Benefit-Cost Analysis: Measuring Benefits

Total economic value (TEV)• TEV of the stock of natural capital:

– all-encompassing measure of the economic value of any environmental asset

• TEV of a change in social wellbeing from a project/policy: – the sum of all relevant WTPs or WTAs for the change– If a change matters to any individual at any current or

future time it should be included in an economic assessment

WTP: willingness to pay

WTA: willingness to accept

Pearce et al. 2006, chp. 6; Revesz and Stavins, 2007

Conceptual model of value• The aggregate WTP or WTA for a change

– Based on the aggregation of individual WTP or WTA

– WTP: the maximum amount of money an individual would pay to attain an improvement in the environment

– WTA: the minimum compensation an individual demands to tolerate a loss of environmental quality

WTP vs. WTA

• Appropriateness of WTP or WTA depends on the baseline allocation of the property right.– individual currently has some right to the good/service

• Yes WTA, i.e. to give it up• No WTP, i.e. to obtain

• Sometimes WTP ≈ WTA, but not always– WTP <= ability to pay– If WTP ≠ WTA, typically WTA>=WTP

• loss aversion, endowment effect

Individual WTP

• Does not require actual payment

• Human-centered/anthropocentric

• Represents preferences of the individual (not the group)– Potential information problem

Keohane and Olmstead (2007, pp. 33-37)

Kopp et al. 1997

A taxonomy of value from environmental assets

Total economic value

Pearce et al. (2006, Chp. 6)

Use & non-use values

• Use value: the benefit of physically using or “consuming” an (environmental) good.

• Non-use value/“passive use”: the benefit or pleasure derived from the knowledge that an (environmental) good exists without using it.– Types:

• Existence value: altruistic value from preserving some amenity• Bequest value: value based on perceived value to future generations.

• Option value: value from preserving the opportunity of future use

– Can only be assessed using stated preference (survey) techniques

Taxonomy of valuation tools• Stated preference (SP) techniques:

– based on questionnaires given to respondents and which elicit the respondent’s WTP (or WTA) for use and/or non-use values (Pearce et al. 2007)

– E.g. contingent valuation (CV), choice experiments, etc. – only way to estimate non-use values

• Revealed preference (RP) techniques– use market information or behavior to estimate the value of a

good not directly traded in a market.– E.g. hedonics, production function, etc.– Key ideas: bundled goods + “behavior trail”– Limited to estimating use value.

(Pearce et al. 2007)

Non-use values recognized by courts

• D. C. Court of Appeals: State of Ohio v. Department of the Interior (880 F.2d 432 (D.C. Cir. 1989))

– Ohio and others sought review of the Dept. of Interior’s natural resource damage assessment rules (under CWA & Superfund).

– Court upheld inclusion of passive-use if it could be reliably measured.

• Passive use losses were compensable (CWA/Superfund).

• Ranking of assessment approaches with CV at the bottom was unwarranted.

Pearce et al. (2006, Chp. 6)

Arsenic

VSL

Hells Canyon Exxon Valdez

Chesap. Bay

Revealed vs. Stated Preference methods: “Myth of market prices” (Fullerton & Stavins, 1998)

• Myth #3: “when non-market solutions are considered, economists still use only market prices to evaluate them” (p. 434)

– “True enough, economists typically favour using market prices, whenever possible

• …because these prices reveal how members of society actually value the scarce amenities and resources under consideration.” (p. 434)

• BUT: BCA “cannot rely exclusively on market prices.”

Valuation methods: rigorous tools for estimating the

value of non-traded environmental goods

A. Stated preference (SP)1. Contingent valuation (CV)2. Choice modeling

B. Revealed preference (RP)1. Hedonic pricing (prices, wages)

i. Property valueii. Wage rates

2. Defensive behavior3. Travel cost4. Cost of illness (COI) 5. Materials damage (maintenance, repair, replacement)

Valuation methods roadmap

Stated Preference (SP)

• John Krutilla (1967): “When the existence of a grand scenic wonder or a unique and fragile ecosystem is involved, its preservation and continued availability are a significant part of the real income of many individuals.”

• SP: Estimates based on direct questioning (survey instruments) to elicit individual valuation for environmental changes– Can capture use & non-use value.

• The only option for non-use value

– Controversial

• Directly ask subjects via a survey about their WTP or WTA

• “Contingent” because solicited valuation is “contingent” (dependent or conditional) on an (hypothetical) outcome.

Stated Preference: Contingent Valuation (CV)

Steps of a stated preference study

(Pearce and Özdemiroglu, 2002)

Structure of the CV survey.(Pearce and Özdemiroglu, 2002)

Potential pitfalls

% of respondents at this value or lower

“cumulative density”

Hypothetical

Real,incentives

Oath

Hypothetical bias

Protest

Lack of budget constraint

Jacquemet et al. 2011

Environmental Economics : http://www.env-econ.net (2005)

Ecosystem Valuation: www.ecosystemvaluation.org (2010)

• Advantages – simple, direct and easily understood, broad applicability (can assess non-use value)

• Disadvantages/sources of controversy – Can be expensive and time consuming – Hypothetical setting and choice

– May be difficult for individuals to value environmental goods and services that they are not used to exchanging like private goods.

– Lack of a strong incentive to tell the truth. – Salience of budget constraint uncertain

– Response is only as “informed” as the respondents– Respondent may be expressing a value on something other than the intended

element– The scenario or the valuation process– A warm glow from giving – Environmental quality in general – The wrong attribute: e.g. health effects of air instead of visibility

– Subject to cognitive anomalies: embedding effect (e.g. 1 versus many species), order effect

Stated Preference: CV

CV example: Exxon Valdez

• Industry complaints re: CV lead to blue ribbon NOAA panel chaired by K. Arrow and R. Solow.

• Non-use value loss estimated using CV by Carson et. al, 2003

http://en.wikipedia.org/wiki/Exxon_Valdez_oil_spill

http://response.restoration.noaa.gov

Ran agroundPrince William Sound1989

Exxon Valdez CV survey instrument• developed over 18-months • face-to-face, national sample• valuation scenario:

– described the damages caused – established a referendum market for eliciting the

respondent’s value • preventing a future accident that would cause an equivalent

amount of damage in the Prince William Sound area

• display cards, photographs, and maps were shown to the respondents to supplement verbal information

Carson et al. (2003)

Example design issues:•Designed to ensure that respondents do not answer a different question than the one they are asked, whether by

• forgetting about their budget constraints or by • letting Prince William Sound stand for all oil spills or even all

environmental damage.

WTP Question & Results

• (Original study) lower bound on the estimated aggregate lost passive use values: $2.8 billion (1990 dollars).– multiplying the number of U.S. households by the estimate of median

WTP

• The WTP question– Discrete-choice referendum

elicitation format to ask whether the respondent would vote for the program if it cost a specified amount that would be paid by a one-time federal tax payment.

A. Stated preference1. Contingent valuation2. Choice modeling

B. Revealed preference1. Hedonic pricing (prices, wages)

i. Property valueii. Wage rates

2. Defensive behavior3. Travel cost4. Cost of illness (COI) 5. Materials damage (maintenance, repair, replacement)

Roadmap progress….

B. Revealed Preference

• Depends on a relationship between a market and non-market good.– Behavior trail

• Estimate the market “footprint” of non-market goods (bads) (Russell 2001)

• For use value only

Method Revealed Behavior (Trail)

Conceptual Framework

Types of Application

Hedonics Property purchased; choice of employment

Demand for bundled goods(differentiated)

Property value and wage models

Defensive Behavior

Expenditures to avoid illness or death

Household production(substitution)

Morbidity/Mortality

Travel Cost Participation in recreational activity and site chosen

Household production(complementarity)

Recreation demand

Cost of Illness Expenditures to treat illness

Treatment costs Morbidity

Adapted from Boyle (Chp 8 in Champ et al. 2003)

Revealed Preference Methods

• Idea: if the price of something is related to multiple characteristics, look at the differences in prices to assess value buyers place on one of those characteristics.

• Key concept -- Bundled goods: People value goods based on a bundle of attributes.

Revealed Pref: Hedonic Pricing Methods

(Couling, 2001)

• Hedonic property value method • Real estate attributes:

• Property, structure, landscaping• Additional “bundled” characteristics: schools, crime level, open space,

environment• Hedonic wage method

• Job attributes: • tasks completed• bundled: workplace community, workplace safety

For overview see Taylor (Chp 10) in Champ et al. (2003)

Hedonic Property Pricing Model

This equation is linear but could alternatively be modeled as semi-log, double log, quadratic, etc. (see Taylor 2003)

01 1 1

h n l

i i j j k ki j k

P H N L

ò

• P: housing price• H: structural and property characteristics

• bedrooms, lot size, …• N: neighborhood characteristics

• median income, school quality, ….• L: location characteristics

• level of the environmental amenity• ε: error term for unobservables

P

L

MWTP for the env. amenity Can use to evaluate amenities and/or disamenities

Bruegel: The Triumph of Death

Approach: statistically break down the value of a good into its component parts to isolate the value of the environmental attribute.

Hedonic Property Value Example

Leggett and Bockstael (2000)• Estimate the value of water quality

in Chesapeake Bay

• Water quality:

reported faecal coliform levels

(affects utility from recreational use)

• Result:

1 unit (count/ml) increase in median annual concentration of pollution property value falls by $5,000.

Ford Pinto memo

• Estimate value of increased risk of on-the-job mortality (Value of a statistical life—VSL).

• Wage rates are higher for those willing to accept riskier jobs (all else equal).

• Idea: Wage differential between two jobs differing only in risk of death provides an implicit VSL

• Elevated wages: “When the crabbing is good a crewman can earn upwards of $1,000 a day. Many timber fellers earn upwards of $60,000 working a nine- or 10-month year.”

• Valuation of occupational risk then applied to a setting of environmental risk (benefits transfer)

CNNMoney.com, 10/13/03

Hedonic wage method

Per 100K

US Bureau of Labor Stat. (2002)

Timber cutter mortality: 118/100,000> 26 times that of the average U.S. worker

How much is your life worth?

Stephen Colbert, The Colbert Report: The Word – “Priceless”http://www.colbertnation.com/the-colbert-report-videos/176175/july-14-2008/the-word---priceless

EPA on VSLWhat Does it Mean to Place a value on life? • “The EPA does not place a dollar value on life, but the Agency does try to

estimate the benefits from reducing the risk of death from environmental contaminants. ..

• For benefit-cost analysis, the question is: How do people value, in dollar terms, this small (but important) reduction to their risk of dying? The process of valuing risk – also known as the process of valuing "statistical life" – does not produce an estimate of the value of life itself. “

What is the "Value of a Statistical Life"? • The "value of statistical life (VSL)" refers to the aggregate estimated value of

reducing small risks across a large number of people. It is based on how people themselves would value reducing these risks

Source: http://yosemite1.epa.gov/ee/epa/eed.nsf/pages/MortalityRiskValuation.htm

Estimating benefits of reducing deaths• For a risk not currently incurred:

– VSL = $WTA/ Δp here WTA is willingness-to-accept increased risk

• For a risk currently incurred:– VSL = $WTP/ Δp here WTP is willingness-to-pay to reduce risk

• E.g. if individuals demand $4 to accept an increase the risk of death of 2x10-6 (that is by 2 in a million) then (using $WTA = $4 and a change in risk Δp=2x10-6).

• VSL = $WTA/ Δp = $4 / (2x10-6) = $2 million

Cropper et al. 2011

VSL• Not intended to reflect the intrinsic value of a life.

– Rather: convenient, imperfect, one-size-fits-all measure of individuals’ demand for risk reductions (in small units, e.g. millionths).

• Its estimation and its use are usually in units of 10-6 (changes in the probability of death in the “millionths”)

– A VSL of $7M implies that an individual would be willing to pay $7.00 to reduce their risk of death by 10-6

– If a policy reduced the mortality risk of everyone in the U.S. by 10-6, then with a VSL of $7M (or $7 x 106), the benefit could be estimated by:

• (Δp x VSL ) x (number affected)• (10-6 x [$7x106] ) x (3x108 )• $7 x 3x108

General issues with hedonic methods

• Models generally assume that households/individuals have perfect information about attributes of the property/job.

• Simultaneity: causality• Property: causality between env. quality and price (e.g. higher

quality leads to higher price, larger tax base, more money for env. quality).

• Wage: causality between risk and wages can go both ways (e.g. higher wage to compensate for air pollution but high wage attracts more workers leading to change in air quality)

• Estimate willingness to pay to reduce a “bad” by looking at avoidance expenditures made to reduce the risk or the impact of the bad.

– E.g. water quality: when faced with water of dubious quality how much do individuals spend to improve their drinking water (expenditures: filters and bottled water)

Revealed Preference: Defensive Behavior

• Estimate value of an amenity (e.g. park) by treating the costs incurred to experience it as its “price”.

• Idea: travel and the recreational area are complements (consumed together)– Information needs (gathered via survey):

• # of trips taken (by indiv’ls/households) to a particular site in a year

• their travel cost to that site– Monetary (out-of-pocket cost: gas, hotel, etc)– Opportunity cost of leisure time (shadow value of time

constraint, e.g. 1/3 to 1/2 wage rate)

Revealed Preference: Travel cost

Travel cost example• Focus on the behavior of the Worthingtons, a single family who lives

a given distance away from a free public park. • Survey work Worthingtons visits this park an average of four

days/year.

• Estimate their travel costs to go from their home to the park and return. – cash travel cost (gas, wear and tear on the car, food, etc.) is $18 per trip – round trip takes one hour each way (need to put a value on the time

spent traveling) • tricky: need value foregone, in terms of salary or other income, by spending

this time traveling rather than working. • Empirical work ⅓ to ½ of the wage rate; • assume their travel time is worth $8.00 per hour Roundtrip cost of travel

time: $8 * 2 = $16 – Price the Worthingtons “pay” for each visit to the park is the total cost

of the trip: $18 + $16 = $34.

• Suppose: there are only three other families within range of the park– Surveyed travel costs for all four:

Travel cost example: Calculating the value

(Worthingtons)

• Calculate (chalkboard exercise—review of plotting demand curve, calc. of benefits, consumer surplus)

For each individual in this “world” calculate1. (Gross) benefit of the park (given their observed number of visits)2. Net benefit of the park

Then sum these values to find the aggregate (1) benefit, and (2) net benefit of the park.

Have we estimated the complete value of the park to these families? What component of the complete value have we estimated? Use value or non-use value? Was this stated or revealed preference?

Assume: • each family is identical accept for their travel cost (can treat the table as any individual family’s demand schedule)

• demand is linear (a straight line).

Travel cost caveats

• in practice much more complicated – Families will differ in terms of many factors

(not just in travel costs)• income levels, presence of alternative parks and

other recreational experiences available to them, etc.

• Solution: collect large amounts of data on many visitors; statistically sort out various influences on park visitation rates.

Travel cost example: Hells Canyon

The Situation• Hells Canyon on the Snake River

(separating Oregon and Idaho)• spectacular vistas, outdoor amenities,

important fish and wildlife habitat• economic potential as a site to develop

hydropower – Generating hydropower damlarge

lakesignificantly and permanently alter the ecological and  aesthetic characteristics of Hell Canyon. 

The BCA Challenge• 1970’s: Env. economists from Resources

For The Future in Washington, D.C. • asked to develop an economic analysis to

justify preserving Hell Canyon in its natural state

http://upload.wikimedia.org/wikipedia/commons/3/36/OR_hells_canyon.jpg

http://www.fs.fed.us/hellscanyon/

*Example from: http://www.ecosystemvaluation.org/travel_costs.htm

Travel Cost: Hells Canyon (cont’d)The Analysis • Economic value of project: Net economic value (cost savings) of

producing hydropower at Hells Canyon was $80,000 higher than at the "next best" site which was not environmentally sensitive.

• Task: Estimate the economic value of losing the environmental amenities of Hells Canyon: Travel cost survey valuation: $900,000– TCS was low-cost/low precision – But researchers did not attempt to strongly defend the "scientific"

credibility of the valuation method/results. – Emphasized that, even if the "true value" of recreation at Hell Canyon

was ten times less (i.e. $90k), it would still be greater than economic payoff from generating power there ($80k).

The Results• Based largely on the results of this non-market valuation study,

Congress voted to prohibit further development of Hell Canyon.

Travel cost example: South African game reserves (Day, 2002)

• What would be the lost welfare to domestic visitors to four game parks?

• Data: survey of 1,000 visitors• Demonstrates the effect of site

substitutes.“Mr. Shuffles”

Torsten Blackwood/AFP/Getty Images.

Method Revealed Behavior (Trail)

Conceptual Framework

Types of Application

Hedonics Property purchased; choice of employment

Demand for bundled goods(differentiated)

Property value and wage models

Defensive Behavior

Expenditures to avoid illness or death

Household production(substitution)

Morbidity/Mortality

Travel Cost Participation in recreational activity and site chosen

Household production(complementarity)

Recreation demand

Cost of Illness Expenditures to treat illness

Treatment costs Morbidity

Adapted from Boyle (Chp 8 in Champ et al. 2003)

Revealed Preference Methods

Revealed versus stated pref.

Econometrics lab, UCB (http://elsa.berkeley.edu/eml/qca_reader/9.combin.pdf)

Revealed Stated

Actual market behavior Hypothetical scenarios

Error: attribute measurement Error: attribute framing

Attribute range: limited Attribute range: extensive, flexible

Use values only Use & non-use values

Optional additional slides

Revealed Pref: Cost of illness

• Used to estimate benefits from policies which result in increased health

• Easy to understand• Not grounded in consumer choice and welfare theory (in contrast

to other methods)• No estimate of marginal pricing or surplus

Pearce and Özdemiroglu (2002)

SP validity tests

Pearce and Özdemiroglu (2002)

Pearce and Özdemiroglu (2002)

Pearce and Özdemiroglu (2002)

Stated Preference:Choice Modeling

(Pearce and Özdemiroglu, 2002)

Pearce and Özdemiroglu (2002)

Hedonic property value method

• Potentially suited for valuing: noise abatement, proximity to waste sites or open space, air pollution, water quality.– Since no market exists for the amenity “peace and quiet”, we have no direct

market evidence on how much this amenity is valued where people live. But, it can be traded implicitly in the property market. (Pearce 2006, chp 7).

• Issues– Based on marginal changes: Appropriate to estimate small changes in environmental

quality (large changes can lead to a change in the hedonic price function due to renegotiation from buyers and sellers as the supply of env. quality shifts)

– Large data requirements (potential for omitted variable bias)

– multicollinearity: nonmarket characteristics tend to move in tandem (e.g. properties near to roads have greater noise pollution and higher concentrations of air pollutants)

• difficult to “tease out” the independent effect of these two forms of pollution

• Trace out the MWTP curve (or demand curve) for a particular amenity, like a national park.

Revealed Preference: Travel cost

trips, v

$

v0

cv0

f(cv, cs, y, z)

• v: trips• cv: trip cost to given site• cs: trip cost to alternative site(s)• y: income• z: demographic variables

Access value: linear single-site modelParsons (Chp 9 in Pearce et al. 2006)

A

B• A+B: total WTP for trips • B: total trip cost• A: “access value”, total

consumer surplus for trips to site in year.