Valuation of ecosystem services III&IV

1. Valuation of ecosystem services III&IV Charit tingsabadh 25 September 2007

2. Revised Schedule, 25/9/07

3. outline • Environmental attributes • Price as sum of values of attributes • Hedonic price method • Implicit price from price function • Examples • House price and environmental attributes

4. Environmental attributes • Goods seen as a bundle of attributes, including environmental ones • Give examples: • House near airport- • House near garbage dump site • House near park with good view • House near BTS • Etc.

5. Price as sum of values of attributes • When we buy a house, we buy the whole bundle • But how does each attribute give value to the total price • Think of a computer- specifications differentiate cheap and expensive computers • Imagine a price function for a cimputer • Same with other goods, involving environmental attributes

6. Hedonic price method • Price function called Hedonic price function • Can have various specifications (forms) • See example:

7. valuationwith hedonic price model • From price function, derive implicit price function • Use this to derive demand curve • Apply standard demand theory to find consumer surplus

8. Valuation 5: Hedonic Pricing • A partial equilibrium model of prices, wages and pollution • The hedonic price equation • From hedonic prices to welfare • Applications: Forests and earthquakes

9. Last week we looked at • The travel cost method, which assumes that certain observable behaviour is a complement (e.g., travel to recreate) or substitute (e.g., airbag for road safety) to unobservable consumption of an environmental good or service • Before that, we looked at restricted demand theory and welfare measures, and contingent valuation: stated preferences • This week: The other revealed preference method, looking at household consumption

10. The Price of Land • The asset price equals the value of the stream of services that the parcel can be expected to provide in the future, netted back to the present • The rental price of land is the value of renting for a short period, e.g., for agricultural land, the difference between expected yield times prices minus the costs of labour, seeds, pesticides etc • Pollution degrades value and thus price

11. Starters • Consider agricultural land in a valley, half of which is upwind a polluting plant, the other half downwind – the difference between land value is only an indication of the value of pollution if this is a small valley in a large market • Consider an open city, with free mobility – utility must be the same everywhere, so land prices exactly compensate for pollution; in a closed city, reducing non-uniform pollution would affect property values as well as utility

12. Wages, Land Prices and Pollution • Arguably, pollution should suppress land prices – but we see that urban land is worth more than rural land • Urban wages are also higher than rural wages – do wages compensate for pollution? • We will construct a model of urban land prices, wages and pollution -- first, analytically and then we‘ll derive a function that can be estimated

13. Wages, Land Prices and Pollution -2 • Consider a number of cities that have different levels of pollution p; firms produce a composite good X (at price 1) and move about freely; the wage rate is w and the land rent r vary between cities • Consumers are identical, purchase X and land for housing L • Assuming free movement, utility is the same everywhere: V(w,r,p)=k

14. Wages, Land Prices and Pollution -3 • In a constant cost industry, average production costs equal marginal production costs equal price, so that for all cities c(w,r,p)=1 • Pollution may affect costs in different ways • Unproductive (pollution hinders production) • Productive (pollution regulation hinders prod.) • Neutral (but wages and rents affect prod.)

15. Wages, Land Prices and Pollution -4 • Higher pollution must be compensated by either higher wages or lower land rents • V=k, p  w, r • If pollution is productive, pollution raises wages but has an ambiguous effect on land rents c=1, p  w, r • If pollution is unproductive, pollution depresses land prices but has an ambiguous effect on wages c=1, p  w, r • If pollution is neutral, pollution decreases land prices and increases wages

16. Hedonic Price Theory • Consider an homogenous area that can be considered a single market from the point of view of, say, houses • Each house is characterised by a single characteristic, z, say, air pollution • We are interested in the relation between price and air quality, p = p(z) • We look at the partial equilibrium, and assume that the market is perfect

17. Hedonic Price Theory -2 • The consumer buys exactly one house as well as other goods x • Alternatively, we consider the budget for buying the house, guaranteeing a certain level of utility • This is known as the bid function – it tells you the maximum amount a consumer is willing to pay as a function of income and air pollution

18. Hedonic Price Theory -3 • The producer maximises profits • This is known as the offer function – it tells you the minimum amount a producer is willing to accept as a function of costs and air pollution • In the equilibrium, the marginal bid, the marginal offer, and the house price are identical – all parties in the market value the house the same, at the margin

19. Hedonic Price Theory -4 • The hedonic price function tells you how price varies with environmental quality and other factors (income) • Take the derivative of the price to environmental quality – this gives the price of environmental quality • Do this for various income levels • This gives the price of env. quality as a function of income – that is, an inverse demand function • Sometimes direct, sometimes statistical

20. Theory and practice • Theory and practice differ substantially • Niceties such as the difference between compensated and uncompensated demand functions are typically ignored • Only one market (housing) is analysed • Market distortions are ignored • The reason: data; although wages and house prices are known, it is hard to get data because of privacy – one can readily get ask prices for houses that are currently on offer, but not actual prices

21. Application: Earthquakes • Does earthquake risk affect house prices? • California designated Special Study Zones (SSZs) which are risky; house owners know and tell potential buyers • The price of house in these zones is $4650 ($2490) lower than that of identical house outside those zones in Los Angelos (San Francisco) • This is half the price of a swimming pool, a third of a view • Before notification, risks were irrelevant

22. Ln(home sale price)

23. Application: Forests • Do green areas affect house prices? • The city of Salo, 32,000 inhabitants, in Finland • About 10% of the area is green • 590 appartments in terraced houses were sold between 1984-1986 • The sale price was regressed on size, distance to city centre, distance to Nokia, age, forest view, type of house, and distance to nearest green area (based on satellite images)

25. example Leggett&Bockstael,1998: Evidence of the Effects of Water Quality on Residential land Prices

26. Another Example

27. Lecture IV: Green GDP • From valuing ecosystems to including them into GDP accounts • What to do? • Green GDP: • Concept • Measurement • Results

28. Green GDP: Concept • GDP measures flow of value-added from activities • Capital measured for GDP as investment (+/- change in capital stock) on expenditure side • Green GDP should measure what? • Flow: ecosystem services • Stock: change in the stock of natural capital that produces the ecosystem services

29. Measurement (1) • For flows, may be already accounted for as part of operating surplus, overstating the rate of profit if natural capital is used • This can be considered resource rent • Example: raw water is not costed for production of tap water, so profit of water company includes rent from use of raw water

30. Measurement (2) • For Stock: value of change in stock of natural capital is not included in GDP estimate • Example: conversion of forest land to farm land counts as +investment for land, but as –investment for forest • Water quality deterioration implies loss of amenity values, but cost is not counted • MANY PROBLEMS!! • See SEEA by the UNSNA • Also paper on ENRAP

31. Results • This will be an interesting class assignment, for someone to present in the presentation sessions. Thank you