Environmental Economics II

1. Environmental Economics II Dr. Anil Markandya hssam@bath.ac.uk – 01225 386954 – Room 3E 4.31b

2. Valuing the Environment • Environmental Valuation • Enable environmental impacts to be included in Cost-Benefit-Analysis (CBA) • To take account of environmental damage in measuring economic performance • To take account of environmental benefits of public programs

3. Categories of environmental benefits • Use Value (UV) • Existence Value (EV) • Option Value (OV)(Option Price = Expected Use Value + OV. • Quasi Option Value (QOV) • Bequest Value (BV) • Total Economic Value (TEV) • TEV = UV+EV+OV+QOV+BV

4. Non-market valuation techniques • Stated Preferences • Contingent Valuation • Choice Modelling • Revealed Preferences • Travel Cost Model • Hedonic Pricing

5. The Contingent Valuation Method • Stated preference technique • Questionnaire based • Direct method • Valuation of a hypothetical scenario • It is called “contingent valuation” because the valuation is contingent on the hypothetical scenario put to respondents • Non Use Values + Use Values • Willingness To Pay (WTP) question

6. Stated Preference Techniques: CVM An interview is used to create the hypothetical market within these questions are asked. The hypothetical market comprises two key parts: a statement of the proposed change; and an institutional mechanism through which the proposed change is to be provided/avoided and financed. The challenge in conducting a CV is to make the market as realistic as possible. The process of directly questioning a sample group to ascertain their valuation of a change can be divided into six stages. These are (each with a number of steps): definition of survey objectives; design of the questionnaire; surveying the sample population; creating a database and performing an exploratory data analysis; estimating WTP values; and reporting the survey results.

7. CVM: Stage 1 - Project Definition - Theoretical Model CV study should begin with a basic theoretical model: two purposes: Identifies the information required from questionnaire Generates predictions allowing results to be checked Number of sources of information that can be used to construct the model, including: predictions of economic theory and existing literature, discussion/meetings with focus groups/affected parties. Participants discuss understanding of the context of the good/service in question, the good/service itself, its “value”, who should provide it, how it should be paid for, whether they would contribute, etc. The information from the focus groups is particularly valuable in designing the CV survey.

8. CVM: Stage 1 - Project Definition - Sample Design For a site-specific resource, the sample may be drawn from: Visitors to the site (‘on-site’ sample) • does not elicit information on the WTP of ‘non-users’; • interviews must be kept short; • procedure is needed to select among visitors to a site Households within a certain radius of the site (‘off-site’ sample) • geographical boundaries need to be defined; • a larger sample required, many households may not visit the site It is also important to carefully select the size of the sample: A larger means more confidence that the sample mean WTP/WTA is a reliable estimate of the ‘true’ mean WTP/WTA. (Balance precision and cost)

9. CVM: Stage 2 - Questionnaire Design - Background Questions General background: Questions on general characteristics of the respondents – information for checking the validity of the valuation results Respondents’ tastes and socio-economic characteristics (is the sample representative?). Personal details - should , come at the end of the questionnaire Respondent’s knowledge of the commodity in question, e.g. background questions concerning the respondent’s visits to a recreation site should cover such issues as: • attitudes towards environmental issues; • proximity of their home to the site; • frequency of visits; • duration of trip; • reason for visit, etc. These questions should be asked at the beginning of the interview as they are relatively straightforward to answer, and will help to build-up the respondent’s confidence.

10. CVM: Stage 2 - Questionnaire Design - Preparation Questions To avoid bias, interviewer must make sure the respondent is aware of: budgetconstraints (you cannot spend more than you have!) their right to refuse to pay for the good If the event of a negative response, the reason must be recorded a ‘zero valuation’ is implied if: the respondent may not be able to pay anything; or the respondent may not be willing to pay anything. a ‘protest bid’ is implied if: the respondent may find it too difficult to establish a monetary valuation; the respondent may disapprove of the concept of expressing environmental resources in monetary terms; or may be hostile towards the institutional context.

11. Format of WTP question • Open Ended: • “How much are you willing to pay for public good A?” • Bidding Game: • 1) “Are you willing to pay X for public good A?” • 2a) If Yes to (1), “Are you willing to pay Y for public good A?” (Y>X) • 3a) If Yes (2a), “Are you willing to pay Z for public good A?” (Z>Y). • 4a) if Yes to (3a) … • If No to (Na), WTP questions stop. • 2b) If No to (1), “Are you willing to pay T for public good A?” (T<X) • … • Payment Cards: • choose a WTP point estimate from a list of values

12. Dichotomous or Discrete Choice CV (Referendum format): • “Are you willing to pay X for public good A?” => STOP • Dichotomous or Discrete Choice CV with follow-up: 1) “Are you willing to pay X for public good A?” 2a) If Yes to 1, “Are you willing to pay Y for public good A?” (Y>X) => STOP 2b) If No to 1, “Are you willing to pay Z for public good A?” (Z<X) => STOP

13. CVM: Stage 2 - Survey Design - “Open-ended” Elicitation Format Respondent simply asked to state maximum WTP for a specific environmental change The advantages of the open ended: Quick and easy to administer and analyse; Can be performed with a smaller sample size; Avoids ‘anchoring’ effects - respondents influenced by suggested starting value. Main drawbacks: Makes strategic bias, more likely The respondent may need a reference point to bound value judgement Respondent must be familiar with the affected commodity in question.      

14. CVM: Stage 2 - Questionnaire Design - “Dichotomous Choice” or “Referendum” Elicitation Format range of values for the max WTP of individuals pre-set. sample of respondents is divided into sub-samples. value within the pre-set range is assigned to each sub-sample (the source of he so-called ‘anchoring effect’). Each respondent asked whether WTP assigned value for proposed change Answer not the max WTP – only consent or refusal to pay a given amount Random utility theory (logit model) are required to estimate the respondent’s mean and median WTP values. Requires large sample. No Incentive to engage in strategic behaviour. Easier to convey decision rule - >50% say “yes”  change provided. Realistic – individuals typically make decisions faced with fixed prices.    

15. CVM: Stage 2 - Survey Design - “DC” Format: An Example After describing their illness, the respondent was given the following valuation question: We are now going to ask you a hypothetical question. Suppose you were told that, within the next few days, you would experience a recurrence of the illness episode that you have just described for us. What would it be worth to you – that is, how much would you pay – to avoid the illness episode entirely? Remember that you are paying to eliminate all of your pain and suffering, your medical expenditure, the time you spent visiting the doctor or clinic, your missed work, leisure or daily activities. Bear in mind if you pay to completely avoid being ill this time, you have to give up some other use of this money. For example, you may reduce your expenditures for entertainment or education. Would you pay dollars to avoid being sick at all? [If NO] Would you pay dollars to avoid being sick at all? [If YES] Would you pay dollars to avoid being sick at all? 300 100 1,000

16. CVM: Stage 2 - Questionnaire Design - “Iterative Bidding” Elicitation Format “suppose you were told that within the next few days you would have a recurrence of the respiratory condition that you have just described. Would you be willing-to-pay $10 to avoid the illness episode entirely?”

17. NOAA Panel Guidelines • Conservative design => better to underestimate WTP • WTP, rather than Willingness to Accept (WTA) • Referendum format (i.e. Yes/No Questions) • Accurate description of the good/scenario => use of focus groups and pretest of the survey instrument • Reminder of substitute commodities • Yes/No follow ups • Checks on understanding and acceptance • Cross tabulations • Sample size circa 500 is a minimum.

18. Other important aspects for questionnaire development (1) • Mail / In Person / On the Phone interview • In person => costly, interviewer bias, time consuming, more accurate, better option if it is difficult to explain the scenario (need pictures), only users if on site • Mail => low response rate, sampling bias => who takes the survey? Those who are interested in the topic?, limited information, relatively inexpensive • Telephone => relatively inexpensive, limited information, not accurate, response rate, developing countries? • Mail + Telephone • Internet • Computer based instruments

19. Other important aspects for questionnaire development (2) • Introduction • Warm-up questions • Questions on the knowledge of the problem / experience with the environmental good => USE values, etc • Description of the scenario • WTP question(s) • Debriefing questions => why did you vote in favour or against the program - Use and Non-Use values investigation => did you vote yes, because (a) you will visit the national park, (b) even if you will never visit the national park, you want future generations to visit the park, etc. • Attitudinal questions • Socio – demographic questions. Ask questions on Income at the end of the questionnaire!!! => we don’t want to irritate the respondent

20. Other important aspects for questionnaire development (3) • Identify protest respondents after the WTP questions (ask why the respondent voted YY, NN, NY, YN) • Analyze the data for the full sample of respondents, then delete those respondents that show protest behaviours • Income. Try to get an answer to the income question. In developing countries, sometimes researchers (Cropper, Alberini) ask a list of expenditures. If you have no information on income from some respondents, don’t loose those observations. Add a dummy equal to 1 for those that did not answer the income question, and 0 otherwise. Set equal to 0 the income of those respondents that did not answer the income question. In your regression the coefficient of the dummy for those that did not answer the income question tells if they are statistically different from those that reported income. In this way you don’t loose the observations! • Clearly define the population of interest • Consider your budget constraint • Make sure that your referendum question avoids free rider behaviours!

21. Payment vehicle • Whose welfare are we interested in? => Important for sampling plan • TAX => One time Tax is incentive compatible • How do we choose the tax level? Focus groups, previous research, pretest, optimal bidding design literature, cost of the public program If Data are not as Shown, use Non- Parameteric Methods

22. CVM: Stage 2 - Questionnaire Design - Payment Vehicle Valuation question needs a realistic institutional context - usually an appropriate payment (or bid) vehicle (instrument). The payment vehicle is the mechanism through which the WTP/WTA values are to be raised/distributed. Key considerations when selecting a payment vehicle are: familiarity – does the respondent understand the payment vehicle? credibility – does the payment vehicle represent a realistic situation? empathy – is the respondent favourably or unfavourably disposed towards the recipient of the funds? feasibility – is the recipient of the funds capable of delivering the improvement? universality – would all the respondents be affected by the payment vehicle?

23. WTP and WTA • The goal of contingent valuation is to measure the compensating or equivalent variation for the good in question. Both compensating and equivalent variation can be elicited by asking a person to report a willingness to pay amount. For instance, the person may be asked to report his WTP to obtain the good, or to avoid the loss of the good. Formally, WTP is defined as the amount that must be taken away from the person’s income while keeping his utility constant: where V denotes the indirect utility function, y is income, p is a vector of prices faced by the individual, and q0 and q1 are the alternative levels of the good or quality indexes (with q1>q0, indicating that q1 refers to improved environmental quality). Z is a vector of individual characteristics. • (Compensating variation is the appropriate measure when the person must purchase the good, such as an improvement in environmental quality. Equivalent variation is appropriate if the person faces a potential loss of the good, as he would if a proposed policy results in the deterioration of environmental quality.) 1)

24. 2) • Willingness to accept (WTA) is defined as the amount of money that must be given to an individual experiencing a deterioration in environmental quality to keep his utility constant: • Where q2 indicates a deterioration in quality compared to the status quo, q0. • In equations (1) and (2), utility is allowed to depend on a vector of individual characteristics influencing the tradeoff that the individual is prepared to make between income and environmental quality. An important consequence of equations (1) and (2) is that WTP or WTA should, therefore, depend on (i) the initial and final level of the good in question; (ii) respondent income; (iii) all prices faced by the respondent, including those of substitute goods or activities; and (iv) other respondent characteristics. • Internal validity of the WTP responses can be checked by regressing WTP on variables (i)-(iv), and showing that WTP correlates in predictable ways with socio-economic variables.

25. Dichotomous-Choice Contingent Valuation • When dichotomous choice questions are used, the researcher does not observe WTP directly: at best, he can infer that the respondent’s WTP amount is greater than the bid value (if the respondent is in favor of the program) or less than the bid amount (if the respondent votes against the plan), and form broad intervals around the respondent’s WTP. To estimate the usual welfare statistics, it is necessary to fit binary data models. • The simplest such models assume that an individual’s response to the WTP question is motivated by an underlying, and unobserved, WTP amount, which is normally (logistically) distributed. Formally, let WTP* be the unobserved WTP: • Where  is both mean and median WTP,  is a zero-mean normal (logistic) error with mean zero. The model is completed by specifying the mapping from the latent variable to the observables: 4) WTPi=1 iff WTPi*>B and WTPi=0 iff WTPi*≤B • where B is the bid that was assigned to respondent i, WTP = 1 means that the response is a “yes,” and WTP = 0 means that the response to the payment question is a “no.” 3)

26. Because we observe discrete outcomes, we must derive the probabilities of “yes” and “no” responses. When attention is restricted to a normal latent WTP, the probability of a “yes” response is, therefore: • Because / is a standard normal variate, • where () is the standard normal cdf. If we define α=μ/σ and β=-1/σ, the probability of a yes response can be rewritten as: 6) Equation (6) is the contribution to the likelihood by a “yes” observation (or a one) in a probit model with the intercept and one regressor—the bid. As long as  is identified and estimable—which requires that the bid amount be varied to the respondents in the survey, so that it becomes a legitimate regressor in the probit model—mean/median WTP is estimated as: 7) 5) =

27. while the standard deviation of WTP is estimated as: 8) • The same formulae produce estimates of mean/median WTP and of the scale parameter of WTP from the logit coefficient if WTP is assumed to be a logistic variate. • A standard probit routine will automatically produce standard errors for and , but not for and . • To obtain the covariance matrix of and , you can use the delta method (Cameron, 1991). • First calculate the covariance matrix of and produced by the probit routine V: 9) where , and , with () the standard normal probability density function (pdf). Next, compute the matrix G : 10) G =

28. Finally calculate the matrix product V1=G’VG, with V1 the covariance matrix of and . Nb This can be done in LIMDEP. • If WTP is assumed to be a logistic variate, the steps required for the delta method are the same, except that w(z) in expression (9) is equal to exp(zi) / [1 + exp(zi)]. • in some studies, depending on the frequencies of the “yes” and “no” responses to the payment questions, formula (7) produces a negative mean/median WTP figure. • Perhaps a better way to avoid this problem is to work with a WTP distribution that is defined only over the positive semi-axis. The Weibull and the lognormal are examples of such distributions. • The cdf for a Weibull with parameters  (>0) and  is • Mean WTP is where () is the gamma function • Median WTP is • The log likelihood function becomes: 11) • where F is the cdf of the Weibull

29. median WTP is generally regarded as a robust, and conservative, welfare statistic associated with the good or proposed policy. It is usually estimated more precisely than mean WTP, and is interpreted as the value at which 50% of the respondents would vote in support of the program, and hence the cost at which the majority of the population would be in support of it.

30. The Double Bounded Dichotomous Choice model • Double bounded models increase efficiency in three ways: • YN and NY answers bound WTP • NN and YY answers further constrain WTP • The number of observation is increased The log likelihood function becomes: where WTPH and WTPL are the lower and upper bound of the interval around WTP defined above, F() is the cdf of WTP, and θ denotes the vector of parameters that index the distribution of WTP. (Notice that for respondents who give two “yes” responses, the upper bound of WTP may be infinity, or the respondent’s income; for respondents who give two “no” responses, the lower bound is either zero (if the distribution of WTP admits only non-negative values) or negative infinity (if the distribution of WTP is a normal or a logistic.))

31. Non parametric models for contingent valuation: the Turnbull estimator • Consider only the first bid answer • For bids indexed j=1,…,M, calculate Fj=Nj/(Nj+Yj) where Nj is the number of No responses to tj and Yj is the number of Yes responses to the same bid, Tj= Nj+Yj • Beginning with j=1, compare Fj and Fj+1. Intuitively, % of No’s should increase with the increase in the bid • If Fj+1>Fj then continue • If Fj+1≤Fj then pool cells j and j+1 into one cell with boundaries (tj,tj+2], and calculate Fj*=(Nj+Nj+1)/(Tj+Tj+1)=Nj*/Tj*. That is, eliminate bid tj+1 and pool responses to bid tj+1 with responses to bid tj. • Continue until cells are pooled sufficiently to allow for a monotonically increasing CDF • Set FM+1*=1, F0*=0 • Calculate the PDF as the step difference in the final CDF: fj+1*=Fj+1*-FJ* for each offered price. These represent consistent estimates of the probability that WTP falls between price j and price j+1.

32. Multiply each offered price (tj) by the probability that WTP falls between it and the next highest price (tj+1) • Sum the quantities from step (9) over all prices to get an estimate of the lower bound on WTP: • Calculate the variance of the lower bound as:

33. ELB(WTP)=0*0.343+5*0.225+25*0.011+50*0.218+100*0.075+ +200*0.017+300*0.111=$56.50 V(ELB(WTP))=(0.343*0.657/102)*(5-0)2+(0.568*0.432/81)*(25-5)2+ +(0.579*0.421/95)*(50-25)2+(0.797-0.203/133)*(100-50)2+ +(0.872*0.128/94)*(200-100)2+(0.889*0.111/81)*(300-200)2=$29.52

34. Literature for this lecture • Haab-McConnell “Valuing environmental and natural resources” chapters 1-5 • Perman et al. Chapter 12 • A good book for the CV: Mitchell-Carson “Using surveys to value public goods: the contingent valuation method” Resources for the Future, Washington, DC, 1989. • Read the paper Alberini, Rosato, Longo, Zanatta “Information and Willingness to Pay in a Contingent Valuation Study: The Value of S. Erasmo in the Lagoon of Venice.” • I’ll post the slides and the paper on my website: http://people.bath.ac.uk/al224/