BENEFIT-COST ANALYSIS Financial and Economic Appraisal using Spreadsheets

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1 BENEFIT-COST ANALYSIS Financial and Economic Appraisal using Spreadsheets Ch. 12: Valuation of Non-marketed Goods Harry Campbell & Richard Brown School of Economics The University of Queensland We have seen how in conducting efficiency benefit-cost analysis we often use market prices, either directly or indirectly, to value or cost project outputs or inputs. We use market prices directly when they are generated by perfectly competitive markets - markets that are not distorted by monopoly, monopsony, taxes or regulations. We use market prices indirectly when we adjust them to generate shadow-prices. In this way prices that are generated in imperfectly competitive markets can provide information that can be used in the BCA. For some project inputs or outputs there will be no market in which they are traded, and hence no market price is available for use either directly or indirectly in the BCA. Some examples of non-marketed outputs or inputs: - recreational fishing - a nice view - air or water pollution - a life saved - a disease prevented Non marketed goods and services are just as relevant to economic welfare as marketed commodities. Since changes in the quantities of non-marketed goods and services affect the level of economic welfare, they need to be valued in efficiency and referent group BCA ( but not in project or private BCA). The analyst is very likely to encounter the problem of valuing non-marketed commodities in BCA. Why? Because project outputs or inputs do not have market prices the market resource allocation may not be efficient. For this reason governments see a need to regulate the private market or undertake public expenditure in areas neglected by the market. The very fact that the government wants a BCA suggests that there may be non-marketed commodities involved. Why are some outputs or inputs that affect the level of economic welfare not marketed? The market is a vehicle for trade in commodities. For trade to occur, property rights in the commodities have to be reasonably complete and enforceable. Buyers may not be willing to pay for an output or input unless they believe they will have full and exclusive use of it for a specified period of time, and will be able to sell it to someone else, if they wish. Commodities that have these characteristics are termed private goods. Public goods are goods which lack some of the property rights characteristics of private goods, and as a consequence are not supplied in efficient levels by the private market. It is best to think of any given commodity as lying in some continuum between a pure private good and a pure public good. A pure public good is one that has the following characteristics: 1. Non-rivalry in consumption: this means that consumption of a unit of the good by one individual does not preclude other individuals from simultaneously consuming that unit. 2. Non-excludability by producers: this means that supplying a unit of the good to one person means that everyone can consume that unit if they choose to; 3. Non-excludability by consumers:this means that supplying a unit of the good to one person means that everyone will consume that unit whether they wish to or not; 1

2 A semi-public good has one or two of the three pure public good characteristics. Examples: 1. Non-rival in consumption and non-excludable by producers: free-to-air broadcasting. 2. Excludable by both producers and consumers but nonrival in consumption: an uncongested motorway 3. Excludable by producers, but non-excludable by consumers, and non-rival in consumption: some kinds of air pollution. 4. Rival in consumption but non-excludable by producers: an open-access fishery. External effects are flows of goods or bads that are generated by the market economy, but are not traded in the market. Some externalities are private in nature - one agent s activity affects the welfare of one other agent eg. your neighbour s tree shades part of your garden. This kind of issue can often be resolved through negotiation. Many externalities are public in nature - they are public goods or bads eg. air and water pollution. Why do we expect to see more public bads than public goods? Excludability is largely a matter of cost. This means that to some extent producers can decide whether to limit availability of the good or bad they produce. It is in their interests to limit availability of goods (which they can charge a price for) but not to limit availability of bads (from which they can derive no benefit). Examples: 1. At some cost TV stations can limit access to their services by accessing cable networks. 2. If a carbon tax is introduced it will be in producers interests to reduce carbon emissions Benefit-Cost Analysis: financial and economic appraisal using spreadsheets, Chapter 12, p. 263 In summary, the private market does not supply efficient levels of goods or bads which are non-excludable and/or non-rival. Provision of public goods is one of the important activities of governments, and is one of the reasons for social benefit-cost analysis: proposed government programs or projects which supply public goods need to be appraised. Furthermore, because many private projects produce non-excludable external effects it cannot be assumed that because they are in the private interest of their proponents they are also in the public interest. Social benefit-cost analysis is used to appraise such projects from a public interest viewpoint before they are allowed to proceed. To be of use the social BCA needs to be able to assess the project s external effects in terms commensurate with its private net benefits. Thus the market failure which provides the major rationale for social BCA at the same time poses one of its major challenges - that of valuation in the absence of market prices. In order to illustrate the use of non-market valuation techniques we will use environmental goods and services as an example. Figure 12.1 Total economic value of coral reef ecosystems Total economic value In benefit-cost analysis we are not interested in the total value of environmental assets, but rather in the likely changes in total value as a result of a proposed project ie. the project either increases the annual value derived from the reef by some amount (a project benefit), or it decreases the annual value of the reef by some amount (a project cost). Direct use values Consumptive uses Coral mining Shell collection Fishing Non-consumptive uses Scuba diving Recreation Indirect use values Storm surge protection Wastewater treatment Fish nursery area Food chain Option values Direct use Indirect use Existence value Biodiversity Recreational amenities Bequest value Biodiversity Recreational amenities Since the services of a coral reef are not traded in a market (because of their public good characteristics) the benefitcost analyst needs to employ non-market valuation techniques to place dollar values on changes in the flow of services generated by the reef. Dollar values are required to make the benefits or costs associated with environmental changes commensurate with the other project benefits and costs. 2

3 Economists generally base non-market valuation techniques on the analysis of supply or demand. Supply-side analysis: this approach generates values based on the costs of either preventing or not preventing environmental damage. We will look at three approaches: - the dose/response method - the opportunity cost method - the preventative cost method Demand-side analysis: this approach generates values based on consumers willingness-to-pay for environmental services. There are two main approaches: - the revealed preference approach - the stated preference approach The dose/response method Environmental attributes such as water quality and reef area enter into the production functions for goods and services. For example, the production function for commodity i might be: X i = f i (K i,l i,m i,q i,a i ) where X is the annual output flow, K,L, and M represent the annual input flows, and Q and A represent water quality and reef area in the region in which production takes place. A change in water quality or reef area (as a result of a proposed project) will cause changes in the level of output of X and possibly in the levels of the inputs K,L and M. Example of the dose/response method: a project to increase sugar production in FNQ is predicted to result in a deterioration of water quality and a reduction in reef area on the GBR. The result will be to reduce the net value of the tourism and fishing industries. The net value is calculated as the change in value of output less the change in the cost of the inputs K,L and M. Clearly the dose/response method can be applied only to those use-values of the environment which are generated by the market system. It cannot be used to estimate non-use values, or to account for non-marketed use-values, such as private (ie. non-commercial) recreation. The opportunity cost method This method calculates the cost of preventing or limiting environmental damage by either not undertaking or modifying the proposed project. Thus the opportunity cost could take the form of forgone project net benefits, or of additional project costs. Once this information has been calculated it is left to the decision-maker to judge whether the benefits of preventing or limiting the environmental damage are large enough to justify the cost. A threshold analysis calculates the minimum value the environmental values would need to take to justify forgoing or modifying the project to prevent or limit the environmental damage associated with the project. The preventative cost method This method assumes that the value of the environmental resource is equal to the cost of preventing or mitigating the environmental damage, or replacing or restoring the environmental asset (the replacement cost method), or relocating the environmental activity. The preventative or replacement cost methods might be a reasonable approach if private individuals or groups were observed to be willing to incur these costs. The replacement cost method is sometimes used in legal processes to estimate damages. Figure 12.2 Measures of Value using the Replacement Cost Method A $ Restoration Benefits (B) Net Benefits Restoration Costs (C) It can be seen from Figure 12.2 that the preventative or replacement cost method can overstate the extent of environmental losses and lead to excessive levels of environmental protection. 0% Q e Restoration Level QL 100% 3

4 Demand-side methods of environmental valuation Revealed preference approaches infer environmental values from observed consumer behaviour eg. : - travel cost method (TCM) - random utility model (RUM) - hedonic pricing model (HPM) Stated preference approaches estimate environmental values by asking consumers what they are willing to pay for the preservation of environmental assets eg.: - contingent valuation method (CVM) - discrete choice modeling (DCM) The travel cost method (TCM) By observing consumer behaviour in the market for travel (a related market) to and from a recreational site we can estimate the annual consumer surplus generated by that site for its users. Example: two consumers have the same income, tastes, and face the same set of prices, except the cost of travel to a recreational site. This means they have the same demand curve for the services of the site. One consumer (B) lives further from the site and pays a higher travel cost per visit. We observe P A < P B, and Q A > Q B. We can treat (P A,Q A ) and (P B,Q B ) as points on the individual demand curve and use the estimated curve to calculate the annual value of consumer surplus accruing to each individual. The random utility model (RUM) Figure 12.6 Approximate Individual Demand Curve for Park Visits Price/cost Per trip ($) Number of trips per annum As with the TCM, the RUM uses trip data and travel costs, together with consumer characteristics such as income level and tastes (level of education or experience) to analyse consumer choice among alternative recreational sites. Unlike the TCM, which assumes the number of visits is a continuous function of price (travel cost), the RUM is a model of discrete choice among substitute sites. Since the RUM takes explicit account of site characteristics in modeling choice among sites, it can be used to value the individual attributes of a site, and changes in site value per trip as a result of changes in these attributes. However it cannot be used to predict changes in the number of visits in response to attribute changes. The hedonic pricing model (HPM) The hedonic pricing model (HPM) regresses observed market prices against the levels of various attributes of a good or service in order to place separate valuations on these attributes. It is widely used in product design eg.: what are consumers willing to pay for each of the individual attributes of a car - automatic transmission, air conditioning, air bags, anti-lock brakes etc.? Using the HPM house price data can be used to value local environmental assets such as air quality or city parks. The hedonic price function is expressed as: P i = f(s i, N i, Q i ) where S i = house and site characteristics, N i - neighbourhood characteristics, Q i = environmental quality characteristics, and i = 1 n is a cross-sectional sample. The contingent valuation method (CVM) The contingent valuation method (CVM) proceeds by asking people what they would be willing to pay for the services of the particular environmental asset in question. It has the advantage of applying to both use- and non-use values. Its disadvantage is the possible presence of various kinds of bias in the results of the survey, including: - hypothetical market bias - respondents are not really paying for the services in question; - strategic bias - respondents try to influence the outcome of the study; - design bias - the way the questions are phrased, particularly the form of the notional payment vehicle, can affect the results. 4

5 Discrete choice modeling (DCM) Discrete choice modeling (DCM) asks people to value a range of options (unlike CVM which values a single option relative to the status quo). The options may consist of various types and levels of environmental protection as well as levels of more conventional forms of economic activity, such as jobs. The survey results can be used to calculate trade-offs between various types and levels of protection and other economic values. Marginal values of types of environmental protection can also be calculated and used to work out the relative value of each policy option. An advantage of DCM is that it may be less prone to bias because of its focus on choice among alternatives. A disadvantage is that there is no rule governing the range of possible alternatives or the possible level of each. Alternative approaches to non-market valuation The supply- and demand-side approaches to non-market valuation try to mimic the market process in some way so as to work out the information the market would have conveyed had it existed. These approaches are based on information generated by random samples of the consumers involved. Some alternative methods are based on sampling selected groups and are regarded as being an integral part of the decision-making process itself: - deliberative value assessment (DVA) - groups of experts investigate and discuss the use of environmental resources and make recommendations; - multi-criteria analysis (MCA) - groups of stake-holders rank alternative performance criteria and the likely success of various policy options in achieving these. 5