demand for environmental goods

8/11/2019 Demand for Environmental Goods

1/13

EurekaWow | Environmental Economics

6thSemester | B.A. Economics (H)

Unit 5: Measuring the Benefits of Environmental Improvements

Charles D. Kolstad, Intermediate Environmental Economics

Chapter 7: Demand for Environmental Goods (skip section VI)

I.

What is so special about an environmental good?

Examples of environmental goods: air quality, existence of a particular species, amenity valueslike clean air or clean rivers.

Environmental goods can be placed within the paradigm of consumer theory because theconsumption of environmental goods also involves trade-offs. In order to consume more of anenvironmental good, resources (money) must be shifted from consumption of conventionalgoods to the protection of the environmental good.

The amount of shift in resources tells us the consumers willingness to pay for the

environmental good, which implies that there is a demand for environmental goods.

The difference between conventional goods and environmental goods is that markets exist forconventional goods, but not for environmental goods.The reasons for this are:

Conventional Goods Market Environmental Goods Market

Conventional goods are properly defined. Definitions of environmental goods are notclear. Eg. What is clean air?

Quantities of goods consumed at differentprice levels are observable.

It is difficult to observe the quantity ofenvironmental goods consumed.

They are private in nature, i.e.characterised by excludability and rivalry.

They share features of public goods, i.e.non-excludability and non-rivalry.

Eg. Milk Eg. Clean air

However, despite the absence of quantities and prices, the demand curve for environmentalgoods can be perceived. If individuals value clean air, they will be willing to pay for it. If thecost of reducing air pollution is high, then people will probably have a higher tolerance for airpollution.At low levels of air quality, individuals might be willing to pay more for clean air,and at high levels of air quality, willing to pay lesser for clean air.

Difference between ordinary public goods and environmental goods:

Ordinary Public Goods Environmental Goods

Eg. Public Schools Eg. WildernessThey are produced by the government at acost, thus the consumers have a referencepoint to the cost of supply of the good.

They are not necessarily produced byanyone. Forests exist on their own, sotrying to deduce their value is difficult.In the case of clean air (by reducing


2/13



pollution), even if the cost of reducing airpollution is known, the cost is dispersed.

II. Willingness to Pay:

The concept of price and consumer surplus is also applicable to environmental goods despite

the absence of a formal market for them.

(Conventional Good) (Environmental Good)

Price Marginal Willingness to Pay (MWTP)

Consumer Surplus Total Willingness to Pay

Marginal Willingness to Pay (MWTP):

This is what an individual is willing to pay for one more unit of an environmental good.

Figure 1

In figure 1 the downward sloping curves represent the marginal willingness to pay at incomelevels $8500, $11500 and $15000 for an additional unit of nitrogen oxide (at different levels ofnitrogen oxide).

What do we know from figure 1?

The negative value of the MWTP for an additional unit of NOx means that the demandcurve lies in the fourth quadrant. This is so because additional NOx is a bad.

The negative value of the MWTP means that individuals need to be compensated forthe additional unit. The compensation increases as NOx increases.

If the X- axis represented reductions in NOx, demand curve will still be downwardsloping, i.e. as the quality of air improves because of reductions in NOx, individuals are


3/13


4/13




5/13



III. Types of Environmental Goods

Environmental goods can be classified on the basis of the way their value is perceived by individuals.The two different kinds of values that can be ascribed to environmental goods by individuals are thefollowing:

a) Use Value:Value of a good associated with its consumption. The kind of consumption variesaccording to the time period of consumption:

Current use I am going to Sariska today

Expected Use I will visit Sariska next year

Possible Use I might visit Sariska in the next 10 years

The use of environmental goods can directly or indirectly affect individuals. An example of directimpact is the negative effectof breathing polluted air on respiratory health. Environmental goods likepollution can also affect producers through increases in the costs of production; for example: the costof producing clean laundry increases with increase in polluted air.

Indirect effects can be understood as that which humans feel through disruption in the ecosystemthatcontribute to economic benefits (when it is involved in production purposes) or to a sense of well-being (when it is used as an amenity). Eg.Impact of air pollution in an area on the travelling experiencethere.

b) Non-Use Value: When an individual values an environmental goodin this way, he does notreally consume it or apply it to derive utility. She derives utility by knowing that someone else

is using it or by knowing that it exists. There are three kinds of non-use values that exist:

Altruistic: Value attached to knowing that someone else is benefiting from using theenvironmental good

Bequest: Value attached to knowing that their future generation will benefit from usingthe environmental good

Existence:Value attached to knowing that the environmental good exists

IV. Measuring Demand

There are two kinds of preferences of consumers that are known: stated preferences andrevealed preferences.

In this method, consumers are introduced to

hypothetical markets and asked how they would

trade off money/ other goods for the

environmental good

Stated Preferences Revealed Preferences

Observe the decisions made by consumers in a

market and infer their preferences and

information about trade-off between the

environmental good and money/ all other goods


6/13



Survey the literature for a particular issue

and apply it to another research.

It is also known as the poor mans

estimation.

Types Types

Hedonic

Pricing

Household

production

Deriving demand by observing thechange in the price of a good as the

amount of a closely related

environmental good changes

Starts with the assumption that

households consume

complementary goods- an

environmental good and a private

good.

The observed expenditure on theprivate good is the lower bound of

the value placed by a household

on the environmental good.

Laboratory

Experiments

Contingent

Valuation

Referendum

Construct hypothetical or real marketswhere markets do not exist and derive

a demand curve.

Involve real resource decisions.

Subjects are actually given the

resource- money, environmental

good, etc.

Information on consumer behaviour

is derived based on how the decisionsmade by the subjects. Such

information is not available from

markets that exist.

Useful, but too expensive to conduct.

A proposal like a tax or subsidy is put to

vote in a community. The consumers

state their preferences through their

votes.

Its usefulness is however limited as it is

applied to just the communities and

the environmental goods involved.

Benefits

Transfer


7/13



V. Revealed Preference and Restricted Demand

Revealed preference measures are most commonly used to estimate the demand forenvironmental goods and services. In the case of conventional goods, consumers change theamount of conventional good x consumed as its own price, the price of complementary goods,

the price of substitutes or the consumers incomes change. By using transactions data andstatistics, the relationship between price and quantity demanded of x is estimated.

The demand for environmental goods cannot be derived in the same manner because of, asmentioned before, the absence of prices for environmental goods. An alternative to derivingdemand is restricted demand.

Figure 3

In figure 3, the demand curve for market good x with q quantity of environmental good at pricepxis given.

x= h(px,q) (i)

The equation in (i), one price and one quantity are given as arguments in the RHS. Werefer to this as a restricted demand. A conventional demand curve has only prices and

income as arguments in the RHS. When q (such as air quality in an area) increases to q+q, x (such as demand for houses

in that area) increases at every price px.

The change in the willingness to pay is given by the shaded region, which is also thechange in consumer surplus when px=px

*.

Using (i) and figure 3, we will derive the MWTP for q.


8/13



MWTP:It is the change in willingness to pay (WTP) when q changes a little. Mathematically,it is the ratio of change in willingness to pay and the change in q.

MWTP=

= (px, q)

This gives us the restricted demand for q.

It is a restricted demand for q because we are only considering the effect of q on the marketgood x. But q, such as improvement in air quality, affects a host of other market goodsandservices like laundry, or even activities like walking, travelling, etc.

VI. Discrete Choice (Skip)

VII. WTP vs. WTA(willingness to accept)

The WTP and WTA for conventional market goods and services is the same. However, in thecase of environmental goods like air pollution, the MWTA for a unit increase inpollution>>MWTP for a unit decrease in pollution. This can be because the WTP can belimited by income or wealth of an individual, but the WTA would also be influenced byadditional factors.

Figure 4 depicts indifference curves for a combination of x(market goods) and q(environmentalgood).

q0 < q1, & hence U0


9/13



Figure 4

Instead, if the consumer has to reduce consuming q from q1to q0, the consumer needs tobe compensated for to be able to remain on U1.

The minimum of x that the consumer is willing to accept for losing q is that amount thatwill keep her at least as well of as she was at (x0, q1), i.e. at U1.Thus, the consumersWTA is AD.

We can see that AD>BC.

Chapter 8 Revealed Preferences: Pollution, Land Prices and Wages

Section IV(A,B,C,D): Hedonic Price Theory

Focus of the Hedonic Price theory is on inferring the value placed on characteristics of goods based onthe observed price of a bundle of characteristics.

To understand this theory, let us take a simple model that involves one homogenous market and onegood (eg. A house in an area) which has only one characteristic (eg. Air quality).The market isperfectly competitive, so all consumers and producers of the good x are price takers.

In this model, we will check:

Price of the good in the market

Price that the consumer is willing to pay for changes in the characteristic of the good p(z)

i.e. how the price of a house changes when the air quality changes Allocation of consumers income between goodx and all other goods, with allocation on

the former depending on characteristic z

A. The Consumer


10/13



A consumer has Utility function U and income y. The consumer buys exactly one house andother goods whose nominal price we suppose is 1.

Budget constraint: x+p(z)=yUtility= U(p(z), x)

p(z)is an increasing function of z. The consumer first decides how much to bid for a house withcharacteristic z, with the maximum she is willing to bid be . Let be the utility level shedesires. Thus, the consumers optimisation problem can be written as:

Max such that U(x,z), x+=y

(y,z, ) can be called the bid function where y, z and are exogenous while and x arechosen. The consumer chooses such that she obtains at least that much utility that she desires

and does not violate her budget constraint.

Figure 1 shows the bid functions of a consumer with different utility levels. The X-axisrepresents the characteristic z and the Y-axis shows the bid, , in dollars.

We can infer that U0= 1. If we put 0 and 1 in the budget constraint:

xo=y-0x1=y-1

0 > 1implies that x1>x0So, U(x1,z1)>U(x0,z1)

The level of z and that the consumer will choose is that point where the bid function is tangent to thehedonic price function, i.e. the bid for z1is equal to the price of z1. At any other level of z, the bid istoo low and the consumer cannot buy any house.

Utility increases

(y,z,U1)

(y,z,U )

p(z)

Air quality z

$

z1


11/13



B. The Producer:

The producers of the house want to maximise their profits given input cost r and characteristicz.

Profit function: =-c(r,z)=c(r,z)-

: profit : price

(r,z,) is the offer function which shows how much a producer is willing to sell the house forwith characteristic z given the input cost and the profit desired by the producer.

Figure 2 shows the offer curves along with the hedonic price function. The higher offer curvesrepresent higher profits as for the same characteristic z, they are charging higher prices.

The optimal level of z is that where the offer curve of the producer is tangent is to the hedonicprice function p(z). At other points, the price of the house is higher than the hedonic price.

Note: different consumers and sellers will have different indifference and offer curves.

Figure 2C. Market equilibrium:

Figure 3 shows the points of choices of z of 3 consumers and 3 producers that maximise theirutilities and profits.

There are three pairs of an offer function and a bid function that are tangent to each other. Theprice line p(z) is formed by the points of tangencies between all bid functions and offerfunctions.


12/13



Figure 3The points of tangency tell us that:

The slope of the offer function and the bid function is the same, and both are equal tothe slope of the price function.

The marginal price charged by a producer is equal to the marginal price of the that aconsumer is willing to pay for an extra unit of z, and to the marginal price of good itselffor an extra unit of z.

The marginal price of the good for an extra unit of z is the price of the characteristicitself.

The marginal valuation by the bidder, the seller and market is the same in equilibrium.

D. Marginal Willingness to Pay (MWTP)

The price function can be used to find out how much of z an individual demands through hermarginal willingness to pay for an extra unit of the characteristic z. The price line does not tellus the demand for z because every consumer and producer is choosing only one point on theprice line, which is not a demand curve. Thus, we will see how a consumers willingness to paychanges as z changes.

Figure 4 shows p(z) and the slope of the price function and MWTP of 2 individuals. Thepoints of intersection of the MWTP curves with p(z) are the different levels of z demanded by

the two individuals.


13/13



Figure 4

The MWTP functions are derived by assuming that the two individuals are the same person,but with differences like income levels; let the observable differences be . There are also

producers with different observable characteristics; let that be called .

i. p(z)= (z,)- demand function

ii.

p(z)= (z,)- supply functionRemarks:

(i) tells us that the marginal willingness to pay for an additional unit of zdepends on the level z and other characteristics like income

(ii) tells us that the price at which z is supplied depends on the existing level of zand other factors like cost.

The method described entails the following steps: Finding the hedonic pricefunction and then measuringits slope and using it as the price of thecharacteristic.

$

demand for environmental goods

Documents