Environmental Regulation

ENVIRONMENTAL ECONOMICS

Pollution Control

Mrinal Kanti Dutta

mkdutta@iitg.ac.in

Department of Humanities and Social Sciences

Indian Institute of Technology Guwahati
Guwahati – 781039
Environmental Regulation 2

What is Pollution?

 Those residual flows, arising from human behaviour

that enter environmental systems

 Not all of the mass of inputs is combined into useful

output; some of the input is converted into
unwanted or residual outputs.

 Pollution through materials balance model

Environmental Regulation 3

Economic activity

Emission flows into

environmental media

Absorption of some
proportion of flow into Non-absorbed emission flows
harmless forms

Accumulation of
pollutant stock

Degradation of stock Stock pollution Flow pollution

into harmless forms damage damage

Pollution damage
Environmental Regulation 4

What is Pollution? -two more things

 Pollution flows may not exist as material wastes
from economic activities (they may not be residual)
 Noise due to open-air orchestra
 Light pollution from urban lighting

 Economist is ultimately interested in the impacts of

production and consumption processes upon
welfare
 Thus, pollution may be defined as the net flows-
those exceeding the absorptive capacity of the
environment and which have damaging effects on
human welfare or upon ecological system in
general
Environmental Regulation 5

What is Pollution? –depletion of quantity and

quality

 Sometimes, pollution affects the quantity of an

environmental resource
 Magnitude of plant and timber growth,
 Size of marine population,

 Quantity of cleaning capacity of the environment is

affected by quantity of waste emissions
Environmental Regulation 6

What is Pollution? –depletion of quantity and

quality

 Pollution affects the quality of an environmental

resource
 Extent of biological diversity, the health of
animal or plant population, air quality, etc.

 Changes in the quality of environmental resources

may have effects upon welfare even more profound
than changes in the quantity

 Health damage due to air pollution

Environmental Regulation 7
Forms of Pollution
 Flow pollution
 When damages result from the level of flow of
residuals (i.e. the rate at which they are
discharged into the environment)
 Noise

 Stock pollution
 When damages are functions of the stock of the
residuals in the relevant environment at any
point in time.
 Emissions are produced at a rate higher than
the absorptive capacity (lead, pcbs, ddt, etc.)
 Also from a mixture of flow and stock effects
Environmental Regulation 8
Forms of Pollution
 Horizontal Zone of Influence:
 Local (sound, light, etc.), regional (sulphur and
nitrogen oxides) and global pollution damage

 Degree of atmospheric mix of pollutants:

 Surface pollutant (water pollution) and global
pollutant damage (in the upper atmospheric
levels, e.g. CO2, CFC, etc.)

 Mobility of emission sources:

 Stationary (power stations, pesticide use in
agriculture) and mobile source of pollution
(vehicle traffic pollution)
Environmental Regulation 9
The efficient level of Pollution
 Efficiency in terms of Pareto efficiency
 Society’s costs or damages of pollution and the social
cost of controlling or abating pollution are to be
considered
 Environmental damage- cost (should be as low as
possible)
 Production or consumption of goods and services are
associated with generation of residuals
 Output should be as high as possible
 An efficient output level would be one that maximises
the net output (pollution)
Net benefit of pollution (NB)= Benefit of the output with
which the pollution is associated (B) - Damages
resulting from pollution (D)
Environmental Regulation 10

Regulating Pollution

Rationale for Regulation:

 Economic Regulation: refers to government

intervention in private actions of firms and
individuals.

 Two theories of regulation:

Public Interest Theory and Interest Group Theory

Public Interest Theory: main purpose of

regulation is the promotion of public interest.
Environmental Regulation 11

Rationale for Regulation:

Interest Group Theory: main purpose of regulation is
the promotion of narrow interest of particular groups in
a society such as individual industries.
Major point of distinction between these two
approaches is:

Public Interest Theory is the normative Theory (which

seeks to explain what should happen in an ideal world)
while the Interest Group Theory is the positive theory
(which seeks to explain why the world works as it
does)
Environmental Regulation 12

Regulating Pollution
Under Public Interest Theory three general reasons
justify for government regulation:

a.Imperfect competition
b.Imperfect information
c.Externalities

Imperfect Competition or Natural Monopoly:

Role of the government, in the presence of natural
monopoly, is to control prices in order to protect the
consumers and prevent collusion and restrict mergers
that may create excessive market power in the hands
of the monopolists.
Environmental Regulation 13

Regulating Pollution
Imperfect Information:

Here the role is to establish a set of liability rules to

encourage the provision of safety-related quality.

Direct intervention in the market specifying

acceptable levels of quality.
Environmental Regulation 14

Regulating Pollution
Externalities:
Main problem is with the provision of public goods
and bads because private provision of these goods
(with the element of publicness: non-rivalry and non-
excludability) is inefficient.

In the case of public bads, the usual approach is for

government to define a set of institutions and
regulation to govern provision of these public bads,
e.g., the government establishes a set of regulations
to restrict the production of pollution.
Environmental Regulation 15

Regulating Pollution
Externalities:

Interest Group Theory of regulation maintains that

rent-seeking is the primary rationale for regulation.

Rent-seeking involves private individuals or firm using

the government to guarantee extra profits (rent)
through government mandated restrictions on
economic activity.
Environmental Regulation 16

Regulating Pollution
A Political Economy Model of Regulation:
The basic problem of environmental regulation involves
the government trying to induce a polluter to take socially
desirable actions, which ostensibly are not in the best
interest of the polluter.
The main problem, therefore, is determination of exact
level of pollution which is best for the society.
In reality the government faces pressures from consumers
and polluters.
Figure 1 presents a highly stylized schematic diagram of
the interactions among government, polluting firms and
consumer citizens.
Environmental Regulation 17
Regulating Pollution A

$, £ Votes
Legislature (State
Ownerships) $, £
B Stock, Bond
Holders
$, £
$, £
Board of
Regulators Directors Wage, payments for goods

Managers Goods

Consumers
Judiciary
/Citizens
Employees
Bads/Poll
ution

Government The Firm Polity

Figure 1
Environmental Regulation 18

Regulating Pollution
The Government as shown in figure 1, consists of
three branches: the Legislature, the Judiciary and the
Regulators

Legislature passes laws defining what the regulators

are to do in controlling pollution.

Regulators are charged with the responsibility of

implementing the legislature's laws

Judiciary: the actions of the regulators are tempered

by the judiciary.
Environmental Regulation 19

Regulating Pollution
The firm consists of several pieces:
the Board of Directors, Managers, Employees,
Stock and Bond Holders.

The Board issues directives to the managers; the

managers issue directives to employees who produce
the product of the firm as well as pollution.

The key point is that regulators direct the Board to take

certain actions, but the Board is removed, by several
steps, from the employees who actually generate the
pollution.
Environmental Regulation 20

Regulating Pollution
There arises Principal-agent problem due to inability
of the regulator (the principal) to completely control
the polluter (the agent).

The firm may not be a passive entity but may in fact

influence legislation, through lobbying or financial
incentives (shown by the line B)

The third component of the figure, the consumers

direct votes and other influence to the legislature (line
A) while at the same time sending money to the firm in
exchange for the goods consumed.
Environmental Regulation 21

Regulating Pollution

Two important lessons can be drawn from the figure:

1. There are many imperfect links between the

legislature and the pollution generating process.

2. The legislation does not necessarily act as an

efficient benevolent maximizer of social well being.
Environmental Regulation 22

Regulating Pollution
• Inclusion of Line B: indicates regulation with
endogenous politics.

• Omission of Line B indicates regulation with

exogenous politics.

• Positive interest group theory is consistent with

endogenous politics model of regulation

• Environmental regulation is susceptible to interest

group theory
Environmental Regulation 23

Basic Regulatory Framework: Command and Control

A. Command and Control:
Under this method the regulator specifies the
steps that individual polluters must take to solve a
pollution problem.

The essence of this method is:

1. The regulator collects the information necessary to
decide the physical actions to control pollution

2. The regulator then commands the polluter to take

specific physical steps to control the pollution.
Environmental Regulation 24

Basic Regulatory Framework: Command and Control

Command and Control can take several forms.
1. The specific pollution control equipments requirement
can be specified or alternatively the regulation may
specify an emission limit for particular types of plants
and particular pollutants.

2. Command and Control may be combined with

significant fines and penalties associated with non-
compliance. This, however, differs from the economic
incentives to abate pollution on two salient points.
Environmental Regulation 25

Basic Regulatory Framework: Command and Control

2.a. Restricted choice for the polluters as to what

means will be used to achieve an appropriate
environmental target
2.b. A lack of mechanism for equalizing marginal
control costs among several different polluters.

3. The best analogy for Command and Control is the

system of central planning (existed in the former
Soviet Union).

However major problem of this is the enormous

requirement of information.
Environmental Regulation 26

Basic Regulatory Framework: Command and Control

Advantages:

a. More flexibility in regulating complex environmental

process and much greater certainty in how
much pollution will result from regulations.

b. It simplifies monitoring of compliance with a

regulation.
Environmental Regulation 27
Basic Regulatory Framework: Command and Control
Disadvantages:
a. The regulatory system may be very costly to administer
as informational costs are high.
b. It may reduce incentives to find better ways to control
pollution
c. Difficulty in satisfying the equi-marginal principle, i.e. it is
almost impossible for command and control regulations
to ensure that the marginal costs of pollution are
equalized among different polluters generating the
same pollution.
d. Finally, the greatest problem with the Command and
Control principle is that the polluter pays only for
pollution control, not residual damage form the pollution
that is still emitted even after controls are in place
Environmental Regulation 28

Basic Regulatory Framework: Economic Incentives

Economic incentives provide rewards for polluters to
do what is perceived to be in the public interest.

Three basic types of economic incentives include:

fees, marketable permits and liability.

Fees:
Fees involve the payment of charge per unit of
pollution emitted. When a polluter must pay for
every unit of pollution emitted, it becomes in the
polluter’s interest to reduce emission.
Environmental Regulation 29

Basic Regulatory Framework: Economic Incentives

Marketable Permit:
A marketable permit allows polluter to buy and sell the
right to pollute.
Trading induces a price or value on a permit to
pollute, thus, causing firms to see polluting as an
expensive activity.
Less pollution means fewer permits need be bought.
Similarly, there is an opportunity cost of emitting, i.e.
by not emitting the firm can sell more permits.
A graphical illustration of the marketable permit is
shown in figure 2.
Environmental Regulation 30

Basic Regulatory Framework: Economic Incentives

Marketable Permit:
Assume a situation where two polluters exist and we
are interested in allowing 100 units of pollution in total.

Let’s start by giving each firm 50 permits.

The equilibrium price of permit is p*.

Environmental Regulation 31

Basic Regulatory Framework: Economic Incentives

Figure 2: Marginal savings from polluting functions for two firms. MS1, Marginal
savings from emitting, firm 1; MS2 Marginal savings from emitting, firm 2; e*,
equilibrium holding of permits; p*, equilibrium price of permits.

Firm 1 Firm 2

MS1

MS2

P*

0 e* 100
100 50 0
Firm 1 holdings 50 Firm 2 holdings
Starting Point
Environmental Regulation 32

Basic Regulatory Framework: Economic Incentives

Liability: The basic idea is that if you harm someone,
you must compensate that person for damage.
Let us take an example of Hazardous waste storage
facility (‘dump’). The dump can do things to minimize
the risk of hazardous wastes leaking in to the
environment through ‘Precaution’. (i.e. if the dump
takes a great deal of precaution the risk of a leak will
be low).
But precaution is expensive and ceteris paribus, the
dump would prefer to take little precaution. Damage to
society also depends upon the level of precaution.
(this is illustrated in Figure 2).
Environmental Regulation 33

Basic Regulatory Framework: Economic Incentives

Liability:
In figure 2, both costs to dump and damage to society
are shown as functions of the level of precaution. The
socially desirable level of precaution is x*, at which the
marginal costs of taking more precaution are just offset
by the reduction in marginal damage from taking more
precaution.

Here, negligence liability works in the sense that the

threat of being held responsible from accident
damages is often a sufficient incentives for firms to
take the socially desirable amount of precaution.
Environmental Regulation 34

Basic Regulatory Framework: Economic Incentives

Figure 3: An Illustration of precaution and liability

Firm
Costs of precaution
C(x)

Expected
accident cost
from precaution
D(x)

x* Precaution (x)
MC (x*) = - MD (x*)
Environmental Regulation 35

Basic Regulatory Framework:

Economic Incentives
Advantages:
 Informational requirements are less significant
 Economic incentives provide an incentive for a
polluter to innovate, finding cheaper ways of
controlling pollution.
 Economic incentives involve the polluter paying for
control costs as well as pollution damage.
Therefore, there is no implicit subsidy to the
industry.
 For many economic incentives the equi-marginal
principle holds true.
Environmental Regulation 36

Disadvantages of EI
Developing an economic incentive that
efficiently and perfectly takes complexities in
environmental transformation into account can
be very difficult. (air pollution)
Given the political conditions, it is very difficult to
adjust the level of incentives (level of fee, no. of
marketable permits) when there is great deal of
uncertainty associated with the environmental
problem.
Instituting tax (on emission) may be very difficult
(it involves transfer of massive amount of wealth
from firms to the government).
Environmental Regulation 37

Complication for Environmental Regulation

A.Space and Time
Pollution regulation is complicated by the physical
environment that interposes itself between polluters
and consumers (illustrated in figure 4).
There are differences between pollution and ambient
concentration of the pollution.
Generally, it is the ambient concentration that causes
damages not the pollution.
However, ambient concentration are imperfectly
connected with the emission, which need to be
regulated.
Environmental Regulation 38

Complication for Environmental Regulation

A.Space and Time
This brings space and time into concern of the
regulators. Generally, sources of pollution nearby
will generate more damage than sources located in
distant suburbs.
Time, though less important than space, also exert
significant influence in environmental
transformation. There is hour-to-hour, day-to-day
and season-to-season variation in pollution.
Capturing these time and space factors in to decision
making is a bit difficult.
Environmental Regulation 39

Complication for Environmental Regulation

Natural Environment

Environmental Regulator

Producers Consumers

Emissions Emissions

Environmental transformation
(transport, decay, combination and deposition)

Ambient levels of pollution

Damage
(to producers, consumers and ecosystems)

Figure 4
Environmental Regulation 40

Complication for Environmental Regulation

B. Efficiency versus Cost Effectiveness

Efficiency (with regulation) calls for emissions that
balance the costs of emissions control with the
damage from ambient pollution, fully taking into
account the complexities relating emissions to
damage.

Cost effectiveness with regulation refers to a set of

environmental regulation that can achieve emission
target at the least cost possible.
Environmental Regulation 41
Complication for Environmental Regulation
C. Ambient-Differentiated versus Emission-
Differentiated Regulation:
Targets of the regulator may be ambient targets or
emission targets. Choosing out this is a bit complicated.
Typically, a unit of pollution form one polluter will have a
different effect on ambient concentrations than a unit of
pollution from another polluter. An ambient-differentiated
regulation will control these two polluters differently,
based on their different contributions to ambient
concentrations.
An emissions-differentiated regulations will ignore the
differences between the two polluters, though the overall
level of emissions will still be controlled in such a way as
to achieve the ambient target.
Environmental Regulation 42

Basic Issues in Environmental Regulation

1. Debate over whether command and control or
economic incentives
2. Public sources of pollution and controlling them
3. Information, particularly private information polluters
may have that regulator needs
4. Risk and how to deal with the problems of risk. What
sort of regulations are appropriate?
5. Growing competition between jurisdiction vis-à-vis
environmental regulations
6. Incidence of regulations: who bears the burden (either
in cost or pollution damage)? Who reaps the benefits?
7. Innovations and technical change.
Environmental Regulation 43

Basic Regulatory Framework: Emission Fees and Marketable Permits

Several issues complicate using incentives to control
pollution: Space, Time and Imperfect competition
I. Space :
A.Sources, Receptors and Transfer Coefficients:
Let us take an example of a river.
Two factories discharge organic waste (sewage) in to the
river
A municipal water supply takes water from the river
Factories are in the upstream of the municipal waste
supply
Further one goes downstream the smaller the effects from
pollution.
Environmental Regulation 44

Basic Regulatory Framework: Emission Fees and Marketable Permits

A. Sources, Receptors and Transfer Coefficients:
Now to correctly regulate the two factories their individual
effects on the municipality have to be taken into account.
At this point, to take space in to account, let’s consider
two points: sources and receptors. A source is a point of
discharge of pollution (e.g. a factory). A receptor is a
point at which people care about the level of ambient
pollution.

Although there are several receptors, in practice, we will

identify a small set of receptors where pollution levels
will be measured. Receptors are scattered over space
and serve as a good proxies for overall level of pollution.
Environmental Regulation 45
Basic Regulatory Framework: Emission Fees and Marketable Permits
In general, there is some relationship between emission
at various sources, e1, e2 . . . ei and concentration of
pollution at any receptor j.
pj = fj (e1, e2, . . .,ei) + Bj (1)
where, Bj background level of pollution at j (perhaps
zero).
In many environmental problems, the physical
environment is linear,
pj = ∑i aij ei + Bi (2)

The coefficient aij is called the transfer coefficient. We

assume Bj = 0. In equation (2), if we change emission at
some source i by a little amount (∆ei), pollution will
change by aij∆ei
Environmental Regulation 46

Basic Regulatory Framework: Emission Fees and Marketable Permits

The transfer coefficient between the source i and the

receptor j is defined as the ratio of the change in
pollution at j to the change in emission at i .
aij = ∆ pj/ ∆ei (3)

Equation (3) gives the conversion rate for emission to

ambient concentration.
Environmental Regulation 47

Basic Regulatory Framework: Emission Fees and Marketable

Permits

B. How much Pollution do we want?

Let’s start with what is the efficient level of pollution?

Efficiency involves equating marginal damage with

marginal savings to the firm from pollution
generation.

To link these we express marginal damage of a firm

as marginal damage per unit of emissions.
Environmental Regulation 48
Basic Regulatory Framework: Emission Fees and Marketable
Permits
B. How much Pollution do we want?
Let us term marginal damage per unit of emissions
from source I as the function MDEi (ei) which is in
contrast to marginal damages per unit of ambient
pollution, MD(p)

MDEi is the ratio of the change in damage {D(p)} to the

change in emission at source i.

MDEi (ei) = {D (p + ∆p) – D (p)}/ ∆ei

= MD (p). ∆p/ ∆ei (4)
= ai MD (p)
Environmental Regulation 49

Basic Regulatory Framework: Emission Fees and Marketable

Permits
As stated above, efficient amount of pollution requires
equating marginal savings from emission with marginal
damage. If there are i = 1, 2, …I sources of pollution,
then following must hold:

-MCi (ei) = MDEi (ei) = ai MD (p), for all i = 1, …, I

(5)

Now for any two sources m and n

MCm(em)/am= MCn(en)/an = MD (p) (6)

Environmental Regulation 50
Basic Regulatory Framework: Emission Fees and Marketable Permits

MC/a is marginal cost per unit of ambient pollution.

i.e. marginal cost in terms of ambient pollution must be
equal to the negative of marginal damage.

Thus efficiency calls for all sources to have the same

marginal costs of emissions, normalized by the source’s
transfer coefficients.

If ‘a’ is high, MC of emissions should be larger.

Two conditions for efficiency:

1.Marginal cost of emission, normalized by the transfer
coefficient must be equalized for all sources
2.Normalized marginal cost must equal the negative of
marginal damage.
Environmental Regulation 51
Basic Regulatory Framework: Emission Fees and Marketable Permits
C. Emission Fees:
We seek emission fees, ti, one for each firm i that yields
efficiency.
These are ambient differentiated fees. Whatever fee is
used, the firms will respond by minimizing direct costs
plus fee payments. This is equivalent to setting
marginal cost equal to negative of the fee:

MCi (ei) = - ti, for all sources i (7)

Thus the condition for efficiency can be re-written as,

tn/an = tm/am for all firms n and m (8)
And, tn = an MD (p) for any firm n (9)
Environmental Regulation 52
Basic Regulatory Framework: Emission Fees and Marketable Permits
C. Emission Fees:

Equation (8) implies that emission fees levied on the

firms must be equal after normalizing by the transfer
co-efficient or control costs across firms are equal.

Equation (9), the second condition, implies that for any

firm marginal damage in emission units (MDE) must be
equal to the emission fee (t), or marginal pollution
damage and control costs are equalized.

Alternatively all firms face same emission fee per unit of

ambient pollution but to convert it to emission units, it
must be multiplied by appropriate transfer coefficient.
Environmental Regulation 53
Basic Regulatory Framework: Emission Fees and Marketable Permits
Thus, it can be concluded that, ambient differentiated
emission fees can achieve efficiency.

However, it is too complicated to let emission fee vary

from location to location.

Normally most emission fees do not depend upon location

even though damages do.

Thus, is applying uniform emission fee inefficient when

damages depend on location?

Let us consider the following illustration (with the help of

figure – 5).
Environmental Regulation 54
Basic Regulatory Framework: Emission Fees and Marketable Permits
In figure 5, marginal savings curve is assumed same for
every firm. As well as marginal damages, normalized by the
transfer coefficient.

t*1, t*2 are efficient taxes

e*1, e*2 are emissions from the two firms (which are
efficient)
uniform emission fee
emissions from firm 1 or firm 2
the shaded area are deadweight loss.
The optimal uniform tax is one that minimizes the total area
of the two triangles.

The loss from a uniform fee depends on the nature of the

marginal cost and damage functions.
Environmental Regulation 55
Basic Regulatory Framework: Emission Fees and Marketable Permits
t Fig. 5.a

MDE1 (e1)

t*1 MDE2 (e2)

t*2

MS (e)

0 e*1 e*2 e
Environmental Regulation 56
Basic Regulatory Framework: Emission Fees and Marketable Permits
t Fig. 5.b

MDE1 (e1)

MDE2 (e2)

t*1

t*2

MS (e)

0 e*1 e*2
e
Environmental Regulation 57
Basic Regulatory Framework: Emission Fees and Marketable Permits
D. Marketable Ambient Permit:
An ambient pollution permit for a receptor “j” gives the
holder the right to emit at any location, provided the
incremental pollution at receptor ‘j’ does not exceed the
permitted amount.

Thus an ambient pollution permit system is a set of

permits, distributed to sources in a well-defined way of
computing the effects of emissions on ambient pollution at
receptors along with a right to buy and sell these permits.

Two Firms: Let’s consider the case of two firms and one
receptor. Suppose EPA issues L1 amount of permits to firm
1 and L2 ambient permits to firm 2 for a total of L = L1 + L2
permits.
Environmental Regulation 58
Basic Regulatory Framework: Emission Fees and Marketable Permits
D. Marketable Ambient Permit:

Now after trading of permits, let l1 and l2 be the

number of permits eventually held by the firms.
i.e. L1 +L2 = l1 + l2 (1)

Equation (1) raises many questions:

a. What will the price of permits be?

b. How much will each firm emit?

Answering the second question first - a firm can emit

whatever is allowed by its permit holdings.
Environmental Regulation 59
Basic Regulatory Framework: Emission Fees and Marketable Permits
Emission and ambient pollution levels are connected by
transfer coefficient.

i.e. a1e1 = l1 (2)

and a2e2 = l2 (3), provided all permits are used.

Suppose, the price of permits is π (an unknown). Then

how much pollution will be emitted?

However many permits a firm may hold, if the price of

permits is greater than the marginal savings from emitting
the firm will want to sell some permits and emit less.
Environmental Regulation 60
Basic Regulatory Framework: Emission Fees and Marketable Permits
If the price of permit is less than the firms’ marginal
savings form polluting, buying permits is easier than
controlling emissions.

We try to find the price for which the desired emission

levels for each of the two firms corresponds to the number
of permits issued.

Total costs for each firm are:

TC1 (e1) = C1(e1) + π (l1 – L1), where Ci (ei) is the
direct cost to firm i,
= C1 (e1) + π (a1e1 – L1) (4)
And,
TC2 (e2) = C2 (e2) + π (l2 – L2)
= C2(e2) + π (a2e2 –L2) (5)
Environmental Regulation 61
Basic Regulatory Framework: Emission Fees and Marketable Permits
In order to Minimize total costs each firm sets the marginal
total costs (MTC) to Zero, i.e.

MTC1(e1) = MC1 (e1) + a1π = 0 (6)

MTC2(e2) = MC2(e2) + a2π = 0 (7)

Which implies: MC1(e1)/a1 = MC2 (e2)/a2 = - π

Or, MS1(e1)/a1 = MS2(e2)/a2 = π (8)

Equation (8) says that marginal savings normalized by the

transfer coefficient should equal to the permit price. This is
analogous to the working of ambient emission fee which
states that marginal savings normalized by the transfer
coefficient equals the same number for all firms.
Environmental Regulation 62

Basic Regulatory Framework: Emission Fees and Marketable Permits

There is one additional equation that gives us

information.

Combining equations (1), (2) and (3) we get,

a1e1+a2e2=L (9)

Equations (8) and (9) constitute three separate

equations in three unknowns (e1, e2 and π) and thus
can be solved.
Valuation of Environmental Goods

ENVIRONMENTAL ECONOMICS

Mrinal Kanti Dutta

mkdutta@iitg.ac.in

Department of Humanities and Social Sciences

Indian Institute of Technology Guwahati
Guwahati – 781039
 2
Valuation of Environmental Goods
 Understanding value of Environmental Goods
requires understanding of the notion of “values”
of environmental goods
 There are two types of values:
 Use Value and Non-use Value

 Use Value: the value derived from the actual

use of a good or service
 Examples:
1. Raw materials from environment used in
production/consumption
2. Trekking through the woods
3. Rafting in the river
 3
Valuation of Environmental Goods

 In case of environmental goods, Use Value could

include current use (I am currently visiting the
park), expected use (I plan to visit the park later
this year) and possible use (I might visit the park
within next 10 years)

 Option Value: The value placed on a future ability

to use the environment people are willing to pay
for an option to use the environment in the future
even they are not currently using it.
 4
Valuation of Environmental Goods
Non-use Value:
It’s a gain in person’s utility without the person
actually using the good directly.

For example, one may value the wilderness

areas in the Seirra Nevada, not because
he/she plans to make use of the
wilderness but because others may, and that
may make him/her feel good

There are three basis types of non-use value:

Existence value, Altruistic vale and Bequest
value:
 5
Valuation of Environmental Goods
Types of non-use value:
 Existence value:
The value a consumer attaches to knowing
something exists ( e.g. One-horned rhinoceros in
Kaziranaga National Park)
 Altruistic value:
It’s a value that the consumers derive from not
consuming the goods themselves but from the fact
they derive the benefit when someone else gains
utility (e.g. If person A’s neighbor derives benefit
from cleaning his front yard, person A obtains utility
from the fact that his neighbours are better off.
 6
Valuation of Environmental Goods
Types of non-use value:
 Bequest value:
 This value arises when one intends to pass a
good or service on to the future generation
 It is associated with the well-being of the
descendants
 For example, if one values passing a
wilderness area on to the next generation that
wilderness area has a bequest value to the
person even if he or she never uses it or
intends to use it
 7
Valuation of Environmental Goods

TOTAL ENVIRONMENTAL VALUE

USE VALUE NON-USE VALUE

EXPECTED
CURRENT USE POSSIBLE USE
USE

EXISTENC ALTRUISTIC BEQUEST

E VALUE VALUE VLAUE
 8
Valuation of Environmental Goods
Why do we have to value the environment?
No price data exists for non-marketed environmental
resources (demand or prices for private goods can be
obtained from the market)
Need for information on benefits and costs of
protecting and restoring the environment to guide
policy makings
Need information on benefits and costs of protecting
and restoring the environment to guide budget
allocations
Need information to guide compensation setting for
victims
 9
Valuation of Environmental Goods

Why do we have to value the environment?

Need information on external costs of development

projects to guide development policies

Need information to guide setting of user

charges/fees/taxes for pollution control

Need information to guide efficient and fair resource

allocation
 10
Valuation of Environmental Goods
Methods of Measuring Environmental Values
Revealed Preference:
In revealed preference approach real choices of
people are observed in some market and
information are inferred on the trade-offs
between money and the environmental good.

Stated Preference:
It basically involves asking people how much an
environmental good is worth.

These information are collected through opinion

polls or surveys.
 11
Valuation of Environmental Goods
Methods of Measuring Environmental Values

Table 1: Methods of valuation of environmental goods

Methods Revealed Preference Stated Preference

Direct Contingent Valuation
Contingent Ranking

Indirect Hedonic Pricing

Travel Cost Method
Household Production Function
Averting Expenditure/Avoided
Cost Approaches
 12
Valuation of Environmental Goods
HEDONIC PRICING METHOD
Hedonic Pricing (HP) Approach is derived from the
characteristic theory of value first proposed by
Lancaster (1966) and Rosen (1974).

This seeks to explain the value of a commodity as a

bundle of valuable characteristics
(e.g. the price/rent of house depends on
number of rooms, availability of garden in the
campus, proximity to shops, noise level in the
neighborhood, air quality levels etc.)
 13
Valuation of Environmental Goods
HEDONIC PRICING METHOD

HP was first applied to environmental valuation by

Ridker and Henning (1967)

HP proceeds on three stages:

First, hedonic price function is estimated
Second, implicit prices are calculated
Third, a demand curve for this variable may be
estimated

Following example brings out these three stages.

 14
Valuation of Environmental Goods
HEDONIC PRICING METHOD
Let’s now consider a simple structure that of a good
(house) with a single characteristics (pollution/air quality
level)

Now we are interested in knowing p(z), the house price

as a function of air quality levels (i.e. how p (z) changes
when air quality changes)

Since price function is an equilibrium concept, resulting

from the interaction of demand and supply function, we
need to look at both consumer and producer side of the
market. Assume that the market is competitive that is
both the consumers and producers take p (z) as given.
 15
Valuation of Environmental Goods
HEDONIC PRICING METHOD
A.The Consumer:

Suppose a typical consumer has utility function U and

income y. The consumer’s problem is to decide how
to allocate income between the house (given the air
quality z) and ordinary goods denoted by x (nominally
priced at 1).

The consumer’s problem is,

maxxz U (x, z) (1.a)
subject to,
x + p(z) = y (1.b)
 16
Valuation of Environmental Goods
HEDONIC PRICING METHOD
We can look at the problem in another way, i.e. for
particular level of z, to determine the amount of x that
needs to be consumed to achieve a particular level of
utility

This in turn determines how much money is spent on

x and how much income is available to spend on the
house.

Fixing z, we can solve the value of x that satisfies

U(x, z) =
 17
Valuation of Environmental Goods
HEDONIC PRICING METHOD
This then defines a particular amount of income available for the
house:
y–x=θ
We can also find out θ solving,

U (y – θ,z) = (1.c)

So given the values of z, y and we determine how much

money is available for the house,
θ (y, z, )

Let us call this a bid function because it represents the amount

of money the consumer may bid for the house with
characteristics z, to keep the utility at the level assuming
income y. (consider this situation in diagram 1)
 18
Valuation of Environmental Goods
HEDONIC PRICING METHOD
 19
Valuation of Environmental Goods
HEDONIC PRICING METHOD

In figure 1, θ (y, z, U0) and θ (y, z, U1) are two bid

functions. Lower bid function is associated with the
higher utility. p (z) is the hedonic price function
determined by the market.

For this consumer the point of choice is the point at

which bid function is just tangent to the price function
p(z) which gives maximum utility with the requirement
that the amount the consumer is willing to pay (θ)
must be equal to the price p(z).
 20
Valuation of Environmental Goods
HEDONIC PRICING METHOD

B. The Producer:
Let’s consider a producer with a given cost structure
and facing constant returns to scale.

Suppose the producer faces input prices r, so that the

unit cost is given by c(r, z).

If the producer offers a price of Φ, then profits per

house are given by,
π = Φ – c(r, z) (1. d)
 21
Valuation of Environmental Goods
HEDONIC PRICING METHOD
B. The Producer:
We can rewrite this as the price necessary to obtain a
certain level of profit, given the level of the
characteristics z: Φ(r, z, π). Let’s call this as offer
function.
The offer function indicates the price at which the
producer will offer the house to obtain a particular profit
level π, given a particular value of input prices, r, and a
particular value of z.

If the producer wants to sell a house, this offer curve has

to intersect the price line. This is illustrated in figure 2)
 22
Valuation of Environmental Goods
HEDONIC PRICING METHOD
Figure 2
P P(z)
R
I
C Φ(r, z, π2).
)
E
Increasing Φ(r, z, π1)
profit

Choice Point

AIR QUALITY Z
 23
Valuation of Environmental Goods
HEDONIC PRICING METHOD

In figure 2, the hedonic price function is shown p(z)

as well as two offer functions for some particular firm,
one function for each of two profits levels π1 and π2.

The correct choice of z is one at which an offer curve

is just tangent to the hedonic price line.
 24
Valuation of Environmental Goods
HEDONIC PRICING METHOD
Market Equilibrium:

Finally, we are now in a position to construct the

hedonic demand functions.

Hedonic price function corresponds to tangency

between the bid functions of some consumer and the
offer function of some producers (Shown in Figure 3).

The tangency determines a choice of z along with a

price p(z) and the price line is constructed.
 25
Valuation of Environmental Goods
HEDONIC PRICING METHOD
Market Equilibrium:

At the tangency points slopes of the bid function, offer

function and the price line are equal.

This equality implies that the producers, the

consumers and the market all have the same
marginal valuation on a unit of the characteristics.
 26
Valuation of Environmental Goods
HEDONIC PRICING METHOD
p(z)
P Φ3 Fig. 3:
R
• Equilibrium in an
I E3 hedonic market
C
• Φi offer function for
E
three producers, i= 1,
Φ2 ө3 2, 3;
• өi bid functions for
Φ1 E2 three consumers, j = 1,
2, 3
• Ek equilibrium
E1 ө2 between producers k
and consumers k, k =
ө1 1,2,3;
• p(z) price of house
with air quality level z.
Air Quality z
 27
Valuation of Environmental Goods
HEDONIC PRICING METHOD
Willingness to Pay:

So far we have measured the hedonic price function

and thus, we know the marginal price/market of air
quality at different levels air quality (z).

This is not a demand function because one individual

chooses only one consumption point along the
hedonic price function, not several consumption
points. One point does not make a demand function.
 28
Valuation of Environmental Goods
HEDONIC PRICING METHOD
Willingness to Pay:

The distinction between the marginal price of z as a

function of z and the marginal willingness to pay for z is
shown in figure 4.

In fig. 4, p`(z) is the slope of a hedonic price line.

MWTP1(z) and MWTP2(z) are the marginal willingness
to pay functions for the two persons.

The point of intersection of the MWTP functions with

the marginal price line gives us the choice of z for the
individual. But how much?
 29
Valuation of Environmental Goods
HEDONIC PRICING METHOD

Fig. 4:
• Marginal willingness
to pay for z.
• P`(z) slope of hedonic
price line with respect
to z (marginal value
of z)
• MWTPi(z) , marginal
willingness to pay for
one unit of z,
consumers i = 1, 2.
 30
Valuation of Environmental Goods
HEDONIC PRICING METHOD

Assume that different individuals making choices

along the hedonic price function are variants of the
same person, simply with different incomes and
characteristics (call these differences £).

Thus we can translate the many observations on

choice of z into a set of data on how marginal
willingness to pay varies with z, and thus statistically
infer a marginal willingness-to-pay function.
 31
Valuation of Environmental Goods
HEDONIC PRICING METHOD

Similarly, MWTP function can be derived for the

producers denoting the differences as β.

We thus have the following equations for demand and

supply:

p`(z) = f (z, £) (1.e)

p`(z) = g( z, β) (1.f)
 32
Valuation of Environmental Goods
HEDONIC PRICING METHOD
Since, the slope of the hedonic price function is
analogous to the price of the characteristics or
marginal willingness to pay for the characteristics,

Equation 1.e states that MWTP depends on the level

of the characteristics and other variables such as
income.

Similarly, equation 1.f is analogous to an inverse

supply function, with the price related to the
quantity supplied (in this case quantity of the
characteristics) and factors that reflect the cost of the
industry β.
 33
Valuation of Environmental Goods
HEDONIC PRICING METHOD
Limitations of Hedonic Pricing Method:
1. Omitted variable bias: if some variable that
significantly affects house price is omitted from the
HP equation and is in addition correlated with one
of the included variables, then the coefficient on
this included variable will be biased.

2. Multi-collinearity: some environmental variables

(such as alternative air pollution indicators) may be
highly collinear. This means that separate
equations for each may need to be estimated,
otherwise the implicit prices will be difficult to
entangle
 34
Valuation of Environmental Goods
HEDONIC PRICING METHOD

Limitations of Hedonic Pricing Method:

3. Choice of functional form for the HP function.

Economic theory does not specify which non-linear
function should be used for the HP equation.

4. Expected versus actual characteristics levels:

house sale may be a function of expected future
environmental conditions in addition to current
observed conditions.
 35
Valuation of Environmental Goods
DOSE RESPONSE METHOD

Dose response method involves finding a link

between environmental change and production
conditions for some marketed goods.

Depending on the behavioral assumptions made and

the statistical techniques employed, welfare estimates
are then calculated using changes in, e.g., profits from
the production of marketed goods.
 36
Valuation of Environmental Goods
DOSE RESPONSE METHOD
For example, Ellis and Fischer (1987) estimated the
contribution that wetland protection makes to the
production of shellfish.

They estimated a production function for Florida blue

club off the Florida Gulf Coast which includes wetland
acreage as an input along with labour and capital.

They found the implied value of an increase in the

wetland acreage from 25000 acres to 100000 acres
to be $ 192658.
 37
Valuation of Environmental Goods
AVERTING EXPENDITURE AVOIDED COST METHOD
This method tries to measure welfare loss to a
household due to increase in averting or preventing
expenditure arising out of decrease in environmental
quality .

The main notion is that a household produces flow of

certain services or goods combining various inputs,
one of which is environmental quality. For example, a
rural household might combine water taken from its
well with purification equipment to produce water
potable.
 38
Valuation of Environmental Goods
AVERTING EXPENDITURE AVOIDED COST METHOD
Now, if water quality in the well declines, the
household must increase its expenditure on other
inputs to maintain quality of drinking water constant.
This averting expenditure, as Cournot and Potter
(1981) showed, can be used to measure welfare loss
to the household of the decline in environmental
quality.

Other examples may include: the value of reduced

risks of car accidents (Blomquist 1979), value of
reduced risk of death as the result of fitting smoke
alarms and noise nuisance from airports (layard
1972)
 39
Valuation of Environmental Goods
AVERTING EXPENDITURE AVOIDED COST METHOD
The conditions under which changes in averting expenditure
(AE) produces exact welfare measures are-

1. The AE must not be a joint product (i.e. it must not generate

other benefits apart from offsetting the change in
environmental quality)
2. The AE must be perfect substitute for the change in
environmental quality
3. The change in AE must be entirely due to the change in
environmental quality
4. None of the inputs must enter directly in to the persons’
utility function
5. Expenditure must not yield benefits outliving the pollution
incident.
 40
Valuation of Environmental Goods
AVERTING EXPENDITURE AVOIDED COST METHOD
These conditions could be summarized as follows:

V(W Q1, Y) = V(WQ2, Y – AE)

Where, V is indirect utility, WQ is well water quality,

Y is income, AE measures Averting Expenditure
and W Q1 > W Q2 .

In other words, utility with the higher level of well

water quality and no averting expenditure is equal
to utility with a lower level of well water quality and
AE.
 41
Valuation of Environmental Goods
TRAVEL COST METHOD
One of the oldest approaches to environmental valuation
Proposed in a letter from Harold Hotelling to the US Forest
Service in the 1930’s, first used by Wood and Trice in 1958,
popularized by Clawsen and Knetsch (1966)
Premises
• People bear cost to visit regions or sites (national park or
estate)
• Hypothesis : These costs are at least equal to the minimum
value of the benefit people get when visiting the sites and their
environmental goods or services. Thus these travel costs can
be used as a proxy for the price of visiting outdoor recreational
sites . (In other words, the recreational benefits at a specific site
can be derived from the demand functions that relate observed
user’s behaviour to the cost of visit.)
 42
Valuation of Environmental Goods
TRAVEL COST METHOD
Steps of analysis
• Estimate the cost of travel and visit for each regions
of origin

• Questionnaire : visitors trip, expenses and

characteristics

•Estimate of the demand for the site (and

environmental goods and services) depending on
the cost of travel and visit and other characteristics
 43
Valuation of Environmental Goods
TRAVEL COST METHOD
Options for Applying the Travel Cost Method

1. A simple zonal travel cost approach, using mostly secondary

data, with some simple data collected from visitors. The
zonal travel cost method is applied by collecting information
on the number of visits to the site from different distances.

2. An individual travel cost approach, using a more detailed

survey of visitors. The individual travel cost approach is
similar to the zonal approach, but uses survey data from
individual visitors in the statistical analysis, rather than data
from each zone. This method thus requires more data
collection and slightly more complicated analysis, but will
give more precise results.
 44
Valuation of Environmental Goods
TRAVEL COST METHOD

3. Hedonic Travel Cost Model which attempts to place

values on the characteristics of recreational resources.

4. A random utility approach using survey and other data,

and more complicated statistical techniques. The
random utility approach assumes that individuals will
pick the site that they prefer, out of all possible sites.
Individuals make tradeoffs between site quality and the
price of travel to the site. Hence, this model requires
information on all possible sites that a visitor might
select, their quality characteristics, and the travel costs
to each site.
 45
Valuation of Environmental Goods
TRAVEL COST METHOD
The travel cost method is applied by collecting
information on the number of visits to the site from
different distances. Because the travel and time costs
will increase with distance, this information allows the
researcher to calculate the number of visits purchased
at different prices: the demand function and the
consumer surplus or economic benefits, for the
recreational services of the site.
Step 1: The first step is to define a set of zones
surrounding the site. These may be defined by
concentric circles around the site, or by geographic
divisions that make sense, such as metropolitan areas
or counties surrounding the site at different distances.
 46
Valuation of Environmental Goods
TRAVEL COST METHOD
Step 2: The second step is to collect information on the
number of visitors from each zone, and the number of
visits made in the last year.

Step 3: The third step is to calculate the visitation rates

per 1000 population in each zone. This is simply the
total visits per year from the zone, divided by the
zone’s population in thousands.

Step 4: The fourth step is to calculate the average

round-trip travel distance and travel time to the site for
each zone, using average cost per mile (km) and per
hour of travel time. What is the opportunity cost of
time?
 47
Valuation of Environmental Goods
TRAVEL COST METHOD

Step 5: The fifth step is to estimate, using regression

analysis, the equation that relates visits per capita to
travel costs and other important variables.

From this, the researcher can estimate the demand

function for the average visitor. In this simple model,
the analysis might include demographic variables,
such as age, income, gender, and education levels,
using the average values for each zone
 48
Valuation of Environmental Goods
TRAVEL COST METHOD
Step 6: The sixth step is to construct the demand
function for visits to the site, using the results of the
regression analysis. The first point on the demand
curve is the total visitors to the site at current access
costs (assuming there is no entryfee for the site)

Step 7: The final step is to estimate the total economic

benefit of the site to visitors by calculating the
consumer surplus, or the area under the demand
curve.
 49
Valuation of Environmental Goods
TRAVEL COST METHOD
Simple Travel Cost Model:
If the price (p) is the only sacrifice made by a
consumer, the demand function for a good with no
substitutes is x=f(p), given income and preferences.
However, the consumer often incurs other costs (c),
such as travel expenses and loss of time. In this
case, the demand function is expressed as x = f(p, c).

Under these conditions, the utility maximising

consumer’s behaviour should be reformulated in
order to take such costs into account.
 50
Valuation of Environmental Goods
TRAVEL COST METHOD
Simple Travel Cost Model:
Given two goods or services (x1, x2), their prices (p1, p2), the
access costs (c1, c2) and income (R), the utility maximizing
choice of the consumer is:
MaxU = u(x1,x2)
Subject to: (p1 + c1) x1 + (p2 + c2)x2 = R (1)

Now, let 'x1' denote the aggregate of priced goods and

services, x2 the number of annual visits to a recreational site,
and assume for the sake of simplicity that the cost of access to
the market goods is negligible '(c1=0)' and that the recreational
site is free (p2=0).
 51
Valuation of Environmental Goods
TRAVEL COST METHOD
Under these assumptions, equation [1] can be written
as:
MaxU = u(x1,x2))
Subject to: p1x1 + c2x2 = R (2)
Under these conditions, the utility maximizing
behaviour of the consumer depends on:
a) His preferences [u(x1, x2)],
b) His budget (R),
c) The prices of the private goods and services
(p1) and
d) The access cost to the recreational site (c2).
 52
Valuation of Environmental Goods
TRAVEL COST METHOD
The TCM is based on the assumption that changes in the costs
of access to the recreational site (c2) have the same effect as a
change in price: the number of visits to a site decreases as the
cost per visit increases.
Under this assumption, the demand function for visits to the
recreational site is x2=f(c2) and can be estimated using the
number of annual visits as long as it is possible to observe
different costs per visit and up to the cost at which visits
become equal to zero.
This simple model can be extended to include the effect of
other substitute sites.
Alternatively, same model can be used to estimate visits per
time be an individual to site with c and p becoming specific to
the individual only.
 53
Valuation of Environmental Goods
TRAVEL COST METHOD
The basic TCM model is completed by the weak
complementarity assumption, which states that trips
are a non-decreasing function of the quality of the site,
and that the individual forgoes trips to the recreational
site when the quality is the lowest possible
 54
Valuation of Environmental Goods
TRAVEL COST METHOD

c2 The Figure depicts

cp the expected
relationship
between the
number of visits
and cost per visit,
c2p given other
variables, showing
that the number of
visits decreases as
c2c
the cost per visit
increases.
o x2p x2c
x2
 55
Valuation of Environmental Goods
TRAVEL COST METHOD
Hedonic Travel Cost Model:
On many occasion, we are interested in the value of
changing characteristics of a site rather than in the
value of the site in toto.
In this respect, hedonic travel cost model attempts
to place values on the characteristics of recreational
resources.
Hedonic travel cost model was first proposed by
Brown and Mendelsohn (1984) and was later
applied to forest characteristics by Englin and
Mendelsohn (1991) and coastal water quality by
Bockstael et. al. (1987)
 56
Valuation of Environmental Goods

Hedonic Travel Cost Model:

Steps:
1. Respondents to a number of sites (e.g. forest) are
sampled to determine their zone of origin.
The levels of physical characteristics are recorded
for each site
A travel cost function is estimated for each zone, as

C(Z) = c0 + c1z1 + c2z2 + … cmzm (1)

Where, C(Z) are travel costs, z1 . . . zm are

characteristics and c0 . .. cm are coefficients to be
estimated.
 57
Valuation of Environmental Goods
TRAVEL COST METHOD
Hedonic Travel Cost Model:

Steps:

A separate regression is performed for each zone

of origin such that each will have a vector of
coefficients {c0… cm}. For a given characteristics m,
the utility maximising individual will choose visits
such that the marginal costs of characteristics (the
coefficient cm) is just equal to the marginal benefit
to him.
 58
Valuation of Environmental Goods
TRAVEL COST METHOD
Hedonic Travel Cost Model:
Steps:
2. Estimate a demand curve for each
characteristics regressing a site characteristic
levels (dependent variable) against the predicted
marginal cost of that characteristic and
socioeconomic variables for each zone of origin.
A separate regression is run for each
characteristics.
The expectation is that the coefficient on the
marginal cost variable will be negative implying that
as the level of a characteristics rises people are
unwilling to pay as much for each further increment.
 59
Valuation of Environmental Goods
Issues and Limitations of the TRAVEL COST METHOD

The travel cost method assumes that people perceive and

respond to changes in travel costs the same way that they
would respond to changes in admission price.
Defining and measuring the opportunity cost of time, or the
value of time spent on traveling, can be problematic. Because
the time spent on traveling could have been used in other
ways, it has an "opportunity cost." This should be added to the
travel cost, or the value of the site will be underestimated.
However, there is no strong consensus on the appropriate
measure: the person’s wage rate, or some fraction of the
wage rate and the value chosen can have a large effect on
benefit estimates.
 60
Valuation of Environmental Goods
Issues and Limitations of the TRAVEL COST METHOD

If people enjoy the travel itself, then travel time

becomes a benefit, not a cost, and the value of the
site will be overestimated. The availability of
substitute sites will affect values.
The most simple models assume that individuals
take a trip for a single purpose: to visit a specific
recreational site.
Interviewing visitors on site can introduce sampling
biases to the analysis.
 61
Valuation of Environmental Goods
Issues and Limitations of the TRAVEL COST METHOD
Measuring recreational quality, and relating
recreational quality to environmental quality can be
difficult.
Standard travel cost approaches provide information
about current conditions, but not about gains or losses
from anticipated changes in resource conditions.
In order to estimate the demand function, there needs
to be enough difference between distances travelled
to affect travel costs and for differences in travel costs
to affect the number of trips made. Thus, it is not well
suited for sites near major population centers where
many visitations may be from "origin zones" that are
quite close to one another.
 62
Valuation of Environmental Goods
TRAVEL COST METHOD
The travel cost method is limited in its scope of
application because it requires user participation. It
cannot be used to assign values to on-site
environmental features and functions that users of the
site do not find valuable.
Most importantly, it cannot be used to measure non-
use values. Thus, sites that have unique qualities that
are valued by non-users will be undervalued.
As in all statistical methods, certain statistical
problems can affect the results. These include choice
of the functional form used to estimate the demand
curve, choice of the estimating method, and choice of
variables included in the model.
 63
Valuation of Environmental Goods
CONTINGENT VALUATION METHOD
Contingent Valuation Method (CVM) was first used
by Davis (1963) in a study of hunters in Maine and
it was widely developed with Bohm (1972), Randal
et.al. (1974), Brookshire et. al., (1976) etc.
The essence of CVM method involves asking
individual to imagine some situation that is
typically outside the individual’s experience and
speculate on how he or she would act in such a
situation.
It is called 'contingent valuation' because the
valuation is contingent on the hypothetical
scenario put to respondents.
 64
Valuation of Environmental Goods
CONTINGENT VALUATION METHOD

CVM exercise can be split in to five stages:

Setting up the hypothetical market
Obtaining bids
Estimating mean WTP and or WTAC
Estimating bid curves
Aggregating the data
 65
Valuation of Environmental Goods
CONTINGENT VALUATION METHOD
As Carson (1991) noted, there are six main
component of a successful CV study:

1. Define Market Scenario

2. Choose elicitation method
3. Design market administration
4. Design sampling
5. Design of experiment
6. Estimate willingness-to-pay function
 66
Valuation of Environmental Goods
CONTINGENT VALUATION METHOD
1. Define Market Scenario:
Is the information to be conveyed to a respondent?
(i.e. one who will be asked about willingness to
pay)
To place the respondent in the right time frame of
mind to give meaning response to questions
Description of the market should be realistic to the
respondent and
Defining appropriate payment mechanism
 67
Valuation of Environmental Goods
CONTINGENT VALUATION METHOD
2. Choosing Elicitation Method:
Having properly defined the market scenario, the next step is
to decide how best to obtain the valuation process.
There are four ways of eliciting value: direct question, bidding
game, payment card and referendum choice.
2.1 Under direct questioning the main task is to ask the
respondents about their willingness to pay for the good.
However, this suffers from a great demerit in the sense that
there are few real markets in which we ask the respondent
to generate data and in most occasion people may not
spend much effort in determining their willingness to pay
which may result in extreme response (either zeroes and
very large numbers)
 68
Valuation of Environmental Goods
CONTINGENT VALUATION METHOD
2.2 Bidding Game:
Bidding game approach was first used by Randal
et.al (1974).
This approach involves a WTP number and seeks a
yes-no response.
If the respondent replies yes, the amount is gradually
increased until a no response is received. Similarly, if
the respondent replies no, the amount is gradually
decreased until a yes is received. The main problem
with this approach is the starting-point bias.
 69
Valuation of Environmental Goods
CONTINGENT VALUATION METHOD
2.3 Payment Card: A card with a number of figures, spanning
the range of responses that might be expected. Each card has
payment amounts along with several reference expenditure
amount.
The basic problem with the payment card is that they can not be
used for telephone surveys.
2.4 Referendum or discrete choice:
Under this approach a willingness to pay figure is offered to the
respondent who is asked if he or she would be willing to pay that
amount, ‘yes’ or ‘no’.
This approach although has the merit of minimizing possible
bias and is also familiar to the people in that people often vote
yes/no on public referenda. One problem with referenda is that
more data are needed to obtain statistically significant results
which raised cost of the survey.
 70
Valuation of Environmental Goods
CONTINGENT VALUATION METHOD
3. Design Market Administration:
Three approaches to survey administration: mail,
telephone and in-person
Mail Survey: cheaper to administer but suffers from
the problem of acute non-response
Telephone Survey: relatively inexpensive to
administer but limited by the availability of telephone
within the population being surveyed.
In-person Survey: Most expensive to administer but
can be more reliable. However it suffers from the
problem of interviewer bias.
 71
Valuation of Environmental Goods
CONTINGENT VALUATION METHOD
4. Sample Design:

It involves two steps: First, select the group (relevant

for the study) from which to draw the sample.
Second, draw the random sample.

5. Experimental Design:

Experimental design requires careful design of

survey instrument, its administration and its ultimate
statistical analysis.
 72
Valuation of Environmental Goods
CONTINGENT VALUATION METHOD
6. Estimation of Willingness to Pay Function:
The last step of the Contingent Valuation Method is
to take the survey results and correctly estimate the
WTP functions.

Problems with the Contingent Valuation Methods:

Despite significant application of CV technique in
eliciting values of environmental goods, the method
has been scrutinized and found to suffer from a large
number of limitations. Following are the important
limitations of this method:
 73
Valuation of Environmental Goods
The value elicited in CV surveys are not based on real
resource decisions - they are hypothetical.

Presence of ambiguity in what people are valuing

Problem of embedding. This problem generally pertains

to the inconsistencies that people face when they are to
value an environmental good (e.g. park) versus a group
of environmental goods (several parks in our case) when
they are substitutes.

Another related problem is the valuation of existence

value.
ENVIRONMENTAL ECONOMICS

Mrinal Kanti Dutta

mkdutta@iitg.ac.in

Department of Humanities and Social Sciences

Indian Institute of Technology Guwahati
Guwahati – 781039
2
 3

ENVIRONMENT DEVELOPMENT TRADE-OFF:

The Environmental Kuznet Curve (EKC)

• In the late 1980’s and early 1990’s some economists

(Krueger and others) took up some studies to
explore the relationships between level of economic
development and environmental quality across
countries.

• Plotting the concentration of certain key pollutants

against per capita income of levels of countries
some studies came up with a pattern of scatter
shown in figure-1.
 4

Pollution The Environmental Kuznet Curve

Early Stage Later Stage

of Economic of Economic
Development Development

Per Capita Income

Figure - 1
 5

The Environmental Kuznet Curve (EKC)

• This scatter indicated a relationship between per

capita income (PCI) and pollution levels of the
shape of an inverted U.

• Owing to the remarkable similarity of this pattern

to Kuznet’s findings about two decades earlier
between PCI and inequality across countries, this
relationship came to be known as the
Environmental Kuznet’s Curve (EKC).
 6

The Environmental Kuznet Curve (EKC)

• The associated hypothesis with this curve has been

put as thus:
 7

ENVIRONMENT DEVELOPMENT TRADE-OFF:

The Environmental Kuznet Curve (EKC)

• The EKC hypothesis points towards a trade-off

between environment and development i.e. it
seems to suggest that underdeveloped countries
will have to forgo environmental quality for the
sake of attaining a higher level of development.

• It further suggests that environmental quality will

be taken care of as developing countries attain
further level of development.
 8

ENVIRONMENT DEVELOPMENT TRADE-OFF:

The Environmental Kuznet Curve (EKC)
The rationale behind the EKC hypothesis can be
summed up in the following quotation:
“At low level of development both the quantity and intensity
of environmental degradation is limited to the impacts of
subsistence economic activity on the resource base and to
limited quantities of biodegradable wastes. As economic
development accelerates with the intensification of
agriculture and other resource extraction and the take-off of
industrialization, the rates of resource depletion begins to
exceed the rates of resource regeneration, and waste
generation increases in quantity and toxicity. At higher
levels of development, structural and services, coupled with
increased environmental awareness, enforcement of
environmental regulations, better technology and higher
environmental expenditures, result in leveling off and
gradual decline of environmental degradation.” (Panayotou
 9

ENVIRONMENT DEVELOPMENT TRADE-OFF:

The Environmental Kuznet Curve (EKC)

• Empirical evidence in support of the EKC is not yet

conclusive to establish the observed trade-off or
the hypothesis as a law.

• Studies based on longitudinal data of developing

countries have not come out as yet.

• The possibility of such studies refuting the trade-off

(the way the Kuznet’s inverted U hypothesis was
refuted by such studies that came up in 1970’s)
cannot be ruled out.
 10

ENVIRONMENT DEVELOPMENT TRADE-OFF:

The Environmental Kuznet Curve (EKC)

• Even if the trade-off was valid for the past

experiences its policy implication for future of
developing countries may not be very useful.

• An obvious policy suggestion which can be drawn

from the trade-off is that developing countries
should focus primarily on growth and economic
development goals without bordering much about
environmental protection in their early stages.

• Because growth itself will take care of

environmental quality at a later stage.
 11

ENVIRONMENT DEVELOPMENT TRADE-OFF:

The Environmental Kuznet Curve (EKC)

• However, such a strategy can be mistaken (as was

the growth oriented strategy of developing countries
like India in the early planning era without much
effort for reduction of poverty, believing that poverty
was supposed to be mitigated by trickle down effect
of high growth)

• Moreover, it is important to note that many

components of environmental quality such as bio-
diversity are non-reversible if degradation exceeds a
threshold levels.
 12

ENVIRONMENT DEVELOPMENT TRADE-OFF:

The Environmental Kuznet Curve (EKC)
• In this context it seems that, despite the ambiguity
associated with the concept, sustainable
development would be a better strategy.

• Moreover, a developing country today need not go

through the same course of development on which
the rationale for the EKC hypothesis has been
formulated.

• For instance, countries like India have made the

transition from a primary sector dominated
economy to a service sector dominated economy
without going through the phase dominated by the
industrial sector.
 13

ENVIRONMENT DEVELOPMENT TRADE-OFF:

The Environmental Kuznet Curve (EKC)
• Such a pattern obviates the need for industrialization
related environmental degradation in the course of
economic development.

• Even if a country needs and chooses to industrialize it

can leap-frog the course of technological advancement
and adopt technologies, which are substantially less
polluting than the technologies used by countries which
industrialized in the past

• The environment-development trade-off might have

existed historically. But it is not inevitable for a
contemporary developing countries to sacrifice
environment quality for the sack of expediting the pace of
development.
14
 15

SUSTAINABLE DEVELOPMENT: BACKGROUND

 The ‘Limits to Growth’ Report

 Energy crisis of 1970s precipitated by oil price
jumps
 Market failure in allocation of environmental
resources
 World Commission on Environment and
Development instituted in 1983
 The report ‘Our Common Future’ articulated the
concept
 16

SUSTAINABLE DEVELOPMENT: DEFINITION

 Development that meets the needs of the present
without compromising the ability of the future
generations to meet their own needs

 Appealing but ambiguous. Some called it

delightfully vague

 Present needs?
 Needs of the future generations?
 Requirements to meet the future needs?

 Difficult to operationalise.
 17

SUSTAINABLE DEVELOPMENT: ECONOMIST’S

PERCEPTION
Resonates with Economists’ conceptualization of
INCOME, i.e., maximum consumption one can have
in a period while remaining as well off in the end as in
the beginning of the period (Solow)
In that light sustainability has been interpreted as an
obligation to conduct ourselves so that we leave to
the future the option or capacity to be as well off as
we are
Hence sustainability requires that the stock of capital-
manufactured, human and natural, is left
undiminished
This, in turn, needs restricting consumption to save
resources for asset creation and conservation and
protection of the environment
 18

SUSTAINABLE DEVELOPMENT : Definitions

A requirement to our generation to manage the
resource base such that the average quality of life
we ensure ourselves can potentially be shared by
all future generations” -Asheim (1994)

SD serving multiple goals- economic development,

a better environment and a particular concern for
poor

Two common features of many definitions of SD:

Equity across generations
Equity within generations

Equity vs. efficiency issue

Sustainability and sustainable development
 19

SUSTAINABLE DEVELOPMENT : Approaches

Two approaches-
Outcome approach
Maintaining the means to generate well-being or
consumption
Outcome approach:
How the economic process directly affects human
well being
Well being is synonymous with utility or welfare of an
individual
Sustainability is the utility of a representative agent in
any period t, U(t) to be non-declining for the rest of
the time from time t* onwards
Defining SD in terms of observable determinants of
utility
 20

SUSTAINABLE DEVELOPMENT : Approaches

Maintaining the resources available to society to

generate well-being or consumption

Resources consist of physical stocks and the

technology

Four forms of capital:

Man-made or produced capital, Km
Human capital, Kh
Natural capital, Kn
Social Capital, Ks
SUSTAINABLE DEVELOPMENT 21

SUSTAINABILITY: Weak and Strong

Weak Sustainability Strong Sustainability treats
views manufactured and natural and man made
natural capital to be capital to be complementary
substitutable
So renewable resources to be
Therefore what matters is used only at rates at which
the total stock of these they regenerate. Use of non-
assets renewable should be
minimized.
Monetary valuation of
stocks possible Resource stock have to be
measured in physical units
 22

EFFORTS AND INDICATORS FOR MONITORING

SUSTAINABILITY

Environmentally Adjusted National Income or

Green NDP (=NDP-Depletion of Natural
Capital-Environmental Damage)

Genuine Savings

Integrated Environmental Economic Accounting

 23

GREEN NATIONAL ACCOUNTS

 Degradation of environmental capital is like

depreciation of man-made capital

 Subtract from gross income to get net income

 Not doing it is steering with a faulty compass

 24

GREEN NATIONAL ACCOUNTS

System of National Accounting (SNA) as a

measure of SD

Income as given by Hicks- that portion of the

value of output which could be consumed in any
year without reducing one’s wealth.

Need for adjustment in conventional accounts

 25

ADJUSTMENTS IN NATIONAL ACCOUNTS

For NR resources, deduct from NNP an amount equal

to the value of annual production (less discoveries)
multiplied by the difference b/w P and MC
For RR, annual production is deducted from annual
growth and then valued using P and MC term
For pollution, amount equivalent to change in stock of
each pollutant multiplied by its marginal abatement cost
Green NNP = NNP- (p1-mc1)•
NR-(p2-mc2) •
R-v(•
S)
 v= marginal cost of abatement for pollution stock S
 26

GENUINE SAVINGS
• Pearce and Atkinson, 1993

• Compares reinvestment in an economy with

depreciation of both natural and man made capital
GS = S - θm- θn

• Positive genuine saving means that the weak

sustainability norm is fulfilled. (natural and man
made capital are perfect substitutes)
 27

ISSUES FOR SUSTAINABLE DEVELOPMENT

• Economic growth is needed and desirable.

• Can needed growth be attained?

• What stress on environment would it put?

• How to make it green growth?

• How to ensure sustainable development?

 28

POVERTY and Environmental Degradation

 Poor people, almost always, bear the burnt of

environmental degradation

 Poverty and environmental degradation are often

caught in a mutually reinforcing downward spiral

 If the spiral is to be arrested, addressing poverty

alongwith environment oriented policy will be
useful
 29

POVERTY and Environmental Degradation

 For appropriate policy formulation, examining the

causality between poverty and environmental
degradation is important

 Poor usually don’t possess means and power to

damage the environment to the point that will
unleash the spiral

 Greed and rent-seeking by the rich and powerful

section are responsible for such degradation of
environment
30
 31

TRADE and ENVIRONMENT

 Two broad categories of issues-

 Those arising from the consequences of

differences in environmental regulations across
countries

 Others concerned with management of global

public bad
 32

TRADE and ENVIRONMENT

 International trade helps a country to specialize

in production of specific commodities
(comparative cost advantage)

 Relative endowment of different types of

natural resources plays an important role in
determining the pattern and volume of trade

 Pattern and volume of trade affects the

environment nationally and globally
 33

TRADE and ENVIRONMENT

 Sources of international trade determining

comparative cost advantage of countries are-
 Differences in labour productivity
 Relative availability of factors of production
including natural resources

 Differential environmental standards or

regulations across countries may also affect
pattern and spatial distribution of trade, and
thereby environment
 34

TRADE and ENVIRONMENT

 International trade → Greater production and

consumption → environmental problems (social
cost)
 Market failure (external costs are not captured
in price)
 Lower price → higher demand and production
(more than socially optimal level)
 Appropriate regulation is required to curtail
output
 35

TRADE and ENVIRONMENT

 Environmental regulation and
specialization in production

 Case of developed and developing

countries

 Pollution haven hypothesis

 36

Global Public Goods and Bads

 Public bads affect all people in a locality
adversely and no one can be excluded
 Local and global public goods and bads
 Individual countries may not have enough
incentives to conserve the goods and limit
use of bads
 Tendency to ‘free ride.’
 Not enough actions and ‘tragedy of
commons’
 Kyoto, Montreal protocol, etc.
 12
PRICING EMISSIONS

IN CHAPTERS 4 AND 5, WE SAW THAT MARKETS CANNOT BE RELIED ON TO PROVIDE TE

when it comes to public bads. Normally, consumer
right amount of pollution -markets fail
preferences are communicated to producers through the price system. The basic problem in
the case of pollution is that without a price system, polluters do not "see" the damage caused
by the pollution they emit. The simplest way to correct this lack of a signal to polluters is to
establish a price for pollution. Just as the price of labor signals to a firm to conserve labor
inputs, a price on pollution will signal to the firm to cut back on pollution as much as is eco-
nomically feasible. The theoretical idea of placing a price on pollution is from the English
economist Arthur C. Pigou and dates to the early twentieth century The more practical
idea of regulating pollution by charging polluters an emission fee per unit of pollution has
its modern origins in the pathbreaking environmental economist, Alan Kneese, whospent
virtually his entire professional career at Resources for the Future in Washington, DC2

I. HOW DO POLLUTERS RESPOND TO EMISSION FEES?

Before turning to how one determines how large or small an emission fee should be, 1t 15
understand fee for their
important to how will
polluters respond
when charged specific
a

emissions. We first define an emission fee:

DEFINITION An emission fee is a price orfee paid by a polluter to a regulatory enfityyor

every unit of emissions the polluter emits.

Consider a firm producing some good (for example, electricity) along with polutoon,

If the emission fee is p and the polluter emits x units of pollution, the payment roL
polluter to the regulator is px. To determine how much the polluter will emit, let C
the production costs associated with emitting x units of pollution, holding goods ou
fixed. One would expect Cto decline as x increases-the polluter saves money by emt
pollution. Total costs for the firm (abatement costs and costs of the fee) are give by
(12.1)
TCx) =
C(x) +px
234
 How Do Polluters Respond to Emission Fees? 235
We know something is minimized when its marginal is zero; furthermore, the
of a sum is the sum of the marginals (the derivative of a sum is the marginal
sum of the
Therefore, total cost in Eq. (12.1) is minimized when x is chosen so that derivatives).

P=-MCC) =MS(x) (12.2)

The interpretation of Eq. (12.2) is that the firm chooses to operate where the marginal
savings from emitting one more unit of pollution (which happens to be equal to the mar
ginal cost of reducing pollution by one unit) is equal to the price of pollution. Emittingga
Smaller amount of pollution would involve abatement costs that are higher than the pol-
lution price-lowering emissions raises total costs. Emitting a larger amount of pollution
than called for in Eq. (12.2) would mean that abatement costs are lower than the emission
fee; thus increasing emissions increases fee payments more rapidly than abatement costs
are lowered and is also a bad idea.
Equation (12.2) indicates that when faced with an emissions fee, firms will abate pol-
lution up to the point where the marginal cost of abatement (or equivalently, the marginal
savings from emitting) is equal to the emissions fee. This point is where the firm's total
costs are lowest.
With multiple firms, each firm will abate to the point where the marginal cost of
abatement is equal to the emissions fee. Thus the equimarginal principal will automati-
cally hold-each firm sets the marginal cost of abatement equal to the same number (the
fee), and thus the marginal cost is the same for all firms.
This is illustrated in Figure 12.1 for two firms-Riley Wreckers and Tucker Tools. In
the left-hand panel of the figure, marginal savings to the firm are shown as a function
of emissions: by emitting one more unit, there is a cost savings to each of the firms. The
right panel shows exactly the same thing, except from the point of view of abatement and
the marginal cost of abatement. With no pollution regulations, there will be no abatement
and emissions will be at the point where marginal savings is zero: E, for Tucker Tools and
E for Riley Wreckers.

- - -

Tucker Tools
..o.. Riley Wreckers
/-MCT
MST
MSR
MCR

amu awe mwu auwm

**

Abatement
ET ET ER ER Emissions AT AR

(a) (b)

when faced With

FIGURE 12.1 Firm choice of emissions/abatement
emission fee, p.
236 CHAPTER 12 PRICING EMIsSiONS

With an emission fee equal to p, the two firms

cut back on emissions (ine
ment) to the points E, and E, (respectively, A, and A) for the two firms Ei abate-
where the marginal cost of abatement/marginal savings
from pollution is exacerate
to the enmissions feee. equal
One of the bonuses of an emissions fee is that the equimarginal principle automas
cally holds. Because the two firms face the same emission fee, they will both set thei
ginal cost of abatement to the same number and thus marginal costs will be e a d
between the two firms (or among any number of firms facing the same emiceio s
fee).
ed

The London Congestion Charge

One of the most successful applications of an environmental charge is the
charge on automobiles in the centers f congested cities. And one of tho
most prominent of these is the charge in London, England. Although not a
charge on emissions, the congestion charge is still a good example of the
use of a tax or fee to correct an externality.
By the 1990s the speed of travel in central London was slower than it
was in 190o, before the advent of the automobile. In 2002 the average
daytime speed was less than 15 km/hr, compared to more than twice that
speed in the less congested night time. In order toaddress this problem,
in 2003 a charge of £5/day (raised to £8/day in 2005) was levied on all
vehicles traveling or parking in central London during the day, excluding
weekends and holidays. The charge is collected by voluntary payment
of the charge by motorists, accompanied by enforcement using cameras
and computers that read license plates. Enforcement is only 85% or so
effective, yet the £100 penalty for scofflaws is sufficient for the system to
work.
Although paying the charge is not popular (a similar system has been
proposed for New York but has faced political opposition), a significant
reduction in congestion has been achieved. Private car travel in central
London is down by a third and daytime travel speeds have increased 20%.

(Source: Leape, 2006.)

II. PIGOVIAN FEES

As was mentioned at the beginning of the chapter, approximately a century ago

English economist Arthur C. Pigou argued for the imposition of taxes ongenerators
pollution. The Pigovian fee, as it has come to be called, is a special kind of emi
fee-an emission fee that is set at the marginal damage of pollution in an atte
restore Pareto optimality to a situation of market failure:
arginal
DEFINITION A Pigovian fee is an emission fee exactly equal to the aggregate a
damage caused by the emissions when evaluated at the efficient level of pollution.
We examine this definition in more detail, first for the case of a singlepoe ofthe
then for the case of multiple polluters. In both cases, there are multiple victims
pollution.
 Pigovian Fees 237
A. A Single Polluter
SuppOse we have a
factory generating pollution in the
amount x at cost C(x), a
marginal costs, MC(). Since costs decline as x is increased, with
negative. Another of
way thinking about this is in marginal costs are
actually
terms of
from emitting one more unit of polution. Of course the marginal savings-the savings
of the marginal costs: MS(X) -MCx). As in the case ofmarginal
= savings is the negative
an emission
the same as the marginal cost of abatement. fee, this is exactly
Further assume there are N people surrounding
the factory and that
causes damage. For the time being, assume that pollution
people cannot use locational choice
to change the amount of pollution they face. Thus there
is nothing a
reduce his or her exposure, short of person can do to
getting the factory to cut back. For person i, the
damage from pollution is Dx), which is positive and increases
in x. There are several
other ways of interpreting this damage. We could also that
say
thepollution in the amount B,(x) with benefits negative and person benefits
i from
could say that D,() is the willingness to pay to eliminate the decreasing inx. Or, we
are given by pollution. Total damages

D) X,D ()
=

(12.3)
The efficient amount of pollution is the amount that minimizes total costs and
damages:
x minimizes {C(x) + D(x)}
(12.4a)
We know that something is minimized when its
a sumis equal to the sum of the
marginal is zero. Further, the marginal of
marginals. Thus we can set the marginal of the quantity
in braces in Eq. (12.4a) to zero:

MCx)+ MDx) = 0
(12.4b)
Substituting the marginal version of Eq. (12.3) into Eq. (12.45) and recognizing that mar-
ginal savings is the negative of marginal cost, we obtain

MS(x) =2, MD «) (12.4c)

In other
words, we seek a level of pollution such that the marginal savings to the firm
from pollution(-MC) is equal to the marginal damage from pollution over the entire
population. Since pollution is a public bad, the aggregate marginal damage (MD) is the
vertical sum of the individual
marginal damages (MD,).
This situation is illustrated in Figure 12.2 for the case of one polluter and two victims
of the
pollution. Shown in the lower half of the figure is the marginal cost of pollution.
Note that this is
negative since every extra unit of pollution the factory is allowed to emit
1Owers total costs for the factory (up to a limit of course). The marginal savings to the
lactory is the negative of this and is shown in the first (upper) quadrant. As the factory
ncreases pollution from no emissions at all, savings are initially quite high. When emis-
oOns are relatively large, the savings from emitting a little more are much smaller. Thus
MS(x) is downward sloping
238 CHAPTER 12 PRICING EMISSIONS

FIGURE 12.2
MDOX) =-MC() Pigovian fee on
with twovictims of pollution. pollutant emissions
MDX) damage to victim 1; MD.0
to victim 2; MD(x), MD,X), marginal margin
dinal
MD,CX) MC(X), marginal gregate marginaldamage
cost of dan
MD2X) MS(X), marginal savings emitting
from
for the mage
po
\luter,
polluter; X, pollution emitting
levels with for tthe
no
&x (emissions) efficient amount of regulationfee.
emissions; p, Pigovian

/MC)

Also shown in Figure 12.2 are the marginal damage functions for the twO victi.
of the pollution: MD (x). Marginal damage is the negative of the demand functiontims
pollution for each of the individuals. Each of the marginal damage schedules for
is
sloping. When pollution levels are small, one more unit of pollution causes little ward
When pollution levels are higher, that extra unit causes more damaoe
is a public bad, aggregate marginal damage, like
damage. Since the pollution
aggregate demand, is the vertical sunm
of individual marginal damages. This is also shown in the
figure [MD()]. The optimal
amount of pollution is the x for which MD() MS(), shown as x* in Figure 12.2. Also
=

shown in Figure 12.2 is the Pigovian fee, p". If the

polluter is charged p* per unit of pollu-
tion, the polluter basically sees pollution as priced at p* and thus the
so that price equals marginal cost:
polluter will pollute

MC(x*) =-p* or MS(x*) = p* (12.5)

The total amount of money the firm
pays for the pollution is p'x"
Note that the Pigovian fee is defined as the
marginal savings from pollution genera
tion at the optimal level of pollution. If we are not at the optimum, the Pigovian fee will
be
neither the current marginal cost of pollution control nor the marginal damage from
the Pigovian fee is not from
polution. Thus any emission fee; it is the marginal savings
pollution at the optimal pollution level.

B. Multiple Polluters
We have seen howa The
Pigovian fee generate the efficient amount of a pubic b
can
case we have looked at luter.
involves a single polluter. Suppose we have more than one p
For the time two
being, assume we have two polluters. Figure 12.3 illustrates
polluters in which the marginal damage function (MD) is the u ge to all
consumers. Shown is the aggrega
How much
marginal savings to each of two firms from genet set to
pollution should each firm generate and how should the Pigoviai
support that level of pollution?
An what the
aggregate marginal savings function for a group of polluters n
es

nit. This
marginal savings will be if the total amount of pollution increases
nit
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The Tragedy of Commons:
Let us take an example of a common grazing land in a village which is open to all the villagers.
Each villager in the pursuit of maximizing individual gain adds more and more cattle to the
grazing field. He gets the full benefits of adding one more animal to the field. His personal
gain from adding one more animal exceeds his personal loss from the damage done to the field
(since the loss done by one more animal is to be shared by all as opposed to the gain which
accrues fully to him). All villagers think the same way and act accordingly to maximize
personal gains. Eventually the total number of cattle exceeds the carrying capacity of the
grazing land and everybody loses from the damage of the land. Thus, in the absence of
appropriate regulation, overexploitation of resources leads to their destruction. Such tragedy
may also occur in case of common fishery in the villages.

Since the problem originates from laxity in defining and enforcement of property right over
the commons, the usual solution suggested is assignment of property rights either in the form
of private property rights or through establishing common property rights regime, which lays
down rules to limit entitlement of individual members to common resources of the community

‘Prisoner’s Dilemma’:
A popular analysis of the ‘Tragedy of Commons’ takes the form of a game known as the
‘prisoner’s dilemma’. To explain this concept let us assume that two persons, Haren and Bittu
have been arrested on the charges of theft. They have been kept separate so that no
communication is possible between them. The options in front of them are: if one confesses
but the other does not, the former will be set free while the later will receive punishment of 5
years in jail. If both confess then they will get a modest punishment, say of 2 years; and if
neither of them confesses his crime they will be freed after 3 months due to lack of evidence.
This is depicted in Table 1. Now Haren thinks that if Bittu does not confess his best option is
to confess and secondly if Bittu confesses, then again his best option would be to confess.
Because if he does not confess and Bittu confesses, he will get a severe punishment of five
years and there is no way for him to know what the decision of the later would be. On the other
hand, Bittu thinks the same way and decides to confess. Thus the likely outcome is that both
will confess and get a punishment of 2 years each. However, it is interesting to note that if both
could have established some contact and cooperated, then they could have got only 3 months’
punishment simply by denying the charges against them. But since they have been kept
separate, cooperation is not possible. The essence of ‘prisoner’s dilemma’ is that lack of
cooperation among the parties deprives them of the best of all the outcomes.

1
 Table 1: The ‘Prisoner’s Dilemma’
Haren
Bittu Confess Don’t confess
Confess 2 years, 2 years free, 5 years
Don’t confess 5 years, free 3 months, 3months

Thus, ‘prisoner’s dilemma’ refers to a situation where each participant receives a

comparatively lower return as a result of non-cooperation than what they would have received
if there were cooperation between them.

The same sort of ‘prisoner’s dilemma’ can be observed in case of the commons. Let us now
take the example of common grazing land used while discussing ‘tragedy of commons’. It was
found that the desperate use by all the herdsmen lead to degradation of grazing land. For the
sake of simplicity let us assume that there are only two herdsmen Haren and Bittu. The different
options open to each one of them are shown in Table 2. As is evident from the table, when one
cooperates in the judicious use of the land but the other does not, the latter is the gainer in
terms of returns from his livestock as he will be putting more and more cattle on the land. If
neither of them cooperates and uses the grazing land indiscriminately then each gets a low
return of 20 each. The best action, however, would have been to cooperate and appropriate a
larger return of 50 each. But their individual rational choices lead to non-cooperation.

Table 2: Common Grazing Land and ‘Prisoner’s Dilemma’

Haren
Bittu Cooperate Don’t cooperate
Cooperate 50,50 10,30
Don’t cooperate 30,10 20,20

However, this undesirable solution may be avoided in a ‘repeated game’ framework. Suppose
the players, Haren and Bittu in our example, go through the dilemma repeatedly. Once
repetitions come into calculation, the players are likely to realize the mutual gain from
cooperation, and their choice of action may be different from what that will be in a one-off
game. There are ample empirical instances when members of a community get together to form
rules to self-regulate the use of their commons and thereby manage to avoid the ‘tragedy of
commons’.

2
Valuation of Environmental Goods

ENVIRONMENTAL ECONOMICS

Mrinal Kanti Dutta

mkdutta@iitg.ac.in

Department of Humanities and Social Sciences

Indian Institute of Technology Guwahati
Guwahati – 781039
 2
Valuation of Environmental Goods
TRAVEL COST METHOD
One of the oldest approaches to environmental valuation
Proposed in a letter from Harold Hotelling to the US Forest
Service in the 1930’s, first used by Wood and Trice in 1958,
popularized by Clawsen and Knetsch (1966)
Premises
• People bear cost to visit regions or sites (national park or
estate)
• Hypothesis : These costs are at least equal to the minimum
value of the benefit people get when visiting the sites and their
environmental goods or services. Thus these travel costs can
be used as a proxy for the price of visiting outdoor recreational
sites . (In other words, the recreational benefits at a specific site
can be derived from the demand functions that relate observed
user’s behaviour to the cost of visit.)
 3
Valuation of Environmental Goods
TRAVEL COST METHOD
Steps of analysis
• Estimate the cost of travel and visit for each regions
of origin

• Questionnaire : visitors trip, expenses and

characteristics

•Estimate of the demand for the site (and

environmental goods and services) depending on
the cost of travel and visit and other characteristics
 4
Valuation of Environmental Goods
TRAVEL COST METHOD
Options for Applying the Travel Cost Method

1. A simple zonal travel cost approach, using mostly secondary

data, with some simple data collected from visitors. The
zonal travel cost method is applied by collecting information
on the number of visits to the site from different distances.

2. An individual travel cost approach, using a more detailed

survey of visitors. The individual travel cost approach is
similar to the zonal approach, but uses survey data from
individual visitors in the statistical analysis, rather than data
from each zone. This method thus requires more data
collection and slightly more complicated analysis, but will
give more precise results.
 5
Valuation of Environmental Goods
TRAVEL COST METHOD

3. Hedonic Travel Cost Model which attempts to place

values on the characteristics of recreational resources.

4. A random utility approach using survey and other data,

and more complicated statistical techniques. The
random utility approach assumes that individuals will
pick the site that they prefer, out of all possible sites.
Individuals make tradeoffs between site quality and the
price of travel to the site. Hence, this model requires
information on all possible sites that a visitor might
select, their quality characteristics, and the travel costs
to each site.
 6
Valuation of Environmental Goods
TRAVEL COST METHOD
The travel cost method is applied by collecting
information on the number of visits to the site from
different distances. Because the travel and time costs
will increase with distance, this information allows the
researcher to calculate the number of visits purchased
at different prices: the demand function and the
consumer surplus or economic benefits, for the
recreational services of the site.
Step 1: The first step is to define a set of zones
surrounding the site. These may be defined by
concentric circles around the site, or by geographic
divisions that make sense, such as metropolitan areas
or counties surrounding the site at different distances.
 7
Valuation of Environmental Goods
TRAVEL COST METHOD
Step 2: The second step is to collect information on the
number of visitors from each zone, and the number of
visits made in the last year.

Step 3: The third step is to calculate the visitation rates

per 1000 population in each zone. This is simply the
total visits per year from the zone, divided by the
zone’s population in thousands.

Step 4: The fourth step is to calculate the average

round-trip travel distance and travel time to the site for
each zone, using average cost per mile (km) and per
hour of travel time. What is the opportunity cost of
time?
 8
Valuation of Environmental Goods
TRAVEL COST METHOD

Step 5: The fifth step is to estimate, using regression

analysis, the equation that relates visits per capita to
travel costs and other important variables.

From this, the researcher can estimate the demand

function for the average visitor. In this simple model,
the analysis might include demographic variables,
such as age, income, gender, and education levels,
using the average values for each zone
 9
Valuation of Environmental Goods
TRAVEL COST METHOD
Step 6: The sixth step is to construct the demand
function for visits to the site, using the results of the
regression analysis. The first point on the demand
curve is the total visitors to the site at current access
costs (assuming there is no entry fee for the site)

Step 7: The final step is to estimate the total economic

benefit of the site to visitors by calculating the
consumer surplus, or the area under the demand
curve.
 10
Valuation of Environmental Goods
TRAVEL COST METHOD
Simple Travel Cost Model:
If the price (p) is the only sacrifice made by a
consumer, the demand function for a good with no
substitutes is x=f(p), given income and preferences.
However, the consumer often incurs other costs (c),
such as travel expenses and loss of time. In this
case, the demand function is expressed as x = f(p, c).

Under these conditions, the utility maximising

consumer’s behaviour should be reformulated in
order to take such costs into account.
 11
Valuation of Environmental Goods
TRAVEL COST METHOD
Simple Travel Cost Model:
Given two goods or services (x1, x2), their prices (p1, p2), the
access costs (c1, c2) and income (R), the utility maximizing
choice of the consumer is:
MaxU = u(x1,x2)
Subject to: (p1 + c1) x1 + (p2 + c2)x2 = R (1)

Now, let 'x1' denote the aggregate of priced goods and

services, x2 the number of annual visits to a recreational site,
and assume for the sake of simplicity that the cost of access to
the market goods is negligible '(c1=0)' and that the recreational
site is free (p2=0).
 12
Valuation of Environmental Goods
TRAVEL COST METHOD
Under these assumptions, equation [1] can be written
as:
MaxU = u(x1,x2))
Subject to: p1x1 + c2x2 = R (2)
Under these conditions, the utility maximizing
behaviour of the consumer depends on:
a) His preferences [u(x1, x2)],
b) His budget (R),
c) The prices of the private goods and services
(p1) and
d) The access cost to the recreational site (c2).
 13
Valuation of Environmental Goods
TRAVEL COST METHOD
The TCM is based on the assumption that changes in the costs
of access to the recreational site (c2) have the same effect as a
change in price: the number of visits to a site decreases as the
cost per visit increases.
Under this assumption, the demand function for visits to the
recreational site is x2=f(c2) and can be estimated using the
number of annual visits as long as it is possible to observe
different costs per visit and up to the cost at which visits
become equal to zero.
This simple model can be extended to include the effect of
other substitute sites.
Alternatively, same model can be used to estimate visits per
time be an individual to site with c and p becoming specific to
the individual only.
 14
Valuation of Environmental Goods
TRAVEL COST METHOD
The basic TCM model is completed by the weak
complementarity assumption, which states that trips
are a non-decreasing function of the quality of the site,
and that the individual forgoes trips to the recreational
site when the quality is the lowest possible
 15
Valuation of Environmental Goods
TRAVEL COST METHOD

c2 The Figure depicts

cp the expected
relationship
between the
number of visits
and cost per visit,
c2p given other
variables, showing
that the number of
visits decreases as
c2c
the cost per visit
increases.
o x2p x2c
x2
 16
Valuation of Environmental Goods
TRAVEL COST METHOD
Hedonic Travel Cost Model:
On many occasion, we are interested in the value of
changing characteristics of a site rather than in the
value of the site in toto.
In this respect, hedonic travel cost model attempts
to place values on the characteristics of recreational
resources.
Hedonic travel cost model was first proposed by
Brown and Mendelsohn (1984) and was later
applied to forest characteristics by Englin and
Mendelsohn (1991) and coastal water quality by
Bockstael et. al. (1987)
 17
Valuation of Environmental Goods

Hedonic Travel Cost Model:

Steps:
1. Respondents to a number of sites (e.g. forest) are
sampled to determine their zone of origin.
The levels of physical characteristics are recorded
for each site
A travel cost function is estimated for each zone, as

C(Z) = c0 + c1z1 + c2z2 + … cmzm (1)

Where, C(Z) are travel costs, z1 . . . zm are

characteristics and c0 . .. cm are coefficients to be
estimated.
 18
Valuation of Environmental Goods
TRAVEL COST METHOD
Hedonic Travel Cost Model:

Steps:

A separate regression is performed for each zone

of origin such that each will have a vector of
coefficients {c0… cm}. For a given characteristics m,
the utility maximising individual will choose visits
such that the marginal costs of characteristics (the
coefficient cm) is just equal to the marginal benefit
to him.
 19
Valuation of Environmental Goods
TRAVEL COST METHOD
Hedonic Travel Cost Model:
Steps:
2. Estimate a demand curve for each
characteristics regressing a site characteristic
levels (dependent variable) against the predicted
marginal cost of that characteristic and
socioeconomic variables for each zone of origin.
A separate regression is run for each
characteristics.
The expectation is that the coefficient on the
marginal cost variable will be negative implying that
as the level of a characteristics rises people are
unwilling to pay as much for each further increment.
 20
Valuation of Environmental Goods
Issues and Limitations of the TRAVEL COST METHOD

The travel cost method assumes that people perceive and

respond to changes in travel costs the same way that they
would respond to changes in admission price.
Defining and measuring the opportunity cost of time, or the
value of time spent on traveling, can be problematic. Because
the time spent on traveling could have been used in other
ways, it has an "opportunity cost." This should be added to the
travel cost, or the value of the site will be underestimated.
However, there is no strong consensus on the appropriate
measure: the person’s wage rate, or some fraction of the
wage rate and the value chosen can have a large effect on
benefit estimates.
 21
Valuation of Environmental Goods
Issues and Limitations of the TRAVEL COST METHOD

If people enjoy the travel itself, then travel time

becomes a benefit, not a cost, and the value of the
site will be overestimated. The availability of
substitute sites will affect values.
The most simple models assume that individuals
take a trip for a single purpose: to visit a specific
recreational site.
Interviewing visitors on site can introduce sampling
biases to the analysis.
 22
Valuation of Environmental Goods
Issues and Limitations of the TRAVEL COST METHOD
Measuring recreational quality, and relating
recreational quality to environmental quality can be
difficult.
Standard travel cost approaches provide information
about current conditions, but not about gains or losses
from anticipated changes in resource conditions.
In order to estimate the demand function, there needs
to be enough difference between distances travelled
to affect travel costs and for differences in travel costs
to affect the number of trips made. Thus, it is not well
suited for sites near major population centers where
many visitations may be from "origin zones" that are
quite close to one another.
 23
Valuation of Environmental Goods
TRAVEL COST METHOD
The travel cost method is limited in its scope of
application because it requires user participation. It
cannot be used to assign values to on-site
environmental features and functions that users of the
site do not find valuable.
Most importantly, it cannot be used to measure non-
use values. Thus, sites that have unique qualities that
are valued by non-users will be undervalued.
As in all statistical methods, certain statistical
problems can affect the results. These include choice
of the functional form used to estimate the demand
curve, choice of the estimating method, and choice of
variables included in the model.
 24
Valuation of Environmental Goods
CONTINGENT VALUATION METHOD
Contingent Valuation Method (CVM) was first used
by Davis (1963) in a study of hunters in Maine and
it was widely developed with Bohm (1972), Randal
et.al. (1974), Brookshire et. al., (1976) etc.
The essence of CVM method involves asking
individual to imagine some situation that is
typically outside the individual’s experience and
speculate on how he or she would act in such a
situation.
It is called 'contingent valuation' because the
valuation is contingent on the hypothetical
scenario put to respondents.
 25
Valuation of Environmental Goods
CONTINGENT VALUATION METHOD

CVM exercise can be split in to five stages:

Setting up the hypothetical market
Obtaining bids
Estimating mean WTP and or WTAC
Estimating bid curves
Aggregating the data
 26
Valuation of Environmental Goods
CONTINGENT VALUATION METHOD
As Carson (1991) noted, there are six main
component of a successful CV study:

1. Define Market Scenario

2. Choose elicitation method
3. Design market administration
4. Design sampling
5. Design of experiment
6. Estimate willingness-to-pay function
 27
Valuation of Environmental Goods
CONTINGENT VALUATION METHOD
1. Define Market Scenario:
Is the information to be conveyed to a respondent?
(i.e. one who will be asked about willingness to
pay)
To place the respondent in the right time frame of
mind to give meaning response to questions
Description of the market should be realistic to the
respondent and
Defining appropriate payment mechanism
 28
Valuation of Environmental Goods
CONTINGENT VALUATION METHOD
2. Choosing Elicitation Method:
Having properly defined the market scenario, the next step is
to decide how best to obtain the valuation process.
There are four ways of eliciting value: direct question, bidding
game, payment card and referendum choice.
2.1 Under direct questioning the main task is to ask the
respondents about their willingness to pay for the good.
However, this suffers from a great demerit in the sense that
there are few real markets in which we ask the respondent
to generate data and in most occasion people may not
spend much effort in determining their willingness to pay
which may result in extreme response (either zeroes and
very large numbers)
 29
Valuation of Environmental Goods
CONTINGENT VALUATION METHOD
2.2 Bidding Game:
Bidding game approach was first used by Randal
et.al (1974).
This approach involves a WTP number and seeks a
yes-no response.
If the respondent replies yes, the amount is gradually
increased until a no response is received. Similarly, if
the respondent replies no, the amount is gradually
decreased until a yes is received. The main problem
with this approach is the starting-point bias.
 30
Valuation of Environmental Goods
CONTINGENT VALUATION METHOD
2.3 Payment Card: A card with a number of figures, spanning
the range of responses that might be expected. Each card has
payment amounts along with several reference expenditure
amount.
The basic problem with the payment card is that they can not be
used for telephone surveys.
2.4 Referendum or discrete choice:
Under this approach a willingness to pay figure is offered to the
respondent who is asked if he or she would be willing to pay that
amount, ‘yes’ or ‘no’.
This approach although has the merit of minimizing possible
bias and is also familiar to the people in that people often vote
yes/no on public referenda. One problem with referenda is that
more data are needed to obtain statistically significant results
which raised cost of the survey.
 31
Valuation of Environmental Goods
CONTINGENT VALUATION METHOD
3. Design Market Administration:
Three approaches to survey administration: mail,
telephone and in-person
Mail Survey: cheaper to administer but suffers from
the problem of acute non-response
Telephone Survey: relatively inexpensive to
administer but limited by the availability of telephone
within the population being surveyed.
In-person Survey: Most expensive to administer but
can be more reliable. However it suffers from the
problem of interviewer bias.
 32
Valuation of Environmental Goods
CONTINGENT VALUATION METHOD
4. Sample Design:

It involves two steps: First, select the group (relevant

for the study) from which to draw the sample.
Second, draw the random sample.

5. Experimental Design:

Experimental design requires careful design of

survey instrument, its administration and its ultimate
statistical analysis.
 33
Valuation of Environmental Goods
CONTINGENT VALUATION METHOD
6. Estimation of Willingness to Pay Function:
The last step of the Contingent Valuation Method is
to take the survey results and correctly estimate the
WTP functions.

Problems with the Contingent Valuation Methods:

Despite significant application of CV technique in
eliciting values of environmental goods, the method
has been scrutinized and found to suffer from a large
number of limitations. Following are the important
limitations of this method:
 34
Valuation of Environmental Goods
The value elicited in CV surveys are not based on real
resource decisions - they are hypothetical.

Presence of ambiguity in what people are valuing

Problem of embedding. This problem generally pertains

to the inconsistencies that people face when they are to
value an environmental good (e.g. park) versus a group
of environmental goods (several parks in our case) when
they are substitutes.

Another related problem is the valuation of existence

value.
 CONTINGENT VALUATION METHOD

HARIPRIYA GUNDIMEDA

DISSEMINATION PAPER - 6

Centre of Excellence in Environmental Economics

(Sponsored by Ministry of Environment and Forests, Government of India)
MADRAS SCHOOL OF ECONOMICS
 DISSEMINATION PAPER SERIES

The Centre of Excellence in Environmental Economics was asked by the Ministry of

Environment and Forests to explain the concepts of environmental economics to non-
economists through a series of short dissemination papers. The authors welcome feedback
on the papers from readers. The following six dissemination papers have been posted on the
Centre Website (http://coe.mse.ac.in).

No. Title Author

1. Environmental Externalities Dr.U.Sankar

2. Vehicular Pollution Control Dr.Vinish Kathuria
3. Environmental Accounting Dr.G.S.Haripriya
4. Public Disclosures Using Information
to reduce pollution Dr. Vinish Kathuria
5. Hedonic price method A Concept Note Dr. Haripriya Gundimeda
6. Contingent Valuation Method Dr. Haripriya Gundimeda

Hard copies may be obtained from:

Member-Secretary
Centre of Excellence in Environmental Economics
Madras School of Economics
Gandhi Mandapam Road
Chennai 600 025

Use of any part of this publication should be duly acknowledged

 CONTINGENT VALUATION METHOD

HARIPRIYA GUNDIMEDA
Associate Professor
Department of Humanities and Social Sciences
Indian Institute of Technology Bombay, Powai
Mumbai – 400 076
Email: haripriya@hss.iitb.ac.in

DISSEMINATION PAPER - 6

Centre of Excellence in Environmental Economics

(Sponsored by Ministry of Environment and Forests, Government of India)

Madras School of Economics

 Contingent Valuation Method

1. What is Contingent Valuation Method?

Some aspects of the environmental resources like scenic view of mountains

and beaches, wilderness experience in national parks, basic life support
functions associated with ecosystem health and biodiversity etc. give utility to
human-beings but do not have market values as they are not directly bought
and sold in the markets. To use a beach, we may be paying a user fee/entry
fee, but this may not be the equivalent to the utility provided by that asset.
Similarly some of us may not be using the environmental resource now, but
would like to have the option to use it in the future/ or we would like
particular species like Asiatic Lion or Giant Panda to be preserved though we
do not use it now because we value its mere existence. In all these cases, the
use of price-based models may not be appropriate. For a marketed good, the
demand and supply for the good at equilibrium determine the market price,
which acts as an invisible hand to allocate the resources efficiently. Other
important characteristic of these marketed goods are the existence of private
property rights and divisibility of factors of production. Because most of the
environmental goods do not have property rights, and even if we assign, we
cannot exactly know the demand for the good, the only way to know about the
people’s preference is to ask them through some hypothetical surveys.

One such technique for the valuation of non-market resources and in fact the
commonly used technique for valuing the non-use values/passive values of the
environment is the Contingent Valuation Method (CVM). This is a survey
based method, where people are asked directly how much money they would
be willing to pay (or willing to accept) to maintain the existence of (or be
compensated for the loss of) some environmental feature such as biodiversity.
This technique is called ‘contingent’ valuation method because people are
asked to state their willingness to pay, contingent on a specific hypothetical

1
scenario and description of the environmental service. The contingent
valuation method is also referred to as a ‘stated preference’ method, because it
asks people to directly state their values, rather than inferring values from
actual choices. The fact that CV is based on asking what people say they
would do (stated) as opposed to what people are observed to do (revealed) is
the source of its greatest strength as well as its greatest weakness.

2. Applications of the Method

The theoretical method was first proposed by Ciriacy-Wantrup (1947) in 1947

as a method for eliciting market valuation of a non-market good. In the paper
on the economics of soil conservation published in 1947, he mentions
“Individuals may be asked how much money they are willing to pay for
successive additional quantities of a collective extra-market good. The choices
offered relate to quantities consumed by all members of a social group. …If
every individual of the whole social group is interrogated, all individual
values (not quantities) are aggregated. The results correspond to a market-
demand schedule”. The method was practically applied in 1963 by Davis
(Davis, 1963) to estimate the value hunters and tourists placed on a particular
wilderness area. The method gained popularity after the use of method in
quantifying the damages following the Exxon Valdez oil spill in Prince
William Sound in USA in 1989. Using this approach, a lower bound estimate
of US $ 2.8 billion was reported to prevent another spill similar to the Valdez
with a mean estimate of $7.2 billion. Given the huge magnitude of numbers
generated by the survey, there was controversy over the use of this technique
for policy making. Hence in 1993 National Oceanic and Atmospheric
Administration commissioned a Blue Ribbon Panel consisting of Kenneth
Arrow and Robert Solow (Arrow et al., 1993) and other economists to answer
the question 'Is CV a valid method for determining the lost economic value
from natural resource damages?’ The report concluded that the CV method
can produce reliable estimates provided the surveys are carefully designed and
controlled due to inherent difficulties in eliciting accurate economic values

2
through survey methods. They also gave some recommendations about how
the CVM survey should be designed.

The application of CVM has increased since then and several papers exist on
CVM. Contingent Valuation Method has been used to estimate the benefits
from increasing air and water quality; reducing risk from drinking water and
groundwater contaminants; outdoor recreation; protecting wetlands,
wilderness areas, endangered species, and cultural heritage sites;
improvements in public education and public utility reliability; reduction of
food and transportation risks and health care queues; and provision of basic
environmental services such as drinking water and garbage pickup in
developing countries (Carson, 2000). In the next section, application of the
method is briefly discussed.

3. How to carry out a Contingent Valuation Survey?

To elicit Willingness to Pay (WTP)/ Willingness to Accept (WTA) using the

CVM, the general approach (as discussed in Hanley, 1990) indicates:

i. Description of the scenario and the impacts of the change in the

provision of an environmental good/service are explained (e.g. who
will pay for the good, who will use the good etc.).

ii. The respondents are invited to consider the proposed context within
which the choice concerning the environmental good/service will be
made; and

iii. The respondents are invited to supply their statements concerning their
Willingness to pay (WTP) for a proposed welfare gain/Willingness to
Accept (WTA) in compensation for a welfare loss, from which the
value attached to a change in the provision of the good/service in
question is inferred. Various elicitation methods can be used to get
their WTP/WTA. One should also ask them how they would like to pay

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 or accept (e.g. higher taxes, entrance fee, donation to charitable trust
etc.) Responses can be elicited either through on-site (face to face;
users only), house to house (face to face; users and non-users) or by
mail/telephone (remote; users and non-users) survey. The major
elicitation techniques used in the literature are:

a. Open ended; "how much are you willing to pay?". This approach
produces a continuous bid variable and may therefore be analyzed
using standard statistical techniques.

b. Take-it-or-leave it (dichotomous choice)- This method was

developed by Bishop and Heberlein (1980). The respondent is
asked "are you willing to pay Rs. X?". This is a closed ended
format, where a Yes or No is expected for the questions. The
amount X is systematically stepped across the sample to test
individuals' responses to different bid levels. This approach
produces a discrete bid variable and requires sophisticated statistical
techniques.

c. Double bound dichotomous choice (with an iterative second round

(double-bound) question) (see Hanneman et al., 1991). For example
if the respondent answers yes to the Rs. X bid then they are asked if
they are WTP say Rs. 2X (or Rs. 1/2X or 1/3X if they answered no
to the initial question).

d. Modified dichotomous choice method – Stevens et al (1991) used

this procedure. Here the respondent was given a specified amount of
money randomly and asked if they would be willing to pay. They
were also given an opportunity to bid an amount less or greater than
the specified amount of money. Responses, therefore, could be
viewed as originating from either an open-ended or a closed-ended
dichotomous choice-bidding format. Unlike the discrete choice
follow-up approach, this method can be used in mail surveys.

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 e. Payment card method - Payment card technique was developed by
Mitchell and Carson (1981) in order to avoid the starting point
problem that can arise in traditional bidding applications. Payment
cards display a range of rupee values starting from zero and
increasing at fixed intervals. The respondent is asked to choose his
WTP/WTA from these values. Sometimes the payment values are
varied for different income groups and the respondent is asked to
choose how much he would be WTP/WTA depending on his
income schedule. This is called as anchored payment card. One can
use either open ended or closed ended questions.

f. Iterative Bidding games – This process is similar to auctions. In the

first step the respondent is asked how much he is willing to pay.
The stated amount is changed iteratively until the highest amount
the respondent is willing to pay/willing to accept is identified.

IV. Analysis of Survey Results

To translate elicited WTP/WTA values to aggregate market demand for the

environmental goods, the following analyses are generally carried out :

a. Calculate the mean WTP (or WTA) from responses - This commonly
involves the omission of protest votes, and/or the use of trimmed
means. In case of dichotomous choice method, mean is obtained by
calculating the expected value of the dependent variable (WTP or
WTA).

b. Estimation of the bid curve to investigate the determinants of

WTP/WTA bids – The WTP/WTA is regressed on variables that affect
the WTP/WTA for e.g., visits (Qij), income (Yi), social factors such as
education (Si), and other explanatory variables (Xi). A parameter of the
environmental quality of the site (Ej) may also be included.

5
 WTPi = f(Qij,Yi, Si, Xi, Ej)

The function can be estimated using suitable econometric techniques.

There is theoretically no correct form to estimate this function.
However, if a log-log function is specified, the coefficients would give
elasticities directly. The elasticities tell us by how much the mean
WTP/WTA would change for a given change in Ej (environmental
variable under consideration). If a dichotomous payment format has
been used then a logit approach is required, relating the probability of a
yes answer to each suggested sum to the explanatory variables listed
above. For a continuous question format ordinary least squares
estimation techniques are often employed.

c. Aggregation

Once the mean WTP is obtained, the values should be aggregated to get
the total WTP for the entire population. This entails decisions about, for
example, moving between household and individual data, and
distinguishing the relevant population.

See Figure 1 for general approach to the CVM method.

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Figure 1: General Approach a CVM Survey

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4. Possible Biases in Contingent Valuation Method

Though CVM is a good method, it suffers from various biases (systematic

over or under statement of true WTP/WTA). Possible source of bias in CVM
method include the following:

i. Starting point bias – This usually occurs in bidding games because the
value selected has an appreciable impact on the final bid. A way to
over come this is the payment card technique but this induces a
different kind of bias called anchoring bias because of the range of
values presented on the payment card. Dichotomous choice questions
are free from anchoring bias. But they also suffer from the bias that the
bid presented to the respondent may be reflecting the respondent’s true
WTP.

ii. Vehicle bias – This occurs if the WTP/WTA varies depending on the
mode of payment. For example, if the respondent is asked how much
they would be willing to pay in the form of a price increase vis-à-vis
other modes of payment like tax, user fee etc., the response may be
different. This difference in WTP dependent on the method of payment
is called vehicle bias.

iii. Information bias - Respondents also may change their values

depending on the amount of information they are given about a given
commodity or situation. For example, if a respondent is provided
information about the mean cost of providing the good, the respondent
may be WTP differently than they would if they were not informed
about the average cost of providing the good. This phenomenon is
termed as information bias.

iv. Hypothetical market bias – The bias occurs due to the hypothetical
nature of the markets. Because the market and payment is anyway
hypothetical, the individuals declared intentions may not be meaningful

8
 at all. This can be minimized by making the hypothetical market as
actual and believable as possible, motivating the respondents well and
changing the elicitation methods.

v. Strategic bias or Free riding bias – If respondents believe that bids will
be actually be collected, they may understate their WTP. This bias also
occurs if an individual feels that the good would be provided anyway if
others contribute, and thereby providing an incentive to free-ride. If the
respondent is keen that the good would be provided, there may be an
incentive to over-state his WTP, thereby ensuring the provision of the
good. This is termed as strategic bias or free riding bias.

vi. Mental account bias (Part-Whole Bias) – Mental account bias is

possible because individuals’ WTP responses fail to distinguish
between the specific good which is under analysis (the ‘part’) and the
wider group of goods (the ‘whole) into which that specific good falls
(Kahneman and Knetsch ,1992) Because of this “when respondents are
asked to value some environmental good they may in fact make that
valuation on the basis of a much wider range of environmental goods”
(Willis and Garrod, 1991). As a result the respondents may pledge
more than their entire income.

vii. Interviewer and Respondent Bias – It is possible that the interviewer or

the very nature in which interview has been carried out can influence
the respondent thereby introducing some bias. For example, the
interviewer can convince the respondent that a particular environmental
good is strongly desirable thereby influencing the WTP of the
respondent. Sometimes respondents may want to impress upon the
interviewer, or they want to prove that they care for environment etc.,
and hence overstate their WTP.

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5. Appraisal - Was the CVM successful?

Given the nature of biases that CVM could potentially produce, we need to
know whether the CVM has been successfully carried out or not. To answer
the question we need to consider the technical acceptability of the evaluation
estimates produced by CVM. The Blue ribbon Panel (Arrow et al., 1993) gave
some suggestions on how to carry a good CVM study.

Suggestions by the Blue Ribbon Panel for a good CVM study

The Blue Ribbon Panel Panel concluded that CVM studies, if found adhering
to the following guidelines, could lead to estimates that would be reliable
enough to be a starting point for a determination of natural resources damages,
whether by the judiciary or by administrators.

1. For a single dichotomous question (yes-no type) format, a total sample

size of at least 1000 respondents is required. Clustering and
stratification issues should be accounted for and random sub sampling
will be required to obtain a bid curve and to test for interviewer and
wording biases

2. High non-response rates would render the survey unreliable

3. Face-to-face interviewing is likely to yield the most reliable results

4. Full reporting of data and questionnaires is required for good practice

5. Pilot surveying and pre-testing are essential elements in any CVM

study

6. Underestimation of WTP/WTA is to be preferred to overestimation of

WTP/WTA.

7. WTP format is preferred to WTA format.

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 8. The valuation question should be posed as a vote on a referendum, that
is, a dichotomous choice question related to the payment of a particular
level of taxation

9. Accurate information of the valuation situation must be presented to the

respondents, particular care is required over the use of photographs.

10. Respondents must be reminded of the status of any undamaged possible

substitute commodities

11. Time-dependent measurement noise should be reduced by averaging

across independently drawn samples taken at different points in time

12. A no-answer should be explicitly allowed in addition to the ‘yes’ and

‘no’ vote options on the main valuation question

13. Respondents must be reminded of alternative expenditure possibilities,

especially when ‘warm-glow’ effects can be prevalent (that is, purchase
of moral satisfaction through the act of charitable giving).

However, it should be emphasized that in practice a well designed and

executed survey is only one of the criteria upon which both CVM and all other
evaluation methods are likely to be judged. Other than that the CVM should
also pass the following tests

a. Price sensitivity test – The higher the cost, lower the demand. In case of
binary discrete choice format, this can be tested by observing whether
the percentage favouring the project falls as the cost of the project
increases. Many good CVM studies pass this test.

b. Scope test - Does the WTP/WTA increase when the amount of the good
increases? Researchers however often found it difficult to establish
this.

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c. Debriefing - why did the respondent answer the way he did? For
example, if he says he is not willingness to pay, the interviewer should
include reasons behind this.

d. Interviewers effect and protests should be examined

e. Sample size must be several hundreds at least

f. Probability of Yes equation should have several significant explanatory

variables

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 REFERENCES

Arrow, K., R. Solow, P.R. Portney, E.E., Leamer, R. Radner, and H.

Schuman. (1993). “Report of the NOAA Panel on Contingent Valuation”.
Federal Register 58(10) : 4601–4614.

Bishop, R.C., and T.A. Heberlein. (1980). “Simulated Markets, Hypothetical

Markets, and Travel Cost Analysis: Alternative Methods of Estimating
Outdoor Recreation Demand”. Staff Paper Series No. 187. Department of
Agricultural Economics, University of Wisconsin, Madison, WI.

Carson, R. (2000). “Contingent Valuation – A user’s guide”. Environmental

Science and Technology 34(8): 1413-1418

Ciriacy-Wantrup, S.V. (1947). “Capital Returns from Soil-conservation

Practices”. Journal of Farm Economics 29: 1181–1196.

Davis, R.K. (1963). The value of Outdoor Recreation: An Economic Study of

the Maine Woods. Dissertation, Harvard University.

Garrod, G. and K.G Willis. (1991). "The Hedonic Price Method and the
Valuation of Countryside Characteristics". Countryside Change Unit
Working Paper 14, University of Newcastle Upon Tyne.

Hanley, N.D. (1990). "Valuation of Environmental Effects: Final Report -

Stage One". Industry Department of Scotland and the Scottish
Development Agency, Edinburgh quoted in “Evaluation of the
Environment - The Contingent Valuation Method”, by I J Bateman and R.
K. Turner, CSERGE working paper GEC 92-18.

Hannemann, W.M., J. Loomis, and B. Kanninen. (1991). “Statistical

Efficiency of Double Bounded Dichotomous Choice Contingent
Valuation”. American Journal of Agricultural Economics. November :
1255-1263.

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Kahneman, D. and J.L Knetsch. (1992). “Valuing Public Goods: The Purchase
of Moral Satisfaction”. Journal of Environmental Economics and
Management 22 : 57–70.

Mitchell, R. C. and R.T Carson. (1981). “An Experiment in Determining

Willingness to Pay for National Water Quality Improvements,” draft
report to the US Environmental Protection Agency, Washington DC.

Stevens, T. H., J. Echeverria, R.J.Glass, T. Hager, and T.A More. (1991)

“Existence Value of Wildlife”. Land Economics. 67(4): 390-400.

Please send your comments to the author at haripriya@hss.iitb.ac.in

14
Centre of Excellence in Environmental Economics

The Ministry of Environment and Forests, Government of India has designated Madras
School of Economics as a Centre of Excellence in the area of Environmental Economics for
a period of ten years from April 1, 2002. The centre carries out research work on:
Development of Economic Instruments, Trade and Environment, and Cost-Benefit
Analysis. The Centre is primarily engaged in research projects, training programmes, and
providing policy assistance to the Ministry on various topics. The Centre is also responsible
for the development and maintenance of a website (http://www.coe.mse.ac.in), and for the
dissemination of concept papers on Environmental Economics.

Madras School of Economics

Madras School of Economics was founded in 1993 as a private post-graduate institution for
teaching and research in economics. MSE offers a two-year Master’s program in Economics
and Financial Economics affiliated to Anna University, and a Ph.D programme affiliated to
both Madras and Anna Universities. MSE has undertaken a large number of research
projects since its inception, including the World Bank sponsored Capacity Building
Programme in Environmental Economics. The World Bank project involved research,
training, curriculum, and overseas fellowship components which were coordinated by
MSE. Subsequently, the Ministry of Environment and Forests approved the proposal to set
up a Centre of Excellence in Environmental Economics at MSE. MSE has also been
designated as an ENVIS Centre in Environmental Economics under the Environmental
Information System (ENVIS) of the Ministry of Environment and Forests, Government of
India. A dedicated program on Trade and Environment, with support from the Ministry of
Environment and Forests, Government of India, has also been started recently at MSE.
Centre of Excellence in Environmental Economics
Madras School of Economics
Gandhi Mandapam Road
Chennai - 600 025
Ph: 2235 2157/2230 0304/2230 0307
Fax: 2235 4847/2235 2155
Email: coe@mse.ac.in
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