EurekaWow | Environmental Economics

6
th
Semester | B.A. Economics (H)
Unit 5: Measuring the Benefits of Environmental Improvements
Charles D. Kolstad, Intermediate Environmental Economics
Chapter 7: Demand for Environmental Goods (skip section VI)
I. What is so special about an environmental good?
Examples of environmental goods: air quality, existence of a particular species, amenity values
like clean air or clean rivers.
Environmental goods can be placed within the paradigm of consumer theory because the
consumption of environmental goods also involves trade-offs. In order to consume more of an
environmental good, resources (money) must be shifted from consumption of conventional
goods to the protection of the environmental good.
The amount of shift in resources tells us the consumers willingness to pay for the
environmental good, which implies that there is a demand for environmental goods.
The difference between conventional goods and environmental goods is that markets exist for
conventional goods, but not for environmental goods.
The reasons for this are:
Conventional Goods Market Environmental Goods Market
Conventional goods are properly defined. Definitions of environmental goods are not
clear. Eg. What is clean air?
Quantities of goods consumed at different
price levels are observable.
It is difficult to observe the quantity of
environmental goods consumed.
They are private in nature, i.e.
characterised by excludability and rivalry.
They share features of public goods, i.e.
non-excludability and non-rivalry.
Eg. Milk Eg. Clean air

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

Ordinary Public Goods Environmental Goods
Eg. Public Schools Eg. Wilderness
They are produced by the government at a
cost, thus the consumers have a reference
point to the cost of supply of the good.
They are not necessarily produced by
anyone. Forests exist on their own, so
trying to deduce their value is difficult.
In the case of clean air (by reducing
EurekaWow | Environmental Economics
6
th
Semester | B.A. Economics (H)
pollution), even if the cost of reducing air
pollution is known, the cost is dispersed.

II. Willingness to Pay:
The concept of price and consumer surplus is also applicable to environmental goods despite
the absence of a formal market for them.

(Conventional Good) (Environmental Good)
Price Marginal Willingness to Pay (MWTP)
Consumer Surplus Total Willingness to Pay

Marginal Willingness to Pay (MWTP):
This is what an individual is willing to pay for one more unit of an environmental good.



Figure 1

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

What do we know from figure 1?

The negative value of the MWTP for an additional unit of NO
x
means that the demand
curve lies in the fourth quadrant. This is so because additional NO
x
is a bad.
The negative value of the MWTP means that individuals need to be compensated for
the additional unit. The compensation increases as NO
x
increases.
If the X- axis represented reductions in NO
x,
demand curve will still be downward
sloping, i.e. as the quality of air improves because of reductions in NO
x
, individuals are
EurekaWow | Environmental Economics
6
th
Semester | B.A. Economics (H)
willing to pay less for clean air. But the MWTP curve will then be positive i.e. the
demand curves will lie in the first quadrant.
The negative MWTP (marginal compensation) at a particular level of NO
x
is higher for
higher income levels. Similarly, the (positive) marginal willingness to pay will be
higher for higher income levels.
Note:Here, we are assuming that MWTP is equal to MWTA (marginal willingness to accept).
The value of marginal damage from one more unit of pollution is always equal to the marginal
benefit from one less unit of pollution. And the MWTP for an extra unit of pollution (the
marginal compensation) is always equal to the negative of marginal damage, as can be seen in
panel of (b) figure 2.

Figure 2
Total Willingness to Pay (TWTP):

This is the sum of all the MWTP when the consumption of an environmental good changes
from 0 to a positive quantity q.This is the triangle with the lighter shaded area in (b) of figure 2.

Since MWTP is the negative of marginal damage from one more unit of pollution, TWTP is
equal to the negative of the total damage from a given level of pollution. Negative TWTP is the
total compensation that individuals should receive for all the air pollution.

TWTP= Consumer surplus= -(total damage from all the air pollution).
EurekaWow | Environmental Economics
6
th
Semester | B.A. Economics (H)

EurekaWow | Environmental Economics
6
th
Semester | B.A. Economics (H)
III. Types of Environmental Goods
Environmental goods can be classified on the basis of the way their value is perceived by individuals.
The two different kinds of values that can be ascribed to environmental goods by individuals are the
following:
a) Use Value: Value of a good associated with its consumption. The kind of consumption varies
according to the time period of consumption:
Current use I am going to Sariska today
Expected Use I will visit Sariska next year
Possible Use I might visit Sariska in the next 10 years
The use of environmental goods can directly or indirectly affect individuals. An example of direct
impact is the negative effectof breathing polluted air on respiratory health. Environmental goods like
pollution can also affect producers through increases in the costs of production; for example: the cost
of producing clean laundry increases with increase in polluted air.
Indirect effects can be understood as that which humans feel through disruption in the ecosystemthat
contribute to economic benefits (when it is involved in production purposes) or to a sense of well-
being (when it is used as an amenity). Eg.Impact of air pollution in an area on the travelling experience
there.
b) Non-Use Value: When an individual values an environmental goodin this way, he does not
really consume it or apply it to derive utility. She derives utility by knowing that someone else
is using it or by knowing that it exists. There are three kinds of non-use values that exist:

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

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

Existence: Value attached to knowing that the environmental good exists

IV. Measuring Demand
There are two kinds of preferences of consumers that are known: stated preferences and
revealed preferences.


In this method, consumers are introduced to
hypothetical markets and asked how they would
trade off money/ other goods for the
environmental good
Stated Preferences Revealed Preferences
Observe the decisions made by consumers in a
market and infer their preferences and
information about trade-off between the
environmental good and money/ all other goods
EurekaWow | Environmental Economics
6
th
Semester | B.A. Economics (H)
Survey the literature for a particular issue
and apply it to another research.
It is also known as the poor mans
estimation.







Types Types
Hedonic
Pricing
Household
production
Deriving demand by observing the
change in the price of a good as the
amount of a closely related
environmental good changes
Starts with the assumption that
households consume
complementary goods- an
environmental good and a private
good.
The observed expenditure on the
private good is the lower bound of
the value placed by a household
on the environmental good.
Laboratory
Experiments
Contingent
Valuation
Referendum
Construct hypothetical or real markets
where markets do not exist and derive
a demand curve.
Involve real resource decisions.
Subjects are actually given the
resource- money, environmental
good, etc.
Information on consumer behaviour
is derived based on how the decisions
made by the subjects. Such
information is not available from
markets that exist.
Useful, but too expensive to conduct.
A proposal like a tax or subsidy is put to
vote in a community. The consumers
state their preferences through their
votes.
Its usefulness is however limited as it is
applied to just the communities and
the environmental goods involved.
Benefits
Transfer
EurekaWow | Environmental Economics
6
th
Semester | B.A. Economics (H)
V. Revealed Preference and Restricted Demand
Revealed preference measures are most commonly used to estimate the demand for
environmental goods and services. In the case of conventional goods, consumers change the
amount of conventional good x consumed as its own price, the price of complementary goods,
the price of substitutes or the consumers incomes change. By using transactions data and
statistics, the relationship between price and quantity demanded of x is estimated.
The demand for environmental goods cannot be derived in the same manner because of, as
mentioned before, the absence of prices for environmental goods. An alternative to deriving
demand is restricted demand.

Figure 3
In figure 3, the demand curve for market good x with q quantity of environmental good at price
p
x
is given.
x= h(p
x
,q) (i)
The equation in (i), one price and one quantity are given as arguments in the RHS. We
refer to this as a restricted demand. A conventional demand curve has only prices and
income as arguments in the RHS.
When q (such as air quality in an area) increases to q+q, x (such as demand for houses
in that area) increases at every price p
x.

The change in the willingness to pay is given by the shaded region, which is also the
change in consumer surplus when p
x
=p
x
*
.
Using (i) and figure 3, we will derive the MWTP for q.
EurekaWow | Environmental Economics
6
th
Semester | B.A. Economics (H)
MWTP:It is the change in willingness to pay (WTP) when q changes a little. Mathematically,
it is the ratio of change in willingness to pay and the change in q.
MWTP=

= (p
x
, q)
This gives us the restricted demand for q.
It is a restricted demand for q because we are only considering the effect of q on the market
good x. But q, such as improvement in air quality, affects a host of other market goods and
services like laundry, or even activities like walking, travelling, etc.
VI. Discrete Choice (Skip)

VII. WTP vs. WTA(willingness to accept)

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

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

q
0
< q
1
, & hence U
0
<U
1

We can observe the following from figure 4:
Increasing q from q
0
to q
1
without any change in x
0
increases utility to U
1
.
The maximum of x that the consumer is willing to sacrifice for q
1
is that amount that
keeps her at least as well off as she was with x
0
& q
0
, i.e. she remains on U
0.

This amount is BC as shown in the figure. Giving up more than BC amount of x will
give her less utility than U
0
even if q=q
1
. Thus BS is the consumers WTP to move
from q
0
to q
1.


EurekaWow | Environmental Economics
6
th
Semester | B.A. Economics (H)

Figure 4

Instead, if the consumer has to reduce consuming q from q
1
to q
0
, the consumer needs to
be compensated for to be able to remain on U
1
.
The minimum of x that the consumer is willing to accept for losing q is that amount that
will keep her at least as well of as she was at (x
0
, q
1
), i.e. at U
1
.Thus, the consumers
WTA is AD.
We can see that AD>BC.

Chapter 8 Revealed Preferences: Pollution, Land Prices and Wages
Section IV(A,B,C,D): Hedonic Price Theory

Focus of the Hedonic Price theory is on inferring the value placed on characteristics of goods based on
the observed price of a bundle of characteristics.
To understand this theory, let us take a simple model that involves one homogenous market and one
good (eg. A house in an area) which has only one characteristic (eg. Air quality).The market is
perfectly competitive, so all consumers and producers of the good x are price takers.
In this model, we will check:
Price of the good in the market
Price that the consumer is willing to pay for changes in the characteristic of the good p(z)
i.e. how the price of a house changes when the air quality changes
Allocation of consumers income between good x and all other goods, with allocation on
the former depending on characteristic z

A. The Consumer

EurekaWow | Environmental Economics
6
th
Semester | B.A. Economics (H)
A consumer has Utility function U and income y. The consumer buys exactly one house and
other goods whose nominal price we suppose is 1.

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

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

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

(y,z, ) can be called the bid function where y, z and are exogenous while and x are
chosen. The consumer chooses such that she obtains at least that much utility that she desires
and does not violate her budget constraint.

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








We can infer that U
0=
<U
1.
Why? For the same characteristic z
1
, the bids are
0
and
1
, and we
can clearly see that
0
>
1
. If we put
0
and
1
in the budget constraint:

x
o
=y-
0

x
1
=y-
1

0
>
1
implies that x
1
>x
0
So, U(x
1,
z
1
)>U(x
0
,z
1
)
The level of z and that the consumer will choose is that point where the bid function is tangent to the
hedonic price function, i.e. the bid for z
1
is equal to the price of z
1
. At any other level of z, the bid is
too low and the consumer cannot buy any house.
Utility increases
(y,z,U
1
)
(y,z,U
0
)
p(z)
Air quality z
$
z
1

EurekaWow | Environmental Economics
6
th
Semester | B.A. Economics (H)
B. The Producer:

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

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

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

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

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

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


Figure 2
C. Market equilibrium:

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

There are three pairs of an offer function and a bid function that are tangent to each other. The
price line p(z) is formed by the points of tangencies between all bid functions and offer
functions.
EurekaWow | Environmental Economics
6
th
Semester | B.A. Economics (H)


Figure 3
The points of tangency tell us that:
The slope of the offer function and the bid function is the same, and both are equal to
the slope of the price function.
The marginal price charged by a producer is equal to the marginal price of the that a
consumer is willing to pay for an extra unit of z, and to the marginal price of good itself
for an extra unit of z.
The marginal price of the good for an extra unit of z is the price of the characteristic
itself.
The marginal valuation by the bidder, the seller and market is the same in equilibrium.

D. Marginal Willingness to Pay (MWTP)

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

Figure 4 shows p(z) and the slope of the price function and MWTP of 2 individuals. The
points of intersection of the MWTP curves with p(z) are the different levels of z demanded by
the two individuals.
EurekaWow | Environmental Economics
6
th
Semester | B.A. Economics (H)

Figure 4

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

i. p(z)= (z,)- demand function
ii. p(z)= (z,)- supply function
Remarks:
(i) tells us that the marginal willingness to pay for an additional unit of z
depends on the level z and other characteristics like income
(ii) tells us that the price at which z is supplied depends on the existing level of z
and other factors like cost.
The method described entails the following steps: Finding the hedonic price
function and then measuringits slope and using it as the price of the
characteristic.




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