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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 4
Valuing the Environment
© 2004 Thomson Learning/South-Western
Introduction
 This chapter pursues the question of how we
should identify our environmental objectives.
 One aspect of this process is the
measurement of both the value of
environmental resources and the value of
changes in the level of environmental quality.
 This is essential information when
comparing the benefits of environmental
policy against the costs of obtaining those
benefits.
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What is value?
 First, the economic view of “value” is
anthropocentric.
 This means value is determined by people
and not by either natural law or government.
 Second, value is determined by peoples’
willingness to make trade-offs.
 When an individual spends money on one
good, there is less available for other goods.
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What is value?
 For market goods, the inverse demand curve
represents a marginal willingness to pay
function.
 Each price on the curve represents a
marginal willingness to pay for a specific
quantity of the good.
 The area under the curve at each
price/quantity combination represents the
total willingness to pay.
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Marginal Willingness to Pay Function
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Marginal Cost Function
 Marginal willingness to pay does not
measure the total benefit associated with
producing a good.
 Resources used to produce the good could
be used to produce other goods that would
benefit society, these benefits must be
subtracted from total value to yield net value.
 Total resource costs can be examined with
the aid of the marginal cost function.
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Marginal Cost Function
 The relevant resource cost associated with a
specific output level is given by the area
under the marginal cost function at that
output level.
 This area represents the opportunity cost of
these resources (the productivity of these
resources in their next most productive use).
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Marginal Cost Function
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Net value
 Net value for a market good is equal to the
sum of consumers’ surplus and producers’
surplus.
 Consider the following example where the
impact of air pollution on the productivity of
agriculture causes less economic output per
acre.
 This impact is represented by a leftward shift
in the MC function and a resulting change in
net value equal to area ABCD.
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Net value for a market good
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Net value for a market good
 The measurement process for determining the
change in net value is much more complicated.
 In the previous example, farmers may elect to plant a
different crop or change quantity of planted acreage
in response to the changing productivity.
 Economic models consider the connectivity of
markets when determining changes in net value.
 An example of this type of analysis is presented in
Table 4.1, which looks at the impact on consumer
and producer surplus from increases and decreases
in different types of pollution.
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Net value for a market good
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Value and Non-market Goods
 While money is one thing that people give-up
or trade-off to obtain goods, it is not the only
thing.
 Time and other opportunities are sacrificed
in order to obtain both market and nonmarket goods.
 Examining these trade-offs can serve as a
basis for valuing non-market goods.
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Value and Non-market Goods
 Non-market goods may have both direct use
and indirect use values.
 Direct use values are associated with
tangible uses of environmental resources,
such as use in manufacturing processes,
recreational activities, or when
environmental quality affects human health.
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Value and Non-market Goods
 Indirect use values are those associated with
more intangible uses of the environment,
such as aesthetic benefits or satisfaction
derived from the existence of environmental
resources.
 Indirect use values are also called passive
use and nonuse values.
 Indirect use values include existence value,
bequest value, altruistic value, option value
and the value of ecological services.
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Indirect Use Value – Bequest Value
 Bequest value refers to the fact that an
individual values having an environmental
resource or general environmental quality
available for his/her children or
grandchildren to experience.
 It is based on the desire to make current
sacrifices to raise the well-being of one’s
descendents.
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Indirect Use Value – Existence Value
 Existence value refers to the fact that an
individual’s utility may be increased by the
knowledge of the existence of an
environmental resource even though the
individual has no current or potential direct
use of the resource.
 An individual may never have opportunity to
see a whale but places value on preserving
the species.
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Indirect Use Value – Altruistic Value
 Altruistic value occurs out of one individual’s
concern for another.
 A person values the environment not just
because that person benefits from the
environmental quality but because the
person values the opportunity for other
people to enjoy high environmental quality.
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Indirect Use Value – The Value of
Ecological Services
 Ecological services include nutrient cycling,
atmospheric processes, carbon cycling,
clean air, clean water, and biodiversity.
 Since people do not always understand the
link between ecological services and their
well-being, it makes the valuation process
more difficult.
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Techniques for Measuring the Value of
Non-market Goods
 The three major categories for measuring the
value of non-market goods include:
 Revealed preference techniques, which look
at decisions people make in reaction to
changes in environmental quality.
 Stated preference techniques, which elicit
values directly through survey methods.
 Benefits-transferred techniques, which look
at existing studies for value of analogous
environmental change.
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Revealed Preference Approaches
 Hedonic pricing techniques are based on the
theory of consumer behavior that suggests
that people value a good because they value
the characteristics of that good rather than
the good itself.
 An examination of how the price of the good
varies with change in the levels of these
characteristics can reveal the prices (value)
of the characteristics.
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Revealed Preference ApproachesHedonic Pricing Techniques
 Assume that all the characteristics of houses
and neighborhoods are the same throughout
the city.
 Houses with higher air quality would have
higher prices.
 This positive relationship can be represented
by the following equation:
H = a + bQ,
where H is housing price, Q is air quality and “b”
tells the researcher how many units H will increase
with each unit of air quality.
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Revealed Preference ApproachesHedonic Pricing Techniques
 In reality prices of houses are dependent on many
different characteristics, all of which need to be
reflected in the calculation of the impact of air
quality on the price of housing.
 The regression analysis can be expanded to include
many right-hand side variables and can be estimated
in a fashion that represents non-linear relationships
among the variables.
 Two types of variables have traditionally been
included as explanatory variables in the hedonic
housing price functions.
 Characteristics of the house itself
 Characteristics of the neighborhood
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Revealed Preference ApproachesHedonic Price Studies
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Revealed Preference ApproachesHedonic Wage Studies
 The hedonic wage approach is based on the
idea that an individual will choose the city in
which he or she resides in order to maximize
his/her utility.
 The individual will consider wages and a
host of other positive (educational or
recreation opportunities) and negative
(crime, pollution) factors.
 Wages adjust to compensate people for
different city characteristics.
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Revealed Preference ApproachesHedonic Wage Studies
 Suppose a person has two job offers, one in a cold
weather city and the other in a warm weather city.
 Suppose each job offers the same salary.
 If the person chooses the warm weather job, and
others do too, the labor pool will increase in the
warm weather city and wages will fall.
 The reverse happens in the cold weather city.
 The difference between the wages in the warm
weather city and the cold weather city compensates
people for the disutility of living in the cold weather.
 This compensating differential can be used to look at
value placed on environmental amenities or risk.
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Revealed Preference ApproachesTravel Cost Model
 The travel cost model is a method for valuing
environmental resources associated with
recreational activity and was first proposed
by Harold Hotelling in 1947.
 The basic premise is that travel cost to a site
can be regarded as the price of access to the
site.
 Multiple observations on travel cost and
quantity of visits can be used to estimate a
demand curve.
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Revealed Preference ApproachesTravel Cost Model
 Once a demand curve has been estimated, the value
of the site to an individual can be estimated by
computing consumer surplus for each individual in
the survey, calculating an average consumer surplus
and then multiplying by the estimated number of
recreationists.
 The travel cost demand curve is often expanded to
include other explanatory variables such as age,
income, family size, education level, and other
socioeconomic variables.
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Revealed Preference ApproachesTravel Cost Model
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Revealed Preference ApproachesTravel Cost Model
 In order to measure how the travel cost demand
curve shifts as environmental quality shifts, the
travel cost demand curve must be estimated with
quality as an explanatory variable.
 There are methodological issues which remain
unresolved concerning the appropriateness of the
travel cost model. These include:
 How to incorporate the opportunity cost of travel time.
 How to properly account for substitutes (multiple sites).
 How to account for a variety of sampling biases.
 How to properly measure recreational quality and relate
this to environmental quality.
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Stated Preference Techniques
 Stated preference techniques solicit values
directly by asking individuals hypothetical
questions.
 Contingent valuation is the most widely used
stated preference valuation technique.
 This method ascertains value by asking
people their willingness to pay for a change
in environmental quality.
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Stated Preference TechniquesContingent Valuation
 The questions used in contingent valuation can take
both open-ended and close-ended form.
 In open-ended questions, respondents are asked to
state their maximum willingness to pay.
 In close-ended questions, respondents are asked to
say whether or not they would be willing to pay a
particular amount.
 The questions must also specify the mechanism by
which payment will be made.
 Consider the following:
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Stated Preference TechniquesContingent Valuation
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Stated Preference TechniquesContingent Valuation
 Information is provided about cause and
effect.
 The payment vehicle is clearly stated and is
appropriate to the particular problem.
 Care must be taken so that the contingent
valuation exercise does not become a
referendum on the payment vehicle, for
example the choice to raise taxes.
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Stated Preference TechniquesContingent Valuation
 Although the contingent valuation method
has been widely used for two decades, there
is considerable controversy over whether it
adequately measures people’s willingness to
pay.
 These arguments are based on informational
issues and on the fact that people may be
indicating their value of something other
than the particular environmental issue.
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Stated Preference TechniquesContingent Valuation
 The informational issue revolves around the fact that people do
not have practice valuing environmental issues so they are not
certain what they are willing to pay.
 A second issue revolves around the fact that the expressed
willingness to pay may be biased because the respondent
wants to feel good, be thought of as a good person, or signal
importance of the issue but not actual willingness to pay.
 A different problem is the potential link the respondent makes
between the question and other issues, for example reduced
pollution and reduced health risks. This may result in double
counting.
 Finally, some researchers believe there is a fundamental
difference between hypothetical decisions and actual
decisions.
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Stated Preference TechniquesConjoint Analysis
 Conjoint analysis is a technique employed by
researchers in marketing, transportation,
psychology, and increasingly economics for
determining individual preference across different
levels of characteristics of a multi-attribute choice.
 Consumers are asked to state which of two
hypothetical goods they prefer, each having a stated
level of different characteristics.
 These choices can be made in a pair-wise fashion or
by ranking a number of alternatives.
 Statistical techniques are used to establish a
relationship between characteristics and preference.
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Stated Preference TechniquesConjoint Analysis
 As long as one of the characteristics is price, it is
possible to use the preference function to derive the
willingness to pay for changes in the levels of
characteristics.
 Conjoint analysis can be viewed as a hedonic price
technique, where hypothetical price substitutes for
actual market price.
 Conjoint analysis could be used to value forest
quality and the importance of various forest
characteristics by defining characteristics of age of
trees, diversity of trees, diversity of other organisms,
etc.
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Stated Preference TechniquesConjoint Analysis
 Conjoint analysis can be used to directly value
alternative national environmental policies by asking
respondents to compare alternative scenarios.
 One advantage of conjoint analysis over contingent
valuation is that it does not ask respondents to make
a trade-off between environmental quality and
money.
 It asks respondents to state a preference between
two choices. This eliminates some of the biases
associated with contingent valuation.
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Stated Preference TechniquesBenefit Transfer Approaches
 The process of estimating values using revealed
preferences or stated preferences approaches can
be quite expensive.
 Benefit transfer refers to the process of taking
values from studies that were previously completed
in other areas, and applying them to the area where
the new decision must be made.
 Although benefit transfer is not a “scientific
methodology” it is associated with hypothesis
testing and formal confidence intervals and there is
a set of alternative methodologies that can be
employed to maximize the quality of information.
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Stated Preference TechniquesBenefit Transfer Approaches
 It is important to use a reference study that is
congruous.
 If many reference studies are available, the
process becomes much easier.
 The appropriate reference study can be
chosen, or a weighted average of the values
can be employed, where weights are chosen
according to similarity between the reference
study and the problem at hand.
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Non-willingness to Pay Based Value
Measures
 Three cost-related techniques fall into this category.
 Avoidance cost- the cost people incur to avoid the
negative consequences of an environmental change.
 Replacement cost – the cost of recreating what was
lost to environmental change.
 Restoration cost – the cost of repairing the
environmental damage.
 Problems:
 Is the restored/replaced environment equivalent?
 Is the value lower because it is no longer authentic?
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Summary
 Even though the economist’s definition of
value is not universally accepted, it can make
a substantial contribution to the decisionmaking process.
 Revealed preference approaches can help
measure direct use values.
 Stated preference approaches can estimate
indirect use values.
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