Estimate and Compare Benefits and Costs of a Project or Policy to decide whether the project or policy should be implemented.

Implement the Project if

Decide: Analysis From Whose Perspective?

Always Take "Social" Perspective

Specify the Project Fully

Location

Estimate Benefits and Costs over the entire life period of the Project

Total net benefits = Benefits - Costs

Specify the life period of the Project

Example: 50 years

Identify each output or benefit of the Project. Example: Benefits of a Dam

Energy, Irrigation, Recreation, etc.

Identify each cost item of the Project

Construction: materials, labor, others

Quantify in Physical Units Each Benefit and Cost Heading for Each Year of the Life Period of the Project

Example: Dam

& B-C Ratio - 1

Add Present Values of Benefits and Costs

Calculate Total Net Benefits

Calculate B-C Ratio

r = discount rate, % per year

PV = present value of FV

In the U.S., the Office of Management and Budget specifies the discount rate for federal projects.

Time Preference Approach of Selecting r

Real rate if benefit and cost estimates in constant $

Nominal rate if benefit and cost estimates include inflation

Real Interest Rate = Nominal Interest Rate - Inflation rate

Redo the PV calculations with different discount rates: Sensitivity Analysis

For comparison of Scopes of a Project, compare only total net benefits. Do not compare B-C ratios.

Show graphically why B-C ratio may be misleading in the comparison of scope.

Vertical Equity: Distribution among different groups of people, e.g. rich and poor

Proportional: distribution in equal proportion of income. Ex: net benefits to both poor and rich equal to 10% of their income

Progressive: more distribution to poor as a proportion of income. Ex: net benefits to poor 15% of income and to rich 10% of income

Regressive: less distribution to poor as a proportion of income. Ex: 15% of income to rich, but 10% to poor.

Risky events have certain probabilities of their occurrence.

Example: Probability of number of oil spills in a year

One oil spill: 0.70

Two oil spills: 0.20

Three oil spills: 0.07

Four oil spills: 0.03

More than 4 oil spills: 0.00

Expected Value of number of oil spills in a year = 1x0.70 + 2x0.20 + 3x0.07 + 4x0.03 = 1.43.

Expected Value =probability-weighted average outcome of a risky event.

How does a person choose among risky outcomes?

Depends on risk preference of the person - 3 types of risk preferences

Risk averseness

Risk seeking

Risk neutral

Example on Risk Preference

(Chapter 7)

Techniques of Estimating Benefits of Improvement in Environmental Quality

• Two Broad Types
• Estimation of Direct Damages
• Estimation of Willingness to Pay.

Estimation of Direct Damages

• Three Kinds of Damages from environmental pollution
• Health damages (such as respiratory diseases)
• Production damages (such as loss of agricultural crops due to salinity in soil)
• Materials damages (such as damages to painted surfaces, metal surfaces, and statues)
• Steps
• Estimation of dose-response relationship
• Relationship between dose of emissions and the extent of damage to the health of a person, or the productivity of land, or the painted/metal/stone surfaces
• Relationship established by medical doctors, natural scientists, and technicians
• Eliminate possible effects of other factors on health or productivity or surfaces
• If relationship available for lab animals only, extend the lab findings on animals to estimate possible health damages to humans.
• Estimation of population exposed to emissions
• number of persons, or number of acres, or number of houses exposed to emissions
• Putting monetary values on damages
• Techniques vary according to the type of damage
• Monetary Values of Health Damages
• the sum of three expenses
• (i) the increased medical and other expenditures on treatment
• (ii) the opportunity cost of lost work time/school days
• (iii) the lost economic productivity of people who die prematurely due to emissions.
• Monetary Values of Production Damages
• the value of outputs lost due to pollution
• Example: when price of output and cost of production are unaffected
• price * loss in quantity of output
• Example: when price of output and/or production cost are affected
• the change in net income (net income = revenue-costs)
• calculate net income in the absence of pollution
• calculate net income in the presence of pollution
• Monetary Values of Materials Damages
• Increase in cost of maintenance because of pollution
• the need of more frequent cleaning and painting of surfaces to restore the quality of painted surfaces and statues.
• Limitations of this Estimation Approach
• An underestimation of damages for a couple of reasons
• Ignores pain and suffering endured by people due to health damages
• Ignores the averting or preventive expenditures incurred by people
• Actual damages would have been higher than observed damages if such expenditures were not incurred
• Estimated direct damages are lower bounds on the estimates of willingness to pay

Estimation of Willingness to Pay

• Two methods
• Indirect
• Direct

Indirect Method

• Ideally, estimation of demand curve for environmental quality is the best approach to measure willingness to pay for environmental quality improvement. However, this is generally difficult to directly estimate. Therefore, efforts are made to estimate it indirectly, observing the behavior of people facing different environmental qualities.
• Method depends on the nature of the environmental problem.
• Wage rate differentials method for evaluating environmental quality at workplaces
• How much wage is a person sacrificing to work at a safer or better environmental quality workplace?
• Property value differentials method for evaluating environmental quality in a location
• How much additional money is a person paying for a similar property at an environmentally better location?
• Travel cost method for evaluating environmental quality at recreational sites
• How much additional travel cost is a person spending to visit a recreation site with a better environmental quality?
• Cost of averting health deterioration for evaluating health risks associated with environmental quality
• How much money is a person spending on averting health deterioration due to poor environmental quality?
• Wage Rate Differentials Method
• Risks to health or life at work places, arising from noise, pollution, or toxic substances, give rise to differences in wages.
• Everything else the same, workers must be offered higher wages to attract them to work in less desirable places.
• Differences in wages may be a measure of workers's willingness to pay for reductions in risks to health or life.
• Obviously, differences in wages would reflect the sum of potential medical expenditures, lost earnings due to illness, potential income loss from premature death, and also the value of pain and suffering likely to be endured by a labor at a noisier, riskier, or more polluted workplace.
• Establishing relationship between environmental quality and wages
• Data on risk to health at a workplace and the wage at the place are collected for many workplaces
• Wages are then regressed on risks to health and other differences in the nature of jobs: wage = a + b (risk level) + c (other attributes of jobs).
• Show this relationship graphically.
• Then, the incremental wage for an increment in risk shows the willingness to pay for reducing the risk.
• Property Value Differentials Method
• Risks to health or life in a polluted area are often reflected in decline in property values in the area.
• Property values capitalize expected increase in repair and maintenance of the property, and expected health damages and pain people would suffer by living in that area.
• Assuming perfect information, any person who buys a house in a noisy area must have considered the price to be low enough to cover any averting expenditures to reduce noise level (thick glasses in the window), any increase in medical expenses and pain and suffering from the noise in the area.
• Observed property values are regressed on observed air qualities and other differences in property and/or locality: housing price = c + d (air quality) + e (size).
• Show graphically.
• Travel Cost Method
• Applicable when travel cost is a major component of total cost of acquiring recreational benefits
• Time and monetary costs expended on traveling to a recreational site are taken as proxies of price and, thus, as a measure of benefits of the site.
• The higher the travel costs, the fewer the number of trips to a recreational site, everything else the same.
• Estimation technique
• Recreationists at alternative sites are surveyed and asked number of trips they undertake in a year and travel costs they incur to visit each of the sites.
• Regress the number of trips on travel costs, individual characteristics of recreationists, and environmental and other physical attributes of alternative sites.
• Number of trips to a site by a recreationist = a - b (travel cost to the site) + c (travel costs to other alternative sites) + d (individual characteristics of the recreationist) + e (environmental and other physical attributes of this site) + f (environmental and other physical attributes of other alternative sites).
• Let there be two alternative sites, Site A and Site B. Let catch rate be one characteristics, other than travel costs, that distinguishes the two sites.
• Then, number of trips to a site by a person = a - b (travel cost to the site) + c (travel cost to another site) + d (individual characteristics of the person) + e (catch rate at the site) + f (catch rate at another site).
• If a pollution control measure leads to improvement in water quality and, thus, increase in catch rate in a site, the above relationship can be used to generate two demand curves, one with the current catch rate and another with a higher catch rate possible from improvement in water quality.
• Show the two curves graphically that the change in consumer surplus measures the willingness to pay for the improvement of water quality.
• Cost of Averting Health Deterioration
• Expenditures people incur on averting health deterioration also reflect people's willingness to pay for improvement in health, as a consequence of improvement in environmental quality.
• Value of Statistical Life
• Emissions may lead to deaths, and valuation of life is generally controversial.
• It is generally the statistical life that is valued in estimating health damages.
• Suppose there are 100,000 people living in an area.
• A pollution control measure is expected to decrease the likelihood of deaths (caused by pollution) from 7 in 100,000 to 6 in 100,000.
• Thus, the measure is expected to save one life in 100,000.
• If each person in the area is willing to pay $2 for the pollution control measure, the value of a statistical life is $200,000 in that area.
• Unlike direct damages approach, indirect methods of estimating willingness to pay include damages, averting expenditures and monetary value of pain and suffering.

Direct Method of Determining Willingness to Pay (Contingent Valuation Method)

• Basic Approach: simply ask people how much they are willing to pay for an improvement in environmental quality
• Called a "stated preference" approach as people state their preference for environmental quality
• No real market for environmental quality
• Respondents are presented with a hypothetical situation of how would they choose if they were faced with a market for environmental quality.
• Therefore, also called contingent valuation method
• "Contingent" because the method asks people how they would act if they were placed in a certain contingent situation.
• Contingent valuation methods have been used for a number of environmental factors.
• air quality, aesthetic beauty of natural sites, recreational quality of beaches, preservation of wildlife species, hunting and fishing, toxic waste disposal, etc.
• Steps
• 1. Describe exactly the environmental quality characteristics being evaluated
• Respondents should fully and clearly understand the characteristics they are valuing.
• 2. Determine sampling procedure and select respondents.
• Selected respondents should be random representation of the community which face the environmental characteristics.
• In other words, each person in the community should have equal probability of being selected as a respondent.
• 3. Design survey and administer questionnaire
• Types of surveys
• personal interview
• phone interview
• mail interview
• focus group interview
• Objective of questionnaire
• get people to think about and reveal their maximum willingness to pay for environmental quality improvement
• 4. Analyze results and aggregate individual responses over the entire community
• Survey Types
• four types listed above
• often cost or budget available for survey may be a determinant to choice of survey type
• personal interview is the most expensive; mail interview may be least expensive, but high nonresponse is likely with mail interview
• phone interview may be less expensive than personal interview, but respondents cannot be shown photographs, and respondents tend to become impatient and annoyed if the interview is lengthy
• personal interview may suffer from interviewer bias, phone interview may have lower interviewer bias, and mail interview is likely not to have this bias
• Questionnaire
• Describe exactly and clearly the environmental characteristics being evaluated.
• If necessary, include photographs for clarity.
• Include a set of questions to find relevant individual characteristics of the respondent: age, gender, income, etc.
• Include questions to elicit responses on maximum willingness to pay of the respondent. See below for methods of eliciting such responses.
• Methods of Eliciting WTP Responses
• Open-ended question
• Bidding game
• Printed payment cards
• Referendum technique
• Open-ended question to solicit WTP responses
• Ask the respondent outright how much maximum they are willing to pay.
• Absolutely no prompting or suggestion from interviewer
• Possibility of high non-response rate due to no knowledge of own WTP
• Possibility of extreme valued responses from those with vested interests or from those strongly committed to or against a cause
• Bidding game
• The bidding game may start from low bid.
• The interviewer starts from a low bid and progressively increases the bid amount until the respondent signals that he or she is not willing to pay more.
• Alternatively, the bidding game may start from high bid.
• The interviewer starts from a high bid and progressively lowers the bid amount until the respondent indicates that he or she would be willing to pay that amount at the maximum.
• Possibility of a starting point bias.
• Often, responses have been observed converging to the starting bid value.
• When respondents are not sure of their true willingness to pay, they may take a clue from the starting bid.
• Printed payment cards
• Different ranges of values, starting at zero, are printed on a card.
• Respondent is asked to check off the range that represents his or her maximum willingness to pay.
• Referendum technique
• The questionnaire mentions a certain dollar amount ($x), and asks whether the respondent is willing to pay that amount.
• $x may be different for different respondents.
• Since there is no alternative bid value available, responses may suffer from "yea-saying" bias, an unreasonably high number of people saying yes.
• No possibility of extreme-valued responses
• People have experience of voting on referendums on political or public policy issues
• Problems
• Hypothetical or abstract nature of the good being valued
• How much willing to pay for 10 percent improvement in visibility in the Grand Canyon?
• Always a possibility that respondent does not clearly and fully comprehend what is being valued
• Lack of knowledge or experience valuing such things
• Respondent, being asked his or her WTP for saving a species from extinction, may have no knowledge of how a threatened species contributes to biodiversity and to the respondent personally.
• Absence of real world constraints
• Lack of income constraint
• WTP for a market good conditioned by ability to pay
• No real payment involved in valuing nonmarket good; therefore, responses may have no relation to ability to pay
• Possibility of ignoring substitution possibilities
• How much a person is willing to pay for apples is conditioned by availability of substitutes, like oranges, grapes, etc.
• WTP for nonmarket goods should also be conditioned by availability of substitutes. Respondents may, however, forget about substitutes
• Possible misstatement of WTP
• No assurance that respondents reveal their true valuation
• Public good nature of most environmental quality characteristics
• Possible free riding or understatement of true WTP
• Possible bias in the opposite direction too, because the share of taxes a respondent might pay for improving environmental quality is likely to be small and have no direct relation to the stated WTP
• Embedding of bigger causes / "Feel good" effect
• Respondents may embed their general attitude or beliefs about environment while putting value on the specific environmental characteristics being evaluated.
• Respondents may provide a positive WTP number, just to look good to interviewers.
• Response may be motivated more by the urge of doing something good for the society, rather than by the urge of providing true willingness to pay for the characteristics in question.
• Advantages
• Flexibility and applicability to a wide range of environmental amenities; virtually anything that can be made comprehensible to respondents can be studied with this technique.
• Indirect methods can estimate only use values of environmental resources, whereas CVM can estimate nonuse values too. See below for more on use and nonuse values.

Use Values and Nonuse Values of Environmental Resources

• Use value
• Use value of a resource is a measure of extractive and/or recreational benefits of the resource.
• Nonuse values
• An environmental resource may have a nonuse value too; a value that is independent of current use of the resource.
• Different kinds of nonuse values discussed below
• Option value
• The value of keeping open the option of using a resource in future.
• A person may not have plans of visiting and enjoying the Grand Canyon now, yet the person may be willing to pay for the preservation of the Canyon so that she could visit the site in future.
• Bequest value
• People may like to preserve resources, not necessarily for themselves but to pass on to future generations.
• The amount they are willing to pay for this purpose is bequest value.
• Existence value
• Even when people are not likely to use a resource now or in future, they may feel good about preserving the resource just for the fact that the resource exists in nature.
• They may be willing to pay for the existence of the resource, for example WTP for preservation of spotted owls.
• Stewardship value
• This value is not related to human use of the environment, but rather to maintaining the health of the environment for the continued use of all living organisms.
• Indirect methods of estimating WTP cannot estimate nonuse values of environmental resources because they are based on actual choices people make in a market place. Nonuse values can be estimated by contingent valuation methods only.

Willingness to Accept (WTA)

• A person may be willing to pay a certain amount for a quality improvement, but the person would have to be paid a certain amount as a compensation to accept a quality deterioration. Therefore, a WTA question may be more appropriate than a WTP question in some cases, for example when there is a proposal of dumping radioactive wastes at a site.
• Theoretically, WTP and WTA amounts should be the same for marginal changes in environmental quality, but CVM studies have reported different responses on WTP and WTA for the same quality change. Explain graphically.
• Possible reasons for differences in WTP and WTA
• 1. Absence of income constraint in WTA situation
• When a person is being asked how much he or she is willing to pay for something, the response is tempered with the fact that many other things too have a claim on his or her limited income.
• On the other hand, when a respondent is being asked how much should the person be compensated to accept a deterioration in quality, income is not an obvious constraint, raising a possibility that the WTA response would be higher than the WTP response.
• Income constraint is absent for the individual respondent, but any compensation to a community to accept an economic bad has to come from limited resources available to a society.
• 2. Theoretical equivalence of WTA and WTP only for marginal quality changes
• When the change is large (which often is the case), the two may be different even theoretically.
• 3. Value of pain vs. value of pleasure
• Often it is observed that people value same level of change differently depending on whether the change is beneficial or detrimental.
• The extent of pain a person feels with a $1,000 decrease of income may be more than the extent of pleasure the person feels with a $1,000 increase in income.
• Economic theory has yet to capture such differences.

VI. TECHNIQUES OF COST ESTIMATION

(Chapter 8)

Besides having monetary costs, a project may impose environmental costs. The National Environmental Policy act of 1970 requires all federal projects to conduct environmental impact analysis (EIA). EIA is the determination of all direct physical effects of a project on the environment, including the after-effects of the project when people adapt to the project. EIA is mostly done by natural scientists.

FEW PRINCIPLES OF COST ESTIMATION

With/Without as opposed to Before/After

Ex: Cost of a Regulation to Control Emissions of Power Plants

Social Opportunity Costs as opposed to Accounting or Monetary Costs

An executive order of 1981 calls for federal agencies to conduct regulatory impact analysis (RIA) for all major federal regulations. RIA is evaluation of benefits and costs of a regulation.

SOME EXAMPLES OF COST ESTIMATES

A SINGLE FACILITY PROJECT:

SMALL WASTEWATER TREATMENT PLANT

See Table 8-1 of the textbook.

A LOCAL ENVIRONMENTAL REGULATION:

TO REDUCE CHEMICAL USE IN AN APPLE ORCHARD

Cost of Regulation = Decrease in net income of the orchard

Net Income = Revenue - Cost

Assume market price of apple is fixed in the locality.

If the regulation forces closure of the Orchard, the entire net income is wiped out, which is the cost of regulation.

* Do not include costs of labor laid off, unless they remain unemployed. But, add any adjustment costs to obtain alternative employment.

COST OF AN INDUSTRY-WIDE REGULATION:

TO REDUCE EMISSIONS IN METAL FINISHING INDUSTRY

Cost of Regulation = Sum of increase in costs of each firm

Representative Firm Approach (when many firms):

Group firms into few categories by size or technology.

Choose one representative firm in each category.

Estimate increase in costs of each representative firm and weigh by the number of firms in each category.

Sum the weighted-increase in costs of all categories.

Example: Table 8-2.

COST OF NATIONWIDE REGULATION

Basic Approach:

Do as in III for each industry.

Find the sum of the costs of regulation of all industries.

Regulation may change outputs in certain industries, which may have impacts on outputs of other industries.

Regulation may expand the pollution-control-technology industry and its outputs.

Need to include all changes in calculating the cost of regulation in an industry.

• In the long run, changes may be more complex, depending upon how environmental regulations affect investment and innovation in the economy.
• Regulations may promote investment on pollution control industry but decrease investment in conventional sectors. If so, economic growth may slow down.
• Some economists disagree that economic growth may slow down with environmental regulations.
• Because of the complexity of the relationship between different sectors of the economy, the impact is assessed using macroeconomic models that include all relationships.
• The models are first run by using historical data and assuming that regulations are not implemented.
• Then the models are rerun by incorporating compliance of regulations. The differences in total output, growth, and employment are then attributed to the environmental regulations.
• Make a transparency of Table 8-4 and present the findings on the effect of environmental regulations on gross domestic product of few selected countries.
• The figures suggest that in some cases there was increase in GDP.
• This is attributed to the fact that those years of the introduction of regulations were the early stages of environmental programs, so the regulations had a dominant stimulating effect on the economy.
• The figures also suggest that the decline in GDP is generally small, this confirms what some economists have suspected.

Problems in Cost Estimation

• It is often difficult to obtain estimates of likely costs under regulation.
• 1. The representative firm approach is difficult to implement when firms in an industry are too heterogenous in size and technology.
• 2. Cost data mostly originate from firms and there is a possibility of misrepresentation of cost data by the regulated firms, to convince agencies to adopt weaker standards of emission control.
• 3. The cost of complying with a regulation in an industry, if estimated at the current level of output, would overestimate the cost of the regulation.
• The industry is likely to go through adjustments because the regulations would increase costs, thereby the price and the output of the industry.
• The actual cost needs to include the adjustments. Use Figure 8-1 to explain, if necessary. The estimation gets more complicated when regulations bring changes in technology of production.
• 4. The regulations may not be the least cost method of targeted reduction in emissions.
• The analyst can then show alternative methods of achieving the same reductions at costs lower than the cost of the regulation.