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Economics of Environmental
Quality
Economics of Environmental Quality
Different types of pollutants call for different types of policy
Optimal pollution modeled as simple tradeoff: Reducing emissions reduces damages Reducing emissions involves opportunity costs
Different types of pollutants call for different types of policy
Optimal pollution modeled as simple tradeoff: Reducing emissions reduces damages Reducing emissions involves opportunity costs
Environmental DamagesAll negative impacts that resource users
experience from environmental degradation Greater the emissions, the greater the damages Examples:
Lung diseasesContaminated waterLoss of biodiversityLoss of recreational uses“defensive” expenditures
Emissions function: Damage = f(quantity of residual)
Ambient function: Damage = f(concentration of pollutant)
Marginal Damage Function
Emissions (tons/yr)
$
Emissions (tons/yr)
$
Ambient (ppm)
$
Ambient (ppm)
$
“threshold” effects
NoiseSO2
Toxic chemicals
Total Damages = sum of marginal damages TD1 = (10)(100)(.5) = $500 TD2 = (25)(100)(.5) = $1250
What accounts for differences in MD1 and MD2? Urban vs rural areas Different seasons
Total Damages = sum of marginal damages TD1 = (10)(100)(.5) = $500 TD2 = (25)(100)(.5) = $1250
What accounts for differences in MD1 and MD2? Urban vs rural areas Different seasons
Marginal Damage Function
Emissions
$
MD1
MD2
$25
$10
15050
Suppose the marginal damage function is given as MD = 8(E - 200), where E measures the emissions of gunk, measured in tons. What is the total damage if E = 260?
a) b) c) d)
0% 0%0%0%
a) $480b) $14,400c) $28,800d) $62,400
1 2 3 4 5
Abatement Costs Costs incurred to reduce pollution emissions
Marginal Abatement Costs (MAC) rise as emissions are reduced
Emissions
$
MAC1
MAC2
$50
$20
240 500
Unregulated Emissions
Total Abatement Cost = sum of marginal abatement costs TAC1 = (20)(260)(.5) = $2600 TAC2 = (50)(260)(.5) = $6500
What accounts for differences in MAC1 and MAC2? Different plant technologies (old vs new) Different time periods
Total Abatement Cost = sum of marginal abatement costs TAC1 = (20)(260)(.5) = $2600 TAC2 = (50)(260)(.5) = $6500
What accounts for differences in MAC1 and MAC2? Different plant technologies (old vs new) Different time periods
Suppose the marginal abatement cost function is given as MAC = 350 – 5E, where E measures the emissions of gunk, measured in tons. What is the total abatement cost if E = 30?
a) b) c) d)
0% 0%0%0%
a) $200b) $4,000c) $6,000d) $12,000
1 2 3 4 5
Optimal Emissions Optimal level is one which minimizes total social costs
Occurs where MD = MAC
Emissions
$MD1
MAC1
$10
20075 450
TD1 TAC1
TD1 = (10)(125)(.5) = $625
TAC1 = (10)(250)(.5) = $1250
Total Social Cost = TD + TAC = $1875
$18
Optimal GunkMD = .25(E – 100)MAC = 90 - 0.15E
What is optimal emissions? What are marginal damages at the optimal level? What are TD? What are TAC? What is Total Social Cost?
What is Total Social Cost if E = 0? What is Total Social Cost if emissions are unregulated?
What happens to optimal emissions if: MD rises? MAC falls?
What would the graph look like that shows E* = 0? What happens to optimal emissions if enforcement
is costly?
What happens to optimal emissions if: MD rises? MAC falls?
What would the graph look like that shows E* = 0? What happens to optimal emissions if enforcement
is costly?
Optimal Emissions
Emissions
$
MD1
MAC1
E1
MD2
E2
MAC2
E* falls
E* falls
MAC1 + C
E3
E* rises
Problem Set 2Question #3
Equimarginal Principle: Revisited
What is TAC of a uniform 50% reduction from the unregulated level?
What is TAC of the equimarginal reduction of 14 tons/week?
Marginal Abatement Costs ($100/week)
Emissions (tons/week) Plant A Plant B
14 0 0
13 2 3
12 4 6
11 6 9
10 8 12
9 10 16
8 13 20
7 16 24
6 19 28
5 22 33
4 26 38
3 30 48
2 40 63
1 55 83
0 85 113
$33,600 $49,600
TAC = $14,900
TAC = $14,400
Types of Analyses Impact Analysis
Enviro IA: Economic IA:
Cost-effectiveness Analysis Estimate cost of alternatives with a certain
objective in mind; benefits not considered
Damage Assessment Estimate value of damages to injured
resource so that the amount can be recovered in court
CERCLA (Superfund)
Benefit-Cost Analysis
Identification and study of all enviro repercussions from actions; natural scientistsRamifications of enviro regulations for specific econ variable; economists
Ex: Williamstown wetlands and economic development
Vilfredo Pareto
Pareto improvement: A policy that makes one person better off and no one else worse off
Pareto improvement: A policy that makes one person better off and no one else worse off
Benefit-Cost Analysis Specify clearly the project/program
Location, timing, affected groups Describe quantitatively the inputs/outputs of
project Involves engineers
Estimate social benefits/costs of inputs/outputs Use monetary metric
Compare benefits and costs Net benefits? Benefit-cost ratio?
Specify clearly the project/program Location, timing, affected groups
Describe quantitatively the inputs/outputs of project Involves engineers
Estimate social benefits/costs of inputs/outputs Use monetary metric
Compare benefits and costs Net benefits? Benefit-cost ratio?
Benefit-Cost Analysis
E0 is current emissions
Proposal to reduce emissions to E2
TB = a + b TC = b Net benefits = a
Maximum net benefits occur at E* Net benefits = a + d
B-C Ratio At E2: (a+b)/b At E*: (a+b+c+d)/(b+c)
Emissions
$MD1MAC1
E* E2 E0
a
b
d
c
Benefit-Cost Analysis
Present Value Calculation
Net PV =
The higher the discount rate, r, the lower the PV What discount rate to use?
Personal time preference? Marginal productivity approach?
Real or nominal interest rate?
time
Costs
Benefits
tt
r
B
r
B
r
BC
)1()1()1( 22
11
0
OMB: r = 7%CBO: r = 2%OMB: r = 7%CBO: r = 2%
today
Interest rate on savings accounts
Interest rate on borrowing money
Future generations? Discounting downgrades future damages Policies with short run benefits and long run costs are
preferred by today’s generation Sustainability criteria as alternative
Distributional concerns? Horizontal equity: treating similarly situated people the same
way Vertical equity: treating people in different situations
differently Risk Analysis?
Uncertainty about the future makes for a probabilistic world
Benefit-Cost Analysis
timeCostsBenefits
today timeCostsBenefits
today
Benefit-Cost Analysis
Program A Program B
Net Benefits Probability Net Benefits Probability
$500,000 0.475 $500,000 0.99
$300,000 0.525 - $10,000,000 0.01
Expected Value: $395,000 Expected Value: $395,000
Measuring the Benefits of EQDirect DamagesWillingness-to-Pay Approach
Revealed Preferences Stated Preferences
Direct Damages Health damages
Health = f(life style, diet, genetics, age, AQ) Medical expenditures Lost income due to illness/death
“cost of illness study”
Estimated Cost of Adult Asthma in the US
Cost for Average Adult ($/Year)
Direct Costs
Drugs 1,605
Hospital Visits 805
Other 770
Subtotal 3,180
Indirect Costs
Complete work cessation 1,062
Lost days but still employed 486
Other 184
Subtotal 1,732
Grand Total 4,912
Source: M.G. Cisternas et al., “A Comprehensive Study of the Direct and Indirect Costs of Adult Asthma,” Journal of Allergy and Clinical Immunology, June 2003.
Direct Damages Health damages
Health = f(life style, diet, genetics, age, AQ) Medical expenditures Lost income due to illness/death
Materials damages Increased maintenance costs
Effect of pollution on production costs Reduced yields on crops
“cost of illness study”
Indirect WTP Methods Value of Health thru Averting Costs
Expenditures made to avoid bad outcomes
Value of Life thru Wage Rate Differentials “statistical life”
Value of a Statistical Life How much would you be WTP to reduce
probability of death by ?
If you are rational, you will take precautions up to the point where MB = MC.
Suppose it will cost $30 to reduce the chance of your death by
$30 = (V)( )
1
100,000
1
100,000
1
100,000
MC MB
V = $3,000,000
Value of a Statistical Life EstimatesStudy VSL in 2000 ($ millions)
Moore and Viscusi (1990) 20.8
Kniesner and Leeth (1991) 0.7
Gegax, Gerking, and Schulze (1991) 2.1
Leigh (1991) 7.1 – 15.3
Berger and Gabriel (1991) 8.6 - 10.9
Leigh (1995) 8.1 – 16.8
Dorman and Hagstrom (1998) 8.7 – 20.3
Lott and Manning (2000) 1.5 – 3.0Source: Table 7.2, p. 145, Field and Field (2006)
Fatality Risk in the USSource of Risk Annual Fatality Risk
A. General
Cigarette smoking (1.5 packs per day) 1 in 150
Cancer 1 in 300
Motor vehicle accident 1 in 5,000
Home accident 1 in 11,000
Poisoning 1 in 37,000
Fire 1 in 50,000
B. Occupational
Mining 1 in 3,200
Manufacturing 1 in 2,400
Construction 1 in 4,300
Retail Sales 1 in 56,000
Finance, insurance, real estate 1 in 77,000Source: Kip Viscusi, “The Value of Risks to Life and Health,” December 1993 Journal of Economic Literature (13):1912-1946.
Cost of Risk-Reducing Regulations
Agency, Year, and Status
Initial Annual Risk
Annual Lives Saved
Cost per Life Saved*
Unvented space heaters CPSC 1980 F 2.7 in 105 63.000 0.10
Passive restraints/belts NHTSA 1984 F 9.1 in 105 1,850.000 0.30
Seat cushion flammability FAA 1984 F 1.6 in 107 37.000 0.60
Concrete & masonry construction
OSHA 1988 F 1.4 in 105 6.500 1.40
Benzene OSHA 1987 F 8.8 in 104 3.800 17.10
Asbestos EPA 1987 F 2.9 in 105 10.000 104.20
Radionuclides EPA 1984 R 4.3 in 106 0.001 210.00
Arsenic/low-arsenic copper EPA 1986 R 2.6 in 104 0.090 764.00
Land Disposal EPA 1988 F 2.3 in 108 2.520 3,500.00
Formaldehyde OSHA 1987 F 6.8 in 104 0.010 72,000.00
* Millions of 1984 $
Source: Kip Viscusi, “Economic Foundations of the Current Regulatory Reform Efforts,” The Journal of Economic Perspectives 10 (1996): Tables 1 and 2, 124-125.
104 = 10,000105 = 100,000106 = 1,000,000107 = 10,000,000108 = 100,000,000
Hedonic Pricing Value of EQ thru Housing Prices Value of EQ thru Intercity Wage Differentials
Travel Costs for Amenities Time and travel costs represent “price” of access Problem Set 2: #11
Hedonic Pricing Value of EQ thru Housing Prices Value of EQ thru Intercity Wage Differentials
Travel Costs for Amenities Time and travel costs represent “price” of access Problem Set 2: #11
Indirect WTP Methods
Southold, Long Island, NY• Calculate value of preserving open spaces• 10 acre open parcel surrounded by 15 avg properties = $410,000
Southold, Long Island, NY• Calculate value of preserving open spaces• 10 acre open parcel surrounded by 15 avg properties = $410,000
Property values next to:• Open Space: + 12.8%• Farmland: - 13.3%• Major Roads: - 16.2%• Zoning: + 16.7%
Property values next to:• Open Space: + 12.8%• Farmland: - 13.3%• Major Roads: - 16.2%• Zoning: + 16.7%
Hells Canyon on the Snake River• Recreation vs Hydropower
• Cost savings of hydropower at Hells Canyon: $80,000• Recreational value of Hells Canyon: $900,000
Hells Canyon on the Snake River• Recreation vs Hydropower
• Cost savings of hydropower at Hells Canyon: $80,000• Recreational value of Hells Canyon: $900,000
Direct WTP Methods Political Referendum
Qualitative assessment only Contingent Valuation
Survey method used to elicit use and non-use values Total WTP = Use value + Nonuse value + Option value
Approach Choice scenario must provide accurate and clear description of the
change in environmental services Open-ended or closed-ended choice format Must specify payment mechanism and opportunity costs
Political Referendum Qualitative assessment only
Contingent Valuation Survey method used to elicit use and non-use values
Total WTP = Use value + Nonuse value + Option value Approach
Choice scenario must provide accurate and clear description of the change in environmental services
Open-ended or closed-ended choice format Must specify payment mechanism and opportunity costs
Sample CV Questions There are less than 1,000 American Crocodiles left. Habitat
necessary for the American Crocodile is rapidly being bought for development. The Nature Conservancy is considering buying land in an effort to save this species. What would you be willing to pay in the form of an annual donation in order to buy enough habitat to save 100 crocodiles?
$_______________
If you said $0, please tell me why?
There are less than 1,000 American Crocodiles left. Habitat necessary for the American Crocodile is rapidly being bought for development. The Nature Conservancy is considering buying land in an effort to save this species. What would you be willing to pay in the form of an annual donation in order to buy enough habitat to save 100 crocodiles?
$_______________
If you said $0, please tell me why?
(From: Environmental Economics & Policy (2007, 5e) by TomTietenberg.)
First, let’s assume that visitors to the Glen Canyon National Recreation Area are to finance environmental improvements by paying an entrance fee to be admitted into the recreation area. This will be the only way to finance such improvements in the area. Let’s also assume that all visitors to the area will pay the same daily fee as you, and all the money collected will be used to finance the environmental improvements shown in the photos.
Would you be willing to pay a $1.00 per day fee to prevent Situation C from occurring, thus preserving Situation A? $2.00 per day? [Increment by $1.00 per day until a negative response is obtained, then decrease the bid by 25 cents per day until a positive response is obtained, and record the amount.] _________$/day
First, let’s assume that visitors to the Glen Canyon National Recreation Area are to finance environmental improvements by paying an entrance fee to be admitted into the recreation area. This will be the only way to finance such improvements in the area. Let’s also assume that all visitors to the area will pay the same daily fee as you, and all the money collected will be used to finance the environmental improvements shown in the photos.
Would you be willing to pay a $1.00 per day fee to prevent Situation C from occurring, thus preserving Situation A? $2.00 per day? [Increment by $1.00 per day until a negative response is obtained, then decrease the bid by 25 cents per day until a positive response is obtained, and record the amount.] _________$/day
Sample CV Questions
(From: Using Surveys to Value Public Goods: The Contingent Valuation Method. Mitchell, Robert Cameron, and Carson, Richard T. 1989. Resources for the Future, Washington, D.C. Pp 4-5.)
Mono Lake, California LA water consumers vs
nesting/migratory birds Average WTP on water bill was
$13/mo (or $156/year) TB exceeded $26m cost of replacing water supply by a factor of 50
Wegge,T., W. Michael Hanemann, and John Loomis. 1996. "Comparing Benefits and Costs of Water Resource Allocation Policies for California's Mono Basin," in Advances In The Economics of Enviornmental Resources, (ed.) Darwin C. Hill, Volume 1, 1996.
Exxon Valdez Oil Spill (1989) 11 million gallons Mean WTP for a program to reduce the risk
of similar damage was a one-time tax payment of $31 per household
Estimated TB = $2.8 billion Exxon paid $0.5 billion in damages + $2
billion in cleanup
Problems with CV Hypothetical nature of questions Truthfulness/free-rider problem Framing issues
WTP vs WTA
Problems with CV Hypothetical nature of questions Truthfulness/free-rider problem Framing issues
WTP vs WTA
Direct WTP Methods
Value of a headacheWhat is the maximum dollar amount you
are willing to pay to avoid a headache?
What is the minimum dollar amount you would accept to have a headache?
WTA is not constrained by
income
Measuring Abatement Costs Level of analysis
Single firm/community/project Industry/region National economy Global
With/Without Principle Production costs:
Before Regulation: $100mFuture w/o Regulation: $120mFuture w/ Regulation: $150m
true marginal cost = $30m
Level of analysis Single firm/community/project Industry/region National economy Global
With/Without Principle Production costs:
Before Regulation: $100mFuture w/o Regulation: $120mFuture w/ Regulation: $150m
true marginal cost = $30m
Concepts of Cost
Explicit Cost Capital Costs: plant and equipment (replacement and
expansion) Operating Costs: production, maintenance, abatement
process (labor, materials, R&D) Enforcement Costs: monitoring, administration
Implicit Costs Higher product prices/reduced consumption Inconvenience of using public transportation/carpools Media switching Illegal dumping
Explicit Cost Capital Costs: plant and equipment (replacement and
expansion) Operating Costs: production, maintenance, abatement
process (labor, materials, R&D) Enforcement Costs: monitoring, administration
Implicit Costs Higher product prices/reduced consumption Inconvenience of using public transportation/carpools Media switching Illegal dumping
Social Costs = Private Costs + External Costs
US Pollution Control Expenditures: 2005
Abatement Expenditures (billions $)
Capital Operating Total % of Total
Air $3.88 $ 8.63 $12.51 47
Water $1.35 $ 6.73 $8.08 30
Solid Waste $0.68 $ 5.32 $6.00 23
Total $5.91 $20.68 $26.59
U.S. Census Bureau, Pollution Abatement Costs and Expenditures: 2005, MA200(05), U.S. Government Printing Office, Washington, DC, 2008. Online: http://www.census.gov/prod/2008pubs/ma200-05.pdf
Single ProjectsExamples
Waste treatment plants Flood-control Solid waste handling Beach restoration Public park Wildlife refuge
Construction Costs
Initial Cost Life (years) Salvage Value
Treatment PlantConveyancesSludge DisposalMitigation costs
3,0001,639 24 24
60954040
544651----
Annual Costs
Operation and Maintenance Pumping Station 21 Treatment Plant 131 Sludge Disposal 4 Total 156
Environmental Costs Mitigation costs 8 Unmitigated costs 46
Present Values
Cost Item Total PV (r=8%)
ConstructionSalvage ValuesAnnual O&MAnnual environmental Total
4,687 -1,195 156 54
4,687 - 6 1,860 644 $ 7,185
Projected Costs of a Small Wastewater Treatment Plant ($1,000)
Costs of a Local Regulation
Costly regulation imposed on local apple grower Raises costs of production: supply shifts to S2
What does apple grower do? Continue producing same quantity?
unlikely if apples are sold competitively Cut production to q2?
lost income to grower, workers, community
S1
S2
P
Applesq1
q2
$
Market price
Why is the lost income
not necessarily a social cost?
Cost of Regulating an Industry Higher production costs are social costs when they
cause CS to fall Estimate cost of “average” firm Rely on cost surveys
Self-reported Uses past data
Higher production costs are social costs when they cause CS to fall
Estimate cost of “average” firm Rely on cost surveys
Self-reported Uses past data
output
$
D
S1
S2
q1q2
P1
P2a b c
a + b = lost consumer surplus = “true” social cost
Costs at the National Level Macroeconomic modeling
Short RunPPF model suggests tradeoff between market output and EQ
Long RunGDP = F(L, K, Tech)PACE diverts resources from these factorsBut, environmental degradation reduces resources
Macroeconomic modeling Short Run
PPF model suggests tradeoff between market output and EQ Long Run
GDP = F(L, K, Tech)PACE diverts resources from these factorsBut, environmental degradation reduces resources
EQ
Market Goods
PACE as Percent of GDPCountry 1994 2000
Portugal 0.7 0.8
Poland 0.9 2.0
Canada 1.2 1.1
Japan 1.3 1.4
France 1.4 1.6
United States 1.6 --
Austria 1.8 2.4
Czech Republic 2.4 1.7
Source: OECD, “Pollution Abatement and Control Expenditure in OECD Countries,” ENV/EPOC/SE(2003)1, Paris, 17 July 2003, p32.
