Economics of Environmental Quality

1. Economics of Environmental Quality

2. Economics of Environmental Quality • Different types of pollutants call for different types of policy • Optimal pollution modeled as simple tradeoff: • Reducing emissions reduces damages • Reducing emissions involves opportunity costs

3. Environmental Damages • All negative impacts that resource users experience from environmental degradation • Greater the emissions, the greater the damages • Examples: • Lung diseases • Contaminated water • Loss of biodiversity • Loss of recreational uses • “defensive” expenditures

4. $ $ Emissions (tons/yr) Emissions (tons/yr) $ $ Ambient (ppm) Ambient (ppm) Marginal Damage Function • Emissions function: • Damage = f(quantity of residual) • Ambient function: • Damage = f(concentration of pollutant) Noise SO2 Toxic chemicals “threshold” effects

5. Marginal Damage Function • Total Damages = sum of marginal damages • TD1 = (10)(100)(.5) = $500 • TD2 = (25)(100)(.5) = $1250 • What accounts for differences in MD1 and MD2? • Urban vs rural areas • Different seasons $ MD2 MD1 $25 $10 50 150 Emissions

6. Suppose the marginal damage function is given as MD = 8(E - 200), where E measures the emissions of gunk, measured in tons. What is the total damage if E = 260? • $480 • $14,400 • $28,800 • $62,400

7. Abatement Costs • Costs incurred to reduce pollution emissions • Marginal Abatement Costs (MAC) rise as emissions are reduced $ MAC2 $50 MAC1 Unregulated Emissions $20 240 500 Emissions • Total Abatement Cost = sum of marginal abatement costs • TAC1 = (20)(260)(.5) = $2600 • TAC2 = (50)(260)(.5) = $6500 • What accounts for differences in MAC1 and MAC2? • Different plant technologies (old vs new) • Different time periods

8. Suppose the marginal abatement cost function is given as MAC = 350 – 5E, where E measures the emissions of gunk, measured in tons. What is the total abatement cost if E = 30? • $200 • $4,000 • $6,000 • $12,000

9. Optimal Emissions • Optimal level is one which minimizes total social costs • Occurs where MD = MAC $ MD1 MAC1 $18 $10 TD1 TAC1 Emissions 75 200 450 TD1 = (10)(125)(.5) = $625 TAC1 = (10)(250)(.5) = $1250 Total Social Cost = TD + TAC = $1875

10. Optimal Gunk MD = .25(E – 100) MAC = 90 - 0.15E • What is optimal emissions? • What are marginal damages at the optimal level? • What are TD? • What are TAC? • What is Total Social Cost? • What is Total Social Cost if E = 0? • What is Total Social Cost if emissions are unregulated?

11. Optimal Emissions $ • What happens to optimal emissions if: • MD rises? • MAC falls? • What would the graph look like that shows E* = 0? • What happens to optimal emissions if enforcement is costly? MAC1 + C MD2 MD1 MAC1 MAC2 E2 E1 E3 Emissions E* falls E* falls E* rises

12. Problem Set 2 • Question #3

13. Equimarginal Principle: Revisited • What is TAC of a uniform 50% reduction from the unregulated level? • What is TAC of the equimarginal reduction of 14 tons/week? TAC = $14,900 TAC = $14,400 $33,600 $49,600

14. Vilfredo Pareto Types of Analyses • Impact Analysis • Enviro IA: • Economic IA: • Cost-effectiveness Analysis • Estimate cost of alternatives with a certain objective in mind; benefits not considered • Damage Assessment • Estimate value of damages to injured resource so that the amount can be recovered in court • CERCLA (Superfund) • Benefit-Cost Analysis Identification and study of all enviro repercussions from actions; natural scientists Ramifications of enviro regulations for specific econ variable; economists Ex: Williamstown wetlands and economic development Pareto improvement: A policy that makes one person better off and no one else worse off

15. Benefit-Cost Analysis • Specify clearly the project/program • Location, timing, affected groups • Describe quantitatively the inputs/outputs of project • Involves engineers • Estimate social benefits/costs of inputs/outputs • Use monetary metric • Compare benefits and costs • Net benefits? • Benefit-cost ratio?

16. E0 is current emissions Proposal to reduce emissions to E2 TB = a + b TC = b Net benefits = a Maximum net benefits occur at E* Net benefits = a + d B-C Ratio At E2: (a+b)/b At E*: (a+b+c+d)/(b+c) Benefit-Cost Analysis $ MD1 MAC1 d a c b Emissions E* E2 E0

17. Benefit-Cost Analysis • Present Value Calculation • Net PV = • The higher the discount rate, r, the lower the PV • What discount rate to use? • Personal time preference? • Marginal productivity approach? • Real or nominal interest rate? Benefits today time Costs Interest rate on savings accounts Interest rate on borrowing money OMB: r = 7% CBO: r = 2%

18. Benefits today time Costs Benefits today time Costs Benefit-Cost Analysis • Future generations? • Discounting downgrades future damages • Policies with short run benefits and long run costs are preferred by today’s generation • Sustainability criteria as alternative • Distributional concerns? • Horizontal equity: treating similarly situated people the same way • Vertical equity: treating people in different situations differently • Risk Analysis? • Uncertainty about the future makes for a probabilistic world

19. Benefit-Cost Analysis

20. Measuring the Benefits of EQ • Direct Damages • Willingness-to-Pay Approach • Revealed Preferences • Stated Preferences

21. Direct Damages • Health damages Health = f(life style, diet, genetics, age, AQ) • Medical expenditures • Lost income due to illness/death “cost of illness study”

22. Estimated Cost of Adult Asthma in the US Source: M.G. Cisternas et al., “A Comprehensive Study of the Direct and Indirect Costs of Adult Asthma,” Journal of Allergy and Clinical Immunology, June 2003.

23. Direct Damages • Health damages Health = f(life style, diet, genetics, age, AQ) • Medical expenditures • Lost income due to illness/death • Materials damages • Increased maintenance costs • Effect of pollution on production costs • Reduced yields on crops “cost of illness study”

24. Indirect WTP Methods • Value of Health thru Averting Costs • Expenditures made to avoid bad outcomes • Value of Life thru Wage Rate Differentials • “statistical life”

25. Value of a Statistical Life • How much would you be WTP to reduce probability of death by ? • If you are rational, you will take precautions up to the point where MB = MC. • Suppose it will cost $30 to reduce the chance of your death by $30 = (V)( ) V = $3,000,000 MC MB

26. Value of a Statistical Life Estimates Source: Table 7.2, p. 145, Field and Field (2006)

27. Fatality Risk in the US Source: Kip Viscusi, “The Value of Risks to Life and Health,” December 1993 Journal of Economic Literature (13):1912-1946.

28. Cost of Risk-Reducing Regulations * Millions of 1984 $ 104 = 10,000 105 = 100,000 106 = 1,000,000 107 = 10,000,000 108 = 100,000,000 Source: Kip Viscusi, “Economic Foundations of the Current Regulatory Reform Efforts,” The Journal of Economic Perspectives 10 (1996): Tables 1 and 2, 124-125.

29. Indirect WTP Methods • Hedonic Pricing • Value of EQ thru Housing Prices • Value of EQ thru Intercity Wage Differentials • Travel Costs for Amenities • Time and travel costs represent “price” of access • Problem Set 2: #11 • Southold, Long Island, NY • Calculate value of preserving open spaces • 10 acre open parcel surrounded by 15 avg properties = $410,000 • Property values next to: • Open Space: + 12.8% • Farmland: - 13.3% • Major Roads: - 16.2% • Zoning: + 16.7% • Hells Canyon on the Snake River • Recreation vs Hydropower • Cost savings of hydropower at Hells Canyon: $80,000 • Recreational value of Hells Canyon: $900,000

30. Direct WTP Methods • Political Referendum • Qualitative assessment only • Contingent Valuation • Survey method used to elicit use and non-use values • Total WTP = Use value + Nonuse value + Option value • Approach • Choice scenario must provide accurate and clear description of the change in environmental services • Open-ended or closed-ended choice format • Must specify payment mechanism and opportunity costs

31. Sample CV Questions • There are less than 1,000 American Crocodiles left. Habitat necessary for the American Crocodile is rapidly being bought for development. The Nature Conservancy is considering buying land in an effort to save this species. What would you be willing to pay in the form of an annual donation in order to buy enough habitat to save 100 crocodiles? $_______________ • If you said $0, please tell me why? (From: Environmental Economics & Policy (2007, 5e) by TomTietenberg.)

32. Sample CV Questions • First, let’s assume that visitors to the Glen Canyon National Recreation Area are to finance environmental improvements by paying an entrance fee to be admitted into the recreation area. This will be the only way to finance such improvements in the area. Let’s also assume that all visitors to the area will pay the same daily fee as you, and all the money collected will be used to finance the environmental improvements shown in the photos. • Would you be willing to pay a $1.00 per day fee to prevent Situation C from occurring, thus preserving Situation A? $2.00 per day? [Increment by $1.00 per day until a negative response is obtained, then decrease the bid by 25 cents per day until a positive response is obtained, and record the amount.]_________$/day (From: Using Surveys to Value Public Goods: The Contingent Valuation Method. Mitchell, Robert Cameron, and Carson, Richard T. 1989. Resources for the Future, Washington, D.C. Pp 4-5.)

33. Mono Lake, California • LA water consumers vs nesting/migratory birds • Average WTP on water bill was $13/mo (or $156/year)  TB exceeded $26m cost of replacing water supply by a factor of 50 Wegge,T., W. Michael Hanemann, and John Loomis. 1996.  "Comparing Benefits and Costs of Water Resource Allocation  Policies for California's Mono Basin,"  in Advances In The Economics of Enviornmental Resources, (ed.) Darwin C. Hill, Volume 1, 1996.

34. Exxon Valdez Oil Spill (1989) • 11 million gallons • Mean WTP for a program to reduce the risk of similar damage was a one-time tax payment of $31 per household • Estimated TB = $2.8 billion • Exxon paid $0.5 billion in damages + $2 billion in cleanup

35. Direct WTP Methods • Problems with CV • Hypothetical nature of questions • Truthfulness/free-rider problem • Framing issues • WTP vs WTA

36. Value of a headache • What is the maximum dollar amount you are willing to pay to avoid a headache? • What is the minimum dollar amount you would accept to have a headache? WTA is not constrained by income

37. Measuring Abatement Costs • Level of analysis • Single firm/community/project • Industry/region • National economy • Global • With/Without Principle • Production costs: • Before Regulation: $100m • Future w/o Regulation: $120m • Future w/ Regulation: $150m  true marginal cost = $30m

38. Concepts of Cost • Explicit Cost • Capital Costs: plant and equipment (replacement and expansion) • Operating Costs: production, maintenance, abatement process (labor, materials, R&D) • Enforcement Costs: monitoring, administration • Implicit Costs • Higher product prices/reduced consumption • Inconvenience of using public transportation/carpools • Media switching • Illegal dumping Social Costs = Private Costs + External Costs

39. US Pollution Control Expenditures: 2005 U.S. Census Bureau, Pollution Abatement Costs and Expenditures: 2005, MA200(05), U.S. Government Printing Office, Washington, DC, 2008. Online: http://www.census.gov/prod/2008pubs/ma200-05.pdf

40. Single Projects • Examples • Waste treatment plants • Flood-control • Solid waste handling • Beach restoration • Public park • Wildlife refuge

41. Projected Costs of a Small Wastewater Treatment Plant ($1,000)

42. Costs of a Local Regulation $ • Costly regulation imposed on local apple grower • Raises costs of production: supply shifts to S2 • What does apple grower do? • Continue producing same quantity? • unlikely if apples are sold competitively • Cut production to q2? • lost income to grower, workers, community S2 S1 P Market price q2 q1 Apples Why is the lost income not necessarily a social cost?

43. Cost of Regulating an Industry • Higher production costs are social costs when they cause CS to fall • Estimate cost of “average” firm • Rely on cost surveys • Self-reported • Uses past data $ a + b = lost consumer surplus = “true” social cost P2 S2 a c b P1 S1 D q2 q1 output

44. Costs at the National Level • Macroeconomic modeling • Short Run • PPF model suggests tradeoff between market output and EQ • Long Run • GDP = F(L, K, Tech) • PACE diverts resources from these factors • But, environmental degradation reduces resources Market Goods EQ

45. PACE as Percent of GDP Source: OECD, “Pollution Abatement and Control Expenditure in OECD Countries,” ENV/EPOC/SE(2003)1, Paris, 17 July 2003, p32.