John B. Braden University of Illinois at Urbana-Champaign

1. John B. BradenUniversity of Illinoisat Urbana-Champaign Economic Modeling for Water Resources NSF Interdisciplinary Modeling Workshop – July 2005

2. Thanks: • Laurel Saito • Heather Segale • Xiaolin Ren NSF Interdisciplinary Modeling Workshop – July 2005

3. Contributions of Economics • Understand Behaviors • Responses to institutions & policies • Market power (size, information) • “Positive” analysis • Design Institutions & Policies • Benefit/cost analysis • Planning for behaviors • “Normative” analysis NSF Interdisciplinary Modeling Workshop – July 2005

4. Limitations of Economics • Anthropocentric • Utilitarian • Statistical • Allocational (efficiency) • Material NSF Interdisciplinary Modeling Workshop – July 2005

5. Economic Modeling • Theory – generate hypotheses • Econometrics – test hypotheses • Operations Research – simulate outcomes – optimize complex systems NSF Interdisciplinary Modeling Workshop – July 2005

6. Outline of Presentation • Basic Economic Models • Pricing Aquatic Ecosystems • Hydro-Economic Models • Bio-Economic Models • Benefit-cost Analysis • Risk and Uncertainty • Summary Remarks NSF Interdisciplinary Modeling Workshop – July 2005

7. Resources for Lecture • Griffin, R.C. Water Resource Economics. MIT Press (forthcoming) • Young, R.A. Determining the Economic Value of Water. Resources for the Future (2005) • Other books & articles on website NSF Interdisciplinary Modeling Workshop – July 2005

8. 1. Basic Economic Models NSF Interdisciplinary Modeling Workshop – July 2005

9. Agent Models • Consumers Maximize Utility Max u(Y,w) , uy, uw> 0 uyy, uww < 0 s.t. PYY + pww < B • Producers Maximize Profit Max π = p1y1 – Σi cixi – cww s.t. y1 = f(X, w) , fx, fw > 0; fxx, fww< 0 NSF Interdisciplinary Modeling Workshop – July 2005

10. Marginal Analysis • Marginal benefits = incremental demand price • Marginal costs = incremental supply price • Operating returns vs. fixed costs NSF Interdisciplinary Modeling Workshop – July 2005

11. Supply Model – Input Choice NSF Interdisciplinary Modeling Workshop – July 2005

12. Supply Model – Output NSF Interdisciplinary Modeling Workshop – July 2005

13. Aggregate Supply NSF Interdisciplinary Modeling Workshop – July 2005

14. Demand Model NSF Interdisciplinary Modeling Workshop – July 2005

15. Aggregate Demand NSF Interdisciplinary Modeling Workshop – July 2005

16. Nonrival (“Public”) Goods • Rival – Ordinary goods that only one person can consume • Nonrival – Goods that can be consumed by many simultaneously • Excluability allows pricing NSF Interdisciplinary Modeling Workshop – July 2005

17. “Public Goods” & Economic Value NSF Interdisciplinary Modeling Workshop – July 2005

18. Markets • Producers offer good & buy inputs • Consumers bid for goods & supply labor • Prices coordinate producers & consumers • Output markets (py, pw) • Input markets (ci, cw) • Parametric to individuals NSF Interdisciplinary Modeling Workshop – July 2005

19. Market Model NSF Interdisciplinary Modeling Workshop – July 2005

20. Welfare Analysis (normative) • Maximize Net Benefits • “Consumer surplus” • “Producer surplus” [returns to owners & fixed inputs] • Competitive Equilibrium  Social Optimum NSF Interdisciplinary Modeling Workshop – July 2005

21. Consumer Surplus Producer Surplus Welfare Analysis – Economic Surplus NSF Interdisciplinary Modeling Workshop – July 2005

22. 2. Pricing Aquatic Ecosystems NSF Interdisciplinary Modeling Workshop – July 2005

23. The Diamond-Water Paradox Diamond fetch very high prices, although they have limited usefulness. Water is essential to life, but fetches very low prices. WHY? NSF Interdisciplinary Modeling Workshop – July 2005

24. Total vs. Marginal Value -- Water NSF Interdisciplinary Modeling Workshop – July 2005

25. Total vs. Marginal Value -- Gems NSF Interdisciplinary Modeling Workshop – July 2005

26. Answering the Paradox • Water: Adequate supplies produce low marginal value (even though basic water needs are highly valued). • Diamonds: Limited supplies produce high marginal value. NSF Interdisciplinary Modeling Workshop – July 2005

27. Pricing Aquatic Ecosystems • Whole vs. components • Value vs. supply cost • Use vs. nonuse NSF Interdisciplinary Modeling Workshop – July 2005

28. Models for Valuing Ecosystems • Market-based (Revealed Preferences): • Expenditures on services – fish & fishing; whale watching • Opportunity cost of laws –Lagragian multipliers on constraint functions • Replacement cost • Experiment-based (Stated Preferences): • Trade-offs between service levels & prices • Willingness to support tax referenda • Expressed willingness to pay NSF Interdisciplinary Modeling Workshop – July 2005

29. Example: Value of ∆ Fishery Quality NSF Interdisciplinary Modeling Workshop – July 2005

30. Example: Value of Wetlands (Earnhart, Land Econ., 2001) • Hedonic housing value – price differentials for homes adjacent to restored wetland vs. not adjacent to any distinct features • Proximity to L.I. Sound, river, stream ~ + 3% • Proximity to restored marsh ~ +16% • Proximity to disturbed marsh ~ -13% • Conjoint choice – selecting between hyp. homes differing in amenities & price • All values ~ 80 – 120% NSF Interdisciplinary Modeling Workshop – July 2005

31. Example: “The Value of the World’s Ecosystem Services & Natural Capital”(Costanza et al., Nature, 1997) • Benefits transfer – borrow marginal values from literature and apply them to increments to env. quality or natural resources • Multiply by total quantity of natural resources • Total value ~ $33 trillion NSF Interdisciplinary Modeling Workshop – July 2005

32. Example: “The Value …” Critique • “Serious underestimate of infinity.” • Total value vs. marginal value • Tools best applied to small changes from status quo • Double - counting NSF Interdisciplinary Modeling Workshop – July 2005

33. 3. Hydro-Economic Models NSF Interdisciplinary Modeling Workshop – July 2005

34. Hydro-economic Topics • Dam management balancing hydropower, recreation, ecological benefits • Administered water allocation • Policy-simulation, e.g., • Auctioned access to locks • Targeted NPS abatement • Instream flow management • Economic forecasting of land use/hydrologic change NSF Interdisciplinary Modeling Workshop – July 2005

35. Example: Downstream Impacts of Development (Johnston et al. JWRPM, 2006) Determine the downstream economic value of low-impact development: • Identify impact categories (flooding, water quality,…) • Use weather series & HSPF to compute stage, flow, and flood frequencies for different development scenarios • Attach typical “prices” to impacts • Calculate economic impact of each scenario • Engineering costing of each scenario NSF Interdisciplinary Modeling Workshop – July 2005

36. Example: Spatial Management of Ag. Pollution (Braden et al., AJAE, 1989) Max π = Revenues – Costs s.t. Crop production functions Spatial pollution transport functions < T* Identifies actions (crop, tillage) by location that minimize economic losses NSF Interdisciplinary Modeling Workshop – July 2005

37. Hydro-economic Challenges • Scale: Markets vs watersheds • Time: Water cycles vs Economic cycles NSF Interdisciplinary Modeling Workshop – July 2005

38. 4. Bioeconomic Models NSF Interdisciplinary Modeling Workshop – July 2005

39. Bioeconomic Topics • Fisheries management • Floodplain & wetlands management • Forecasting landscape change and effects on ecosystems NSF Interdisciplinary Modeling Workshop – July 2005

40. Example: Efficient Protection of Fish Habitat (Braden et al., WRR, 1989) Max π (crops, tillage, pesticides) s.t. Prob {HSI (sed., chem.) > H*} > R NSF Interdisciplinary Modeling Workshop – July 2005

41. Example: Economic/Runoff/Fish/Model [Braden et al., WRR, 1989] NSF Interdisciplinary Modeling Workshop – July 2005

42. Example: Cost/Habitat Suitability [Braden et al., WRR, 1989] NSF Interdisciplinary Modeling Workshop – July 2005

43. Fish Habitat: Discharges vs. Impacts (Braden et al, AJAE, 1991) Impact Targets: Min C(x) s.t. Pr{q(x,h[x],ε)>Q} > A Q = Habitat Qual., A = reliability ε = stochastic factor Discharge Standards (Proxy): Min C(x) s.t. Pr {h(x) > H} > B h intermed to q; H linked to Q NSF Interdisciplinary Modeling Workshop – July 2005

44. Example: Habitat Impacts vs Discharges [Braden et al., AJAE, 1991]. NSF Interdisciplinary Modeling Workshop – July 2005

45. Example: Floodplain Management for Crops and Fish in Bangladesh (Islam & Braden, Env. Devel. Econ., 2006) MaxHiΣc,t φtNRcit*Hcit + Σf,tφtNRfi(qfit)*Hfit s.t. ΣcHci + Σf Hfi < H all t [area] qfit =gfit(Hfit) [nonlinear production] Differentiates production functions by land capability, crop, and species types NSF Interdisciplinary Modeling Workshop – July 2005

46. Floodplain Model Implementation • Fourier analysis (econometric) simulation of flood levels • Monthly average water levels -> flood coverages w/ digital elevation model • Land capabilities identified • Capabilities changeable with levees • Optimize land allocations to activities by max economic returns NSF Interdisciplinary Modeling Workshop – July 2005

47. Bioeconomic Modeling Challenges • Matching spatial and temporal scales • Model complexity • Simplifications that lose information (e.g., averaging) NSF Interdisciplinary Modeling Workshop – July 2005

48. 5. Benefit-Cost Models NSF Interdisciplinary Modeling Workshop – July 2005

49. Policy Analysis • Maximum Net Benefits • Potential Pareto Optimality – costs not actually compensated • Function of existing distribution • Discounting • Opportunity cost of time • Max NPV = Σt {(Benefits)t - (Costs)t} (1 + r)t NSF Interdisciplinary Modeling Workshop – July 2005

50. 6. Risk and Uncertainty NSF Interdisciplinary Modeling Workshop – July 2005