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Facoltà di Economia “G. Fuà” Università Politecnica delle Marche Elements of Environmental Economics 1. Welfare economics: public goods and externalities Review of basic concepts Property rights and Coase Theorem 2. The Economic value of environmental goods and its components Components of the economic value of environmental goods Willingness to pay and demand for an environmental good 3. Methods for measuring the economic value of environmental goods Direct and indirect methods Case studies: the Exxon Valdez oil spill 1 Public goods and externalities: basic concepts - 1 Economics is the discipline dealing with the optimal allocation of scarce resources: alternative uses, limited availability Environmental-natural resources are economic resources: they can be exploited in alternative uses but they are also limited (finite) Scarcity can be absolute (stock): exhaustible (non-renewable) resources Scarcity can be relative (flows-cycles): renewable resources The optimal allocation (use) of environmental resources is the socially efficient one (Pareto Optimality or Efficiency) Social efficient means that maximizes the Social Net Welfare (the sum of net welfare of single individuals) though eventually redistributable 2 Public goods and externalities: basic concepts - 2 Who or what makes this optimal allocation of resources be achieved? Why environmental-natural resources should behave differently? Voluntary exchange (trade) among agents guarantees that efficiency is achieved, therefore the market is the appropriate institutional mechanism (2 Theorems of Welfare Economics) Voluntary exchange, however, does not lead to social efficiency whenever it concerns public goods instead of private goods, that is: Non-rival goods (several agents can simultaneously use the good without negative effect on utility: non-competition on the good) Non-excludable goods (no one can exclude another from the good: free access to the good) 3 Public goods and externalities: basic concepts - 2 DEFINITION OF PUBLIC GOOD Low High Low (Pure) Public Goods Pool or Common Goods (Commons) High Excludability Rivalry Club Goods (Pure) Private Goods The use (production) of a public good implies social costs (or benefits) that can not be traded (paid) (Externalities) In this case, voluntary exchange can become efficient only if the public good is “privatized”, that is, exclusive property rights are assigned on it (Coase Theorem) 4 An example: the polluted vs. the polluter - 1 We have a society made of two individuals: a polluter and a polluted Let’s consider an environmental (=non-tradable) good (good E), for instance quality of air/water of the polluted (e.g., inhabitants of a town) The polluter produces a private (=tradable) polluting good (good Q) i.e. it provokes a decrease of air/water quality (decrease of E). E decreases as production of Q increases. The polluter aims at producing quantity Q that maximizes his/her profit. The private net benefit function B(Q) is the polluter profit. Function B(Q) increases as Q increases but increases less with the increase of Q i.e., B’(Q)=d B(Q) / d Q >0 and B’’(Q)=d2 B(Q) / d2 Q <0) due to decreasing marginal return and/or reduction of Q market price. . How much is the optimal Q production? The optimal level of Q, i.e. that maximizes B(Q), is found when B’(Q)=d B(Q) / d Q = Bm(Q)=0. Bm(Q) is the Marginal Net Private Benefit 5 An example: the polluted vs. the polluter - 2 Total Net Benefit Bm(Q) QP Quantity of private good (Q) Quantity of environmental good (E) Efficient quantity from a private perspective. What about from the social perspective? 6 An example: the polluter vs. the polluted – 3 For the polluted, the reduction of air/water quality (i.e, E) implies a damage (therefore, an explicit or implicit cost) C(Q) The additional damage (cost) will be higher as Q increases; in other words, the marginal cost Cm(Q) is increasing in Q The social optimal solution is the level of Q that makes the net social benefit [B(Q) - C(Q)] maximum Bm(Q) Cm(Q) Quantity of environmental good (E) QS QP ES EP Quantity of private good (Q) Efficient quantity from a social perspective 7 Coase Theorem - 1 The socially efficient level of Q, QS<QP, identifies at once also the socially optimal level of “consumption” of the environmental (public) good E. This optimality occurs when: MaxQ SB(Q) B(Q) C (Q) Bm(Q) Cm(Q) How to achieve it? The polluter uses the public good generating a cost that it does not bear (pay) (negative externality) as such good is neither rival nor excludable, therefore there is no market (trade) that forces the polluter to pay for it. The Coase Theorem stresses the relation occurring between the allocative role of the market and the assignment of exclusive property rights on public goods It states that (R. Coase, The problem of social cost, 1960): once exclusive property rights on a public good are assigned, the market as the place where these rights are negotiated and traded (without transaction costs) is able to restore the socially optimal use of the public good itself independently on initial allocation of rights. 8 Coase Theorem - 2 Firstly, assume that property rights on good E are assigned to the polluted. Initially we will observe Q=0 and we will have Q>0 only if the polluter is willing to purchase part of the rights on E and the polluted is willing to accept this payment. From this perspective, function Cm(Q) represents the lowest price the polluted is willing to accept to sell the rights on the respective quantity of E; therefore, it is a “pollution” supply function. Function Bm(Q) represents the maximum price the polluter is willing to pay to have access (rights) to the respective quantity of E; therefore, it is a “pollution” demand function. Costo sociale marginale Cm(Q) Beneficio netto marginale Bm(Q) We will actually observe a trade of rights on E when Bm(Q) = Cm(Q) as in any other case it is possible to find another trade solution that makes both agents better off: QS identifies the equilibrium in this market, that is, identifies the exchanged quantity and the market equilibrium price (P*). Bm(Q) Cm(Q) P* Q=0 QS 9 Coase Theorem - 3 Secondly, assume that property rights on good E are assigned to the polluter. Initially we will observe Q=QP and we will have Q<QP only if the polluted is willing to purchase part of the rights on E and the polluter is willing to accept this payment thus to reduce production of Q. Rights’ trade occurs with the same final and efficient result (equilibrium) independently on how property rights on E are initially allocated (attributed). There are no overall welfare (allocative) implications upon rights’ assignment. Nonetheless, the distribution of these benefits is evidently different over the two cases: the distributional implications of initial assignment remains relevant. Costo sociale marginale Cm(Q) Beneficio netto marginale Bm(Q) From this perspective, function Cm(Q) now represents the highest price the polluted is willing to pay to purchase the rights on the respective quantity of E; therefore, it is a “de-pollution” demand function. Function Bm(Q) now represents the minimum price the polluter is willing to accept to sell the rights on the respective quantity of E; therefore, it is a “de-pollution” supply function. We will still observe a trade of rights on E when Bm(Q) = Cm(Q) as in any other case it is possible to find another trade solution that makes both agents better off: Even in this second case QS (and P*) identifies the equilibrium in this market, that is, identifies the exchanged quantity and the market equilibrium price. Bm(Q) Cm(Q) P* Q=0 QS QP 10 Problems with the Coase Theorem Some complications interfere with the concrete application of the Coase Theorem : We can not exclude income effects (movements of B(Q) e C(Q) as a consequence of the different allocation of property rights). Such income effects still allow for the social efficiency to be achieved but this is no more independent on initial rights allocation (the efficient level changes under different initial allocation). The Theorem excludes transaction costs and says nothing on how negotiation and trade should actually occur to make these transactions costs really negligible. As trade concerns public goods it also neglects the problem of free-riding that may always arise whenever more than two agents are involved. The Theorem says nothing on how we should in practice measure the value of the environmental good E (in particular the cost associated to its reduction borne by the polluted). E being a public good we have no explicit market price suggesting how large this value may be (it is the problem of 11 measuring the economic value of environmental-natural goods). The economic value of environmental goods and its components While B(Q) may be easily computed from market values (of Q, for instance), how can we know C(Q), that is, the cost associated to the reduction of one unit of E? In other words, which is the economic value of one unit of the environmental-natural good E? A correct definition and identification of such economic value is evidently needed to make the Coase Theorem working, therefore to identify the socially efficient level of use of E, as well as the transactions needed to achieve such level. We deal with to the “economic value” as we are interested in the value of environmental goods expressed in monetary terms and, therefore, comparable to other values (for instance B(Q)). Such monetary value in fact expresses the welfare (utility) loss or gain of individuals and, therefore, expresses individuals' preferences. Environmental goods may be evaluated also on a multicriterial basis (in which the monetary value is just one criterion) as in methods like the Environmental Impact Evaluation (EIE or VIA) and the Environmental Strategic Evaluation (ESE or VAS) 12 A taxonomy for economic values of environmental goods The economic value associated to an environmental-natural good is the sum of different components. First of all we distinguish between the use value and the intrinsic value (or existence value, or non-use value, or passive use value) The use value expresses the utility that an individual can obtain from using that good. We can distinguish further between: DIRECT USE VALUE: it expresses the utility from an actual/current use of that good (for instance, the value of a park when we actually visit it) INDIRECT USE VALUE : it expresses the utility from a potential/future use of that good (e.g., the value of park when we are willing to visit it) Option value: the value given by an individual to maintain the option of using the good in terms of current use of other individuals, future use of individual him/herself, use of future generations Quasi-Option value : the value given by an individual to maintain the options above while in presence of uncertainty and irreversibility about the future state of the good Existence (or Passive Use) Value is the acknowledgement that the good has an intrinsic value, in other words a value that is not dependent on any kind of current or future use and also independent on the existence of the individual him/herself expressing that kind of preference (for instance, the value associated to rare species 13 under risk of extinction) Total Economic Value (TEV) Direct Use Value Total Option Value Use Value Quasi-option Value Existence Value TEV Existence Value 14 Measuring the TEV A correct measure of the economic value of an environmental good should take into account all the components of the TEV The indirect use value and the existence value, however, are hardly measureable and methods proposed so far are controversial and problematic In any case, the general principle underlying economic evaluation is looking for some expression of individuals’ preferences for that environmental good, that is, utility they obtain from that good in whatever form (actual use or existence) According to conventional consumer theory, such preferences reveal themselves in the form of demand (or willingness to pay) for that environmental good. The relation occurring between demand and economic value, however, is not so trivial. 15 Demand for an environmental good and its economic evaluation - 1 Price (P) If we want to express the economic value of a generic good E (private or public) in terms of individuals’ preferences, the more intuitive way (at least according to the conventional consumer theory) is to reconstruct the aggregate demand for that good P = f(E); such function expresses the Willingness to Pay (WtP) for a given quantity of good E: For a given available quantity of good E*, under the hypothesis that a market exists, the demand function indicates that the market price would be P* P*. Is this the WtP that establishes the value of E*? E* Quantity (E) 16 Demand for an environmental good and its economic evaluation - 2 Price (P) Prezzo (P) WtP = total consumers’ utility The WtP, in fact, is not only given by the total expenditure for hypothetically purchasing the quantity E* but it also includes what consumers would be willing to pay for lower quantity of that good. The economic value (the WtP) of E*, therefore, is the sum of actual expenditure and consumer surplus CONSUMER SURPLUS P* TOTAL HYPOTHETICAL EXPENDITURE E* Quantità (E) (E) Quantity 17 To pay or to compensate? Theoretically, for a rational agent (consumer), given an initial endowment E*, to pay for one more unit of E (WtP) or to be compensated (Willingness to Accept compensation, WtA) for one less unit of E should be exactly equivalent (WtP=WtA) At least under certain conditions this is what economic theory would suggest. In empirical analysis, however, this equivalence is often violated and relevant differences between WtP and WtA may be observed: usually WtA>WtP. If we exclude income effects, the only explanation for this evidence would rely on non-rational behaviours, at least from the strictly economic perspective, though fully logical from a psychological perspective. Cognitive dissonance does indentify this different perception of the same choice problem depending on the perspective on which an individual is initially positioned: in the former case (WtP), the individual finds him/herself in the buyer perspective, therefore he/she is cautious in attributing a value (a price) often underestimating it; in the latter case (WtA) a compensation (revindicative) perspective prevails and therefore individuals tend to exaggerate the value (price) of the good. 18 Methods for measuring the economic value of environmental goods Beside what we are really interested in (WtP, WtA…), the problem remains how to measure it since no market (therefore, market values) exists for such goods where the demand behaviour can be really observed and, consequently, the demand function estimated In practice, the basic idea to achieve this evaluation is to reconstruct this unobservable (or latent) demand. To do this we need in fact to reconstruct a non-existent (latent) market. There are two different approaches to reconstruct a market value for non-traded or nontradable goods. Observing existent markets (surrogated markets) Creating an hypothetical market Consequently, methods are usually classified as follows: INDIRECT EVALUATION METHODS: the value of the environmental good is obtained through real markets of private goods whose value is somehow linked to the presence of the environmental good itself. DIRECT EVALUATION METHODS : the value of the environmental good is obtained by letting the potential consumer really express his/her preferences on an hypothetical market of that good 19 Indirect e direct methods DEFENSIVE EXPENDITURE (COST) METHOD INDIRECT METHODS (based on assigned or revealed preferences) HEDONIC PRICE METHOD TRAVEL COST METHOD DIRECT METHODS (based on declared preferences) CONTIGENT VALUATION METHOD (CVM) EXPERIMENTAL METHODS (experimental auctions, artificail markets…) Indirect methods are able to measure only the direct use value while direct methods (in principle) are able to reconstruct the whole TEV. We will skip the defensive expenditure method (the value is the cost borne to protect the environmental good from a damage or restore/surrogate it after a damage) and the experimental methods (just in the initial stages of application) HOWEVER: An increasing number of evaluations are based on the so-called secondary studies, that is on methods using evaluations directly obtained in previous studies (primary studies) adapted through appropriate methodology (Benefit 20 Transfer Method) Hedonic Price Method - 1 It is based on the fact that in some real markets the value of a (private) good depends, among other things, on the presence of the environmental good. Typical cases concern the house market (and house prices) and wages for jobs under particular environmental condition (for instance, exposition to emissions). Let’s consider the house market as the driving example. Suppose that we observe a set of prices in the house market. These prices actually refer to transactions made on heterogeneous goods, namely houses. In other words prices depend on a set of intrinsic characteristics of houses themselves (size, position, age, etc.) among which we may also find the presence/absence of the environmental good (for instance, noise). This is the idea of hedonic price that typically concerns markets where goods of different quality are traded. The hedonic price allows us to derive the value individuals assign to the presence/absence of the environmental good The method proceeds in two phases: Estimation of the relation between observed market prices and the presence of environmental good E 21 Derivation of the WtP for E and of the consequent demand function Hedonic Price Method - 2 The first problem is to establish a functional relation between house prices P, its qualitative characteristics X and the presence of E (e.g. exposition to noise, in decibel): P = f (X, E) The second problem is to separate and “isolate” the effect of E on P, that is, how P varies as E varies with all other characteristics X remaining constant (ceteris paribus). In mathematical terms it means to calculate the partial derivative P/ E which is, graphically, the slope of this curve: As P indicates the price really paid for a given house, this slope indicates the revealed WtP for a additional unit of E. If, as in the figure, such slope is decreasing in E, the WtP for E is negatively correlated with quantity of E, which is exactly how a demand function should behave. P P/ E E 22 Hedonic Price Method - 3 P/ E As the slope of P=f(X,E) with respect to E measures the WtP for different levels of E, the function relating such slope with E is, in fact, the demand curve for E from which the value of the given environmental good can be easily computed (just integrate the curve…) : WtP Curve for E) DaP ((Demand Curva di Domanda) E 23 Travel Cost Method – 1 This method is particularly (say, exclusively) suited for environmental goods with a touristic-recreationalleisure value (utility). For instance, C natural parks, tropical islands, species of great attractiveness etc. The hypothesis underlying the method is that visiting such goods implies a cost, namely a travel cost (let’s call it a “ticket”) and that the number of visits of a single individual (or of a group of individuals) is negatively correlated with the travel cost (ticket price) according to this function: Q = f (C), where Q is the number of visits and C is the travel cost (the ticket price). Therefore, such cost does make the WtP for that good explicit (revealed) and the function looks like a demand function: Q 24 Travel Cost Method – 2 In practice, we observe individual travel choices and for any individual is usually not possible to observe how the number of visits varies as C varies. Therefore, through surveys made on visitors at the entrance of the site, we need to collect information about: Number and provenience of the visitors Costs borne for the visit As the travel cost usually depend on the distance, we have to firstly cluster visitors according to zone of provenience and then compute the respective frequency of visit and the cost of the visit. ZONE 1 ZONE 2 ZONE 3 ZONE 4 Frequency rate per 1000 inhabitants 25 Travel Cost Method – 3 The WtP and, therefore, the demand curve for good (site) E can be then reconstructed on the base of a high-enough number of regions (zones) of provenience: C The whole area below the demand curve expresses the WtP, therefore the value attributed to E by a representative consumer. The total demand, and the total value, can be obtained by aggregating this individual demand over all visitors. ZONE 1 ZONE 2 ZONE 3 ZONE 4 Frequency rate per 1000 inhabitants As visits are usually registered over a limited period of time (an year, a season, etc.) the actual use value of good E has to be computed by the capitalizing the WtP (the value) measured over one single period (year). 26 Contingent Valuation Method (CVM) - 1 The Contingent Valuation Method (CVM) aims at making the individuals’ preferences on the environmental E good explicit. This is obtained through the creation of an hypothetical market, that is where transactions are hypothetical (≠artificial market) The method, therefore, does not only involve those individuals that actually use the good but also those that may assign a value to it. For this reason it allows for the measure of the whole TEV and not only of the use value. It is also much more flexible than indirect methods as can be applied to many different environmental goods provided that the survey and the hypothetical market design is adapted accordingly. It may separately measure and compare the WtP and WtA In practice, the method consists in asking a sample of individuals to express their WtP or WtA with interviews or surveys. 27 Contingent Valuation Method (CVM) - 2 The method consists in three logical phases (which usually are different parts of the interview or questionnaire, as well): Establishing and characterizing the sample (stratification) in terms of age, gender, income, ecc. Creating the hypothetic market (contingent market): DESCRIPTION OF THE CURRENT STATE OF THE GOOD DESCRIPTION OF THE HYPOTHEITCAL CHANGE OF THE STATUS OF THE GOOD FIX MODALITIES OF FRUITION AND OF PAYMENT OF THE GOOD Request of WtP (or WtA) Direct indication of a value open-ended question (free value) payment card (choice among alternative values) bidding game (choice on the base of a bid game between the interviewer and the interviewed) Statistical elaboration on a dichotomous choice (closed-ended question: yes/no) 28 Contingent Valuation Method (CVM) - 3 Which kind of value is actually requested (WtP or WtA) depends on the kind of interview-survey, on the kind of environmental good, on the degree of sophistication of the measure we are aiming at. By aggregating individuals WtP (or WtA) it is possible to directly compute the value of the environmental good in relation to its passage from the current status (E* or E1) to the modification (E1 or E*) , that is the contingent transaction under evaluation Price (P) Prezzo(P) Once all answers are collected, the anomalous ones (outliers) have to be eliminated as they indicate: strategic behaviour (freeriding), irrational behaviour, misunderstanding on the transactions, etc. All these aspect would undermine the correct measure of the value P* P1 E* E1 (E) 29 Quantità (E) Quantity A case-study: the Exxon Valdez oil spill (1) Carson et al., 2003: Contingent Valuation and lost passive use: damage from the Exxon Valdez oil spill. Environmental and Resource Economics, 25, 257-286. On the night of 24/03/89 the oil tanker Exxon Valdez left the port of Valdez (Alaska) carrying approximately 53 million gallons of crude oil. In reaching the open sea out of the Valdez Bay (through Prince William Sound) it crashed into the rocks. Within few days it had spilled almost 11 million gallons of oil into the Prince William Sound. Perhaps the largest environmental disaster in US history (250000 seabirds and 22 whales killed, for instance, but no human victims) This ambitious and complex study aimed at calculating the loss of existence value (or lost passive use) due to the incident, that is, its economic damage. Before the Exxon Valdez case, the CVM (and existence value itself) was considered (at least in the US) as an extreme solution in damage evaluation. However, in the law suit brought by the State of Alaska against Exxon, these experts were asked to specifically evaluate the damage in terms of lost passive use to establish the appropriate compensation claimed to the Court: it is an unprecedented case. 30 A case-study: the Exxon Valdez oil spill (2) The method adopted is a pretty classic application of CV: sample+suervey+value estimation SAMPLE: 1600 families across US (not only Alaska); 75% of questionnaires returned SURVEY (Questionnaire): Description of the area and of the damage (information+pictures) Request of WtP (in the form of a tax) to fund a state programme preventing from similar incidents (coastal guard escorting oil tankers out of the Sound) Dichotomous choice+bidding game Value estimation The median WtP is estimated at 48$ per family Total value: between 3 e 7 billions $ Conclusions: Damage valuation is very high (but also very volatile) The State of Alaska firstly received a compensation of 1 billions $ Exxon also spent 2 billons $ for “defensive expenditure” Total compensation: about 6,8 billions $ 31 Comparative analysis (pros and cons) The cons of indirect methods: They can be applied only to some specific and limited contexts and environmental goods, those whose value affects other market values or are somehow related to travel costs They only measure the direct use value not the whole TEV More generally they do not take into account preferences of individuals not participating to the observed markets The cons of CVM It is a costly and complex method Results strongly depend on apparently technical details: how the survey is carried out, how the transaction is presented, which payment forms are considered… Results are still “hypothetical” as they do not concern real revealed preferences 32 Where are we? Our map: from Environmental Economics to Environmental Policies Externalities Public Goods Direct Methods Property Rights Socially efficient use (allocation) of Assignment environmental-natural goods Indirect Methods Coming Soon: Measurement Method Environmental Policies Demand Function Consumer Welfare Consumer Theory 33