Valuation 8: Defensive expenditures (HPF)

1. Valuation 8: Defensive expenditures (HPF) • Revealed preference methods • Defensive expenditures • Damage costs • Defensive expenditures: A simple model • An example: Urban ozone

2. Last week • Contingent choice modelling and its variants • Steps and design stages for choice modelling • Some econometrics • Application to green product choice

3. Revealed preference methods • People make choices within markets: prices paid and quantities purchased • Derive values people place on environmental amenities and disamenities from purchase decisions • Stated preference methods: intended behaviour; non-use values • Four commonly used methods: TCM, HPM, defensive expenditures and damage costs

4. Revealed preference methods -2

5. The Household production function approach • A household combines an environmental good/bad with market goods to produce and „experience“ that directly provides utility • To enjoy a national park people must visit the park and this costs money • To defend against an environmental bad such as traffic noise money is spent on insulation • The household production function (HPF) approach involves investigating changes in the consumption of commodities that are substitutes or complements for the environmental good of interest

6. Defensive expenditures • Measures the “demand” for environmental bads • A rational consumer buys self-protection up to the point where the marginal cost of additional measures exceeds the marginal benefits from the reduction • Averting inputs include air filters, water purifiers, noise insulation and other defensive or self-protection inputs; these are substitutes • In all these cases an individual combines quantities of a public bad with a quantity of a market good to produce what actually gives utility

7. Excurse: Damage costs • The method estimates the resource cost associated with environmental change, rather than WTP • Does not include any estimate of consumer surplus or marginal prices • In the health context: cost of illness approach • This is the sum of direct and indirect costs associated with illness, injury, or death • Direct costs (out-of pocket expenses) • Diagnose, treat, rehabilitate, or support ill or injured persons • Indirect costs (the value of output that is not produced) • Mainly foregone earnings

8. Defensive expenditure: A simple model • Noise pollution (P) from a nearby road • higher Ps are worse • The individual is only interested in the level of quiet within the house (Q) • higher Q is better • The homeowner buys noise insulation and other equipment to reduce the level of noise within the house • Defensive expenditure: D(Q,P) to achieve Q for a given P

9. The homeowner’s problem • The homeowner’s problem to choose between conventional goods (X) and Q is: • Outdoor noise does not enter the utility function, it is outside of the control of the individual X Y D(Q*,P) X* U1=U(X,Q) U0=U(X,Q) Y=X+D(Q,P) Q Q*

10. A simple model (2) • Suppose the level of noise (P) increases slightly • consumer has to spend more to achieve same noise level • If income increases • The level of utility is the same • Compensating surplus • What happens if income is not adjusted? • Lower level of utility • Substitution effects: Q drops • Defensive expenditure < true marginal WTP

11. The effect of a change in pollution X P2 > P1 Y=X+D(Q,P2) Y=X+D(Q,P1) U1 U2 Q2* Q1* Q

12. Algebraically • Suppose we change P slightly by DP • The consumer adjusts the choice of Q and X • Defensive expenditure changes byDD and indoor noise levels byDQ DD=D(Q+DQ, P + DP)-D(Q,P) =D(Q+DQ, P + DP)-D(Q, P + DP)+ D(Q, P + DP)-D(Q,P) =DQDQ+DPDP DQ=[D(Q+DQ, P + DP)-D(Q, P + DP)]/ DQ DP=[D(Q, P + DP)-D(Q,P)]/ DP The marginal WTP to avoid a change in P DD/DP =DQ(DQ/DP)+DP Generally: DD/DP <DP

13. An example: Urban ozone • Significant extension to previous model • pollution level enters directly into the utility function • Study by Dickie and Gerking (1991) • Estimate the demand for ozone pollution for two cities in the metropolitan area of Los Angeles • Burbank and Glendora • Compare the results to out-of-pocket medical expenses (damage costs) associated with elevated ozone in each of the two cities

14. Burbank and Glendora • Suppose Burbank Glendora New Standard Old Standard

15. The basis of the analysis • Both cities have a significant amount of air pollution • What is the WTP for an average resident of each city to reduce the maximum ozone level during a year to either 12 or 9 pphm? • The analysis is based on people’s willingness to purchase health care to compensate for the health-related damage from ozone pollution • Ozone causes coughing and other breathing difficulties

16. The modelling approach • Utility is a function of market goods (X), health (H) and exposure to air pollution (A) • Defensive expenditure (M) depends on health (H), air pollution (A) and the individuals health status (R) • We write this as a health production function which tells us how much health will result if M is spent on medical care • The budget constraint is defined on the basis of time available to generate income

17. The modelling approach (2) • The indirect utility function giving maximum utility attainable is • If we could observe utility we could statistically estimate the equation • Dickie and Gerking compensate this by observing whether people visit a doctor • If they do, there must be a utility gain from visiting and V1 (M>0) > V0 (M=0) • They use a random probability model and estimate the probability to visit a doctor • The binary choice problem is M>0 if V1 - V0 > 0 and M=0 if V1 - V0 = 0

18. The data • Sample of 256 residents of the two cities • All are household heads with full-time jobs • Married white males with compromised respiratory functions are oversampled • Respondents were asked about • long-term health status • contacts with the medical care delivery system • socio-economic/demographic and work environmental characteristics • typical out-of-pocket expenses incurred for a visit to their doctor • commuting and waiting time required to see their doctor • Each contact with a respondent was matched to daily measures of ambient air pollution concentrations

19. The results

20. Conclusion • Estimates are lower bounds • As expected, out-of-pocket medical expenses are much lower • Earlier studies on defensive expenditures found much smaller values • $0.04 to $4.00 per year per person • Other regions • Lower ozone levels • No oversampling of respiratory impaired • CV studies found similar values • The broad range of WTP estimates poses an awkward situation for policy makers