markets either
Example, some people clean their own
windows; changes in these “expenditures”
should also be included.
Keywords
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stated preference methods
Contingent Valuation Method (CVM)
revealed preference methods
sample bias
Next
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Reading: Chs. 4-5 in Hanley and Spash
(1993), Ch. 7 in F&O, and Chs. 16-17 in
Kolstad.
Particular examples are cited in the references
list and references there…
NEXT
Stated preference methods: CONTINGENT
VALUATION
READ CHAPTER 14