ENVR E-115Sustainable Development

Introduction to the Economics of Sustainability

November 13, 2007

How much does gasoline cost?

Introduction to Shadow Pricing?

National Geographic, June, 2004, p. 97

Economics of Sustainability

Natural, man-made, and human capital Definitions of sustainability Problem of defining objectives Practical sustainability criteria

Place economic values on environmental costs and benefits (User Pays and Polluter Pays Principles)

Avoid damage to critical natural capital as far as possible (the Precautionary Principle)

Avoid irreversible processes Limit the use of natural assets to their sustainable yield,

otherwise include the costs of replacing these assets (Cost of Remediation)

Issues covered (Chap. 9) Evolution of economic thinking about

sustainability Adam Smith, Ricardo, Marx, Keynes

Concepts of welfare Utility maximization Pareto optimality

Macroeconomic concepts Production approach to to GDP

Microeconomic concepts Demand, supply, and price

Public goods Public goods Common property Private goods

Issues covered (Chap. 10) Externalities Externalities and market failure Valuation Total economic value Economic assessment of

sustainable projects Assessment of climate change

mitigation

Evolution of Economic Thinking

- and the role of different factors -Land, Labor, Capital (Adam Smith, Ricardo)

Labor, Capital

(19th century Industrial Revolution, Marx)

Capital

(Marxism in 20th century USSR)

Capital, Labor (Keynes)

Capital, Labor, Land

(Modern environmental economics)

CONCEPTS OF WELFARE

Utility Maximization

GNP as a Proxy for Utility

Economic Efficiency …an organization of production and consumption such that

all unambiguous possibilities for increasing economic well-being have been exhausted.

…an allocation of resources such that no further reallocation is possible which would provide gains in production or consumer satisfaction to some firms or individuals without simultaneously imposing losses on others (Pareto optimality)

…Pareto optimality can be expressed simply on attainment of; economic efficiency in production of goods and services; economic efficiency in distribution of goods and services; and resource allocation consistent with consumer preferences.

Pareto Rests on Several Value Judgments

1. Individual preferences count, the economic welfare of a society is based upon the welfare of individual citizens

2. The individual is the best judge of his/her own well-being3. A change that makes everybody better off with no one

being worse off constitutes a positive change in welfare.

To get to modern Benefit/Cost practice from Pareto need the “compensation test.” In other words, if the gainers could compensate the losers and still be better off, the change is judged an improvement. This leads to “potential Pareto” improvement.

Some Macro Economic Concepts

Sustainable Social Net ProductSustainable Social Net Product based on Hick’s definition of income (i.e. maximum value that a person can consume in a period of time and still expect to be as well off at the end of the period as he was at the beginning = Net National Product minus Defensive Expenditures minus the Depression of Natural Capital

SSNNP = NNP – DE – DNC

“Cost-of-Repair” approach emphasizes measuring the “Defensive Expenditures” part of this index.

SOURCE: Daly, 1990

WEAKCombined value of all assets remain constant, or increasing, means that substitution of one form of capital (natural) by another (manufactured) is possible.

STRONGNatural capital is a complement to manufactured capital rather than a substitute. This means that natural capital (eg, fisheries or forests) can only be exploited at their natural rate of growth.

Sustainability can be Weak or Strong

Gross Domestic Product or Expenditure, 1930–2000 (in billions of current dollars)(GDP=GNP-net factor earnings from ROW, NNP=GNP-consumption of fixed capital)

Item 1930 1940 1950 1960 1970 1980 1990 1995 1999 20001

Gross domestic product $91.3 $101.3 $294.3 $527.4 $1,039.7 $2,795.6 $5,803.2 $7,400.5 $9,268.6 $ 9,872.9

Personal consumption expenditures

70.2 71.2 192.7 332.2 648.9 1,762.9 3,831.5 4,969.0 6,250.2 6,728.4

Gross private domestic investment

10.8 13.6 54.1 75.7 150.4 484.2 847.2 1,110.7 1,636.7 1,767.5

Exports of goods and services

4.4 4.8 12.3 25.3 57.0 278.9 557.2 818.6 989.8 1,102.9

Imports of goods and services

4.1 3.4 11.6 22.8 55.8 293.8 628.6 902.8 1,240.6 1,466.9

Government10.0 15.1 46.9 113.8 237.1 569.7 1,181.4 1,372.0 1,632.5 1,741.0

Some Micro Economic Concepts

Public, Common Property, and Private Goods

Public Good: non-excludable, non-rival consumption. (Lighthouse, flood control)

Common Property: non-excludable, rival consumption. (Fisheries, polluting streams)

Private Goods: excludable, and rival consumption. (Irrigation, domestic water supply.

Two Fundamental Issues in Environmental Economics and

Policymaking1. Externalities

• Spatial• Temporal

2. Valuation• Qualitative• Quantitative

Externalities and Market Failure

When is an external effect an Externality?

You are driving a car when the person next to you lights up a cigarette. Is this an externality or not? It is, because you were never asked.

If the person asks permission to smoke, and you give permission? It is not, because you indicate that you are willing to accept the damages.

If he asks and you tell him it will cost him $1? It is not, because if he does not smoke you are not affected, and if he does you have set the price for compensation.

In both of the latter two cases you are part of the decision-makingprocess and the externalities have been internalized.

How Externalities and Valuation Affect Decision Making

(an example from a Mangrove forest)Location of Goods and Services

On-Site Off-site

Valuation of Goods and

Services

Marketed

1Usually included in an economic analysis (e.g., poles, charcoal, woodchips, mangrove crabs)

2May be included (e.g., fish or shellfish caught in adjacent waters)

Non-marketed

3Seldom included (e.g., medicinal uses of mangrove, domestic fuelwood, food in times of famine, nursery area for juvenile fish, feeding ground for estuarine fish and shrimp, viewing and studying wildlife)

4Usually ignored (e.g., nutrient flows to estuaries, buffer to storm damage)

SOURCES OF MARKET FAILURE

Public goods (non-excludable; non-rival consumption)

Common property resources (non-excludable; rival consumption)

Externalities Un-priced assets and missing markets Lack of property rights Transaction costs Irreversibility Ignorance and uncertainty

SOURCES OF GOVERNMENT (POLICY) FAILURE

Failure to correct market distortions Subsidies to resource users and polluters Inappropriate tax incentives and credits Over-regulation and under-regulation Conflicting regulatory regimes Bureaucratic obstacles and inertia

The Concept of Total Economic Value (TEV)

u s u a lly m e asu reso u tp ut

D ire c t u s e va lu es(s tru c tu ra l va lu e s)

u su a lly m e as u resb e n e fits /s erv ices

In d irec t us e va lu es(fu n ctio n a l va lu e s)

O p tion v a lu es

U se va lu es

E x iste n ce va lu es B e qu e st va lu es

N o n-u se v alu es

Total Econom ic Value

Approaches to Valuation Changes in

Production Crops, fisheries,

water Health Opportunity cost

Hedonic Approaches Property value Land values Wage differential

Survey Techniques CVM (Contingent

Valuation Method) Surrogate

Markets Travel Cost

The Hedonic Pricing Method is most often used to estimate economic values for ecosystem or environmental services that directly affect market prices.  It is most commonly applied to variations in housing prices that reflect the value of local environmental attributes. For example, it can be used to estimate economic benefits or costs associated with:

• environmental quality, including air

pollution, water pollution, or noise• environmental amenities, such as aesthetic

views or proximity to recreational sites

The basic premise of the hedonic pricing method is that the price of a marketed good is related to its characteristics, or the services it provides. In general, the price of a house is related to the characteristics of the house and property itself, the characteristics of the neighborhood and community, and environmental characteristics.  Thus, if non-environmental factors are controlled for, then any remaining differences in price can be attributed to differences in environmental quality.  For example, if all characteristics of houses and neighborhoods throughout an area were the same, except for the level of air pollution, then houses with better air quality would cost more.  This higher price reflects the value of cleaner air to people who purchase houses in the area.

The Contingent Valuation Method (CVM) is used to estimate economic values for all kinds of ecosystem and environmental services.  It can be used to estimate both use and non-use values, and it is the most widely used method for estimating non-use values.  It is also the most controversial of the non-market valuation methods. The contingent valuation method involves directly asking people, in a survey, how much they would be willing to pay for specific environmental services.  In some cases, people are asked for the amount of compensation they would be willing to accept to give up specific environmental services.  It is called “contingent” valuation, because people are asked to state their willingness to pay, contingent on a specific hypothetical scenario and description of the environmental service.

Contingent valuation is one of the only ways to assign dollar values to non-use values of the environment—values that do not involve market purchases and may not involve direct participation. These values are sometimes referred to as “passive use” values.  They include everything from the basic life support functions associated with ecosystem health or biodiversity, to the enjoyment of a scenic vista or a wilderness experience, to appreciating the option to fish or bird watch in the future, or the right to bequest those options to your grandchildren. It also includes the value people place on simply knowing that giant pandas or whales exist. 

One of the first contingent valuation studies (1987) to measure the use and non-use values that citizens have for public trust resources was a survey of California households regarding willingness to pay for increased water flows into Mono Lake. The State of California Water Resources Control Board (WRCB) was faced with a decision about how much water to allocate to Los Angeles from sources flowing into Mono Lake.  The reduced water flows to the lake were affecting food supplies for nesting and migratory birds. The cost of providing alternate sources to replace the water going into Mono Lake was $26 million per year.The average willingness to pay per household was estimated from the survey to be $13 per month, or $156 per year. Is the decision to invest in alternate resources justified to save Mono Lake?

Valuing Human Health Risk Private costs (born by individual)

Pain & suffering, private medical expenses, lost income

External costs (born by others) Publicly provided or insured medical expenses,

sick pay Methods

Cost of illness, human capital Willingness to pay for benefit (WTP),

willingness to accept compensation for harm (WTA)

The Value of a Life SavedBody – for chemicals ≈ $5

– for fluids, DNA & tissues ≈ $45 × 106

– 1,000 gm of bone marrow at $23,000/gm ≈ $23 × 106

Doctors & – $250,000 for non-economic damages, i.e., pain andInsurance Co. suffering

Median plaintiff in wrongful death cases – $900,000

Sept. 11, 2001 – $250,000 to $7 × 106

Feb. 2004 – injured 9-year old awarded $47 × 106 against Ford

US Air Force – ski gondola causes 20 deaths, awarded $2 × 106 each

The Value of a Life Saved (cont.)

US Government – shot down Iranian airliner in 1988, 290 victims, $300,000 for wage earners; $150,000 for non-

wage earners

Deaths in Iraq – US GI killed, family receives $250,000

DOT – values road improvements at $3 × 106

EPA – $3 × 106 in 1984 for benzene emissions

OSHA – $5.3 × 106 for life saved due to grain dust rules

SuperFund – $3.2 × 106 per life saved

EPA under Bush – reduced from $6.1 to $3.7 × 106

Value per Statistical Life

Is NOT a measure of the intrinsic worth of an individual

Does NOT measure what an individual would pay to avoid certain death (or accept as compensation for certain death)

Depends on (total) baseline risk income and wealth

May depend on other characteristics of risk e.g., acute trauma or chronic disease “voluntary” or “involuntary”

May depend on social, cultural, economic factors

Choice of Valuation Technique Environmental Impact

Measurable change in production

Change in environmental quality

Yes

Nondistorted market prices available?

Use change-in-productivity approach

Use surrogate market approaches, apply shadow prices to changes in production

Yes No

Habitat

Opportunity-cost approach

Replacement cost approach

Land value approaches

Contingent Valuation

Air and water quality

No

Cost-effectiveness of prevention

Preventive expenditure

Replacement/ relocation costs

Health effects

Sickness Death

Medical costs

Loss of earnings

Human capital

CEA of prevention

Recreation

Contingent valuation

Travel cost

Aesthetic, Biodiversity, Cultural, Historical assets

Contingen Valuation

Contingent Valuation

Hedonic wage approach

Contingent Valuation

Costs and the time value of money

CATEGORIES OF COSTS Capital cost

Operation and maintenance costs

Variable costs and fixed costs

Salvage value

ENGINEERING NEWS RECORD COST INDEX

Construction Cost Index History (1908-2003)HOW ENR BUILDS THE INDEX:

200 hours of common labor at the 20-city average of common labor rates, plus 25 cwt of standard structural steel shapes at the mill price prior to 1996 and the fabricated 20-city price from 1996, plus 1.128 tons of portland cement at the 20-city price, plus 1,088 board-ft of 2 x 4 lumber at the 20-city price

 

Construction Cost Index 1908-1979

TIME VALUE OF MONEY

CASH FLOW DIAGRAMS The cash flow diagram is a simple

tool to depict the cash flows over time

You must have an interest rate on the diagram

Capital costs

O&M costs

Salvage value

FUNDAMENTAL DISCOUNT FACTORS

P (present value)

F U(uniform series amount)(future amount)

Some Case Studies

Market Interest Rates US Long-term Government Bonds 1789-1999 (adjusted for inflation)

CLIMATE CHANGE EXAMPLE

Mean reverting based upon averaging between 1% and 7%

Random walk based upon thousands of random walks between 1% and 7%

Expected Discounted Value of Climate Mitigation Benefits (Due to a 1 ton

reduction in 2000)(per ton Carbon)

Gov. bond rate

Benefits from 1 ton of carbon mitigation

Relative to constant rate

4% Constant $5.74Random walk $10.44 82%Mean reverting $6.52 14%

2% Constant $21.73Random walk $33.84 56%Mean reverting $23.32 7%

7% Constant $1.48Random walk $2.88 95%Mean reverting $1.79 21%

The European spot market for carbon-trading on Nov. 12, 2007 was 21.9 Euros (approx. US$ 30).

Case Study 2: Hedonic Valuation

Hedonic Valuation Approaches: Use information on observed behavior to

estimate WTP (willingness to pay) for an environmental amenity (an economic ‘good’) or disamenity (an economic ‘bad’)

Requires information on transactions and differences in environmental quality

Often applied to housing, hotel rooms or other locational decisions (e.g. wages and a ‘sunshine tax’)

Case Study 2: Hedonic Valuation – Two Examples

1. Flats and hotel room pricing in resorts (e.g. on the beach in Hawaii)

Price varies with floor (higher floors are more expensive)

Price varies with view ocean view ‘garden view’… usually the parking lot, maybe the

mountains! Price vary with season:

High season/Low season Or, as in Costa Rica, high season and the ‘green’

season (e.g. rain!)

Case Study 2: Hedonic Valuation – Two Examples

2. Pricing of faculty flats at a university in China

1. 6 storey building, no lift, one flat per floor, roof leaks.2. What is the monthly rental per flat? If ground floor

rents for $100 per month, what are the monthly rents for the following floors?

Floor 2 ___ Floor 3 ___ Floor 4 ___ Floor 5 ___ Floor 6 (top) ___

Case Study 3: Valuing Health Impacts and Air Pollution –

SANTIAGO DE CHILE Major capital city with air and water

pollution problems Decision needed on levels of

investment in pollution control, and what to invest in

Desire to set investment between sectors and needs, e.g. control of air versus water pollution

Case Study 3: Valuing Health Impacts and Air Pollution –

SANTIAGO DE CHILECalculation of benefits of each control strategy1. Use a dispersion model to determine change in population-

weighted ambient exposures resulting from each control strategy.

2. Translate change in ambient exposures into health changes using dose-response functions:

Life-years gained (reductions in premature mortality) Reduced hospital admissions Fewer restricted-activity days Fewer cases of chronic bronchitis

3. Translate health benefits into health time gained plus reduced medical costs.

4. Value healthy time at the wage rate to compute a lower bound to the dollar value of health benefits.

Case Study 3: Valuing Health Impacts and Air Pollution –

SANTIAGO DE CHILEHow Can We Value a Life Saved?Several Major Approaches are commonly

used:1. Human Capital Approach/Loss of earnings

Uses the present value of future earnings lost due to premature death.

Theoretically flawed Ethically questionable Often used to give a lower bound estimate

Case Study 3: Valuing Health Impacts and Air Pollution –

SANTIAGO DE CHILE2. Wage differential approach to estimate VOSL – Value Of a Statistical Life (revealed preferences)

Uses information on different wages for jobs with different levels of risk to estimate peoples WTAC (willingness to accept compensation) for increased risks.

Example:Wage differential approach (U.S. data):

Common Values from $3x106 to $5x106

Range $1.9 - $10.7x106 (1990)WTP/CVM:

Range $1.2 - $9.7x106

VOSL studies in U.S. are typically 5-10 times higher than foregone earnings.

Case Study 3: Valuing Health Impacts and Air Pollution –

SANTIAGO DE CHILE3. WTP studies for reduced risk of

premature deathAsks a WTP question for reduced risk (stated

preferences)Examples: Canada: to value a 5 in 10,000 risk change

C$657/.0005 =~ C$1,314,000 (about US$ 830,000) U.S. studies:

Range from $1 to $5 x 106

Average: $3,000,000

Case Study 3: Valuing Health Impacts and Air Pollution –

SANTIAGO DE CHILEAnnualized benefits and costs of air pollution

control strategy in Santiago, Chile (US$ millions)

Program Component

Benefits Costs Net Benefits

Fixed sources 27 11 16Gasoline vehicles 33 14 19Buses 37 30 7Trucks 8 4 4Control Strategy 108 60 48

Source: World Bank, 1994

Recapitulation of Themes

Define GDP?Gross Domestic Product is the total final value of goods and services produced in the country by locally-owned firms or workers. This includes the value of products that are produced in that country for local consumption or for export, but does not include the imports from other countries. GDP is calculated by adding private and public spending, investments and exports, minus imports, and minus value generated by foreign-owned companies.

How are supply and demand curves estimated?The supply curve is the marginal cost of the producers, so it may be calculated from the production costs. The demand curve for a given product represents the total quantity of that product that people will want to buy at a given price. It is the sum of the total demand of all individuals in that society. So, demand is a behavioral aspect of consumers and supply is the technical response of producers.

Price elasticity reflects the effect of changes in price on the quantity that the consumers demand. The formula is: (DQ/Q)/( DP/P), where P is price and Q quantity. A price elasticity of 1 means that a price increase will lead to a quantity change of the same proportion. Demand may be elastic (elasticity > 1), meaning that a small change in price will cause a large change in demand. Demand may be inelastic (elasticity < 1) meaning that a large change in price will cause a small change in quantity.

Income elasticity reflects the sensitivity of demand to changes in income – that is, the change in quantity demanded at different income level. The formula is: (DQ/Q)/(DI/I), where I is income and Q quantity. Basic needs, such as basic food products, have low income elasticity (<1). Luxury goods have a high income elasticity (>1).

INCOME AND PRICE ELASTICITY

Public Goods, Common Property Resources, and Private GoodsPublic Goods: non-excludable, non-rival consumption. (Lighthouse, flood control)Common Property resources: non-excludable, rival consumption. (Fisheries, polluting streams)Private Goods: excludable, and rival consumption. (Irrigation, domestic water supply.

ExternalitiesExternalities are caused when the actions of one person affect the welfare of other people who are not involved in that person’s decision-making process. The externalities may be positive or negative.

Shadow Pricing Refers to the assigning of prices to non-traded goods, or adjusting the value of traded goods to account for market failures

Evaluating Health BenefitsHuman capital approachWage differential approachWillingness to pay using contingent valuation

Discounting the futureMarket rates of discountSocial rates of discountPure time preferenceNon-exponential discounting for

intergenerationalProblems

Sources of Market FailurePublic goods (non-excludable; non-rival consumption)Common property resources (non-excludable; rival consumption)ExternalitiesUn-priced assets and missing marketsLack of property rightsTransaction costsIrreversibilityIgnorance and uncertainty