Valuation of Non-marketed Goods pot

We have seen how in conducting efficiency benefit-costanalysis we often use market prices, either directly orindirectly, to value or cost project outputs or inputs.. In benefit-cost anal

© Harry Campbell & Richard Brown

School of Economics The University of Queensland

We have seen how in conducting efficiency benefit-costanalysis we often use market prices, either directly or

indirectly, to value or cost project outputs or inputs

We use market prices directly when they are generated by

perfectly competitive markets - markets that are not

distorted by monopoly, monopsony, taxes or regulations

We use market prices indirectly when we adjust them to

generate shadow-prices In this way prices that are

generated in imperfectly competitive markets can provideinformation that can be used in the BCA

For some project inputs or outputs there will be no market

in which they are traded, and hence no market price is

available for use either directly or indirectly in the BCA

Some examples of non-marketed outputs or inputs:

Since changes in the quantities of non-marketed goods andservices affect the level of economic welfare, they need to

be valued in efficiency and referent group BCA ( but not

in project or private BCA)

The analyst is very likely to encounter the problem of

valuing non-marketed commodities in BCA Why?

Because project outputs or inputs do not have market pricesthe market resource allocation may not be efficient For

this reason governments see a need to regulate the privatemarket or undertake public expenditure in areas neglected

by the market

The very fact that the government wants a BCA suggests

Why are some outputs or inputs that affect the level of

economic welfare not marketed?

The market is a vehicle for trade in commodities For trade

to occur, property rights in the commodities have to be

reasonably complete and enforceable Buyers may not be

willing to pay for an output or input unless they believe

they will have full and exclusive use of it for a specified

period of time, and will be able to sell it to someone else,

if they wish Commodities that have these characteristics

are termed private goods

Public goods are goods which lack some of the property

rights characteristics of private goods, and as a consequence

It is best to think of any given commodity as lying in somecontinuum between a pure private good and a pure public

good

A pure public good is one that has the following

characteristics:

1 Non-rivalry in consumption: this means that consumption

of a unit of the good by one individual does not preclude

other individuals from simultaneously consuming that unit

2 Non-excludability by producers: this means that supplying

a unit of the good to one person means that everyone can

consume that unit if they choose to;

3 Non-excludability by consumers:this means that supplying

a unit of the good to one person means that everyone will

A semi-public good has one or two of the three pure publicgood characteristics Examples:

1 Non-rival in consumption and non-excludable by

producers: free-to-air broadcasting

2 Excludable by both producers and consumers but

non-rival in consumption: an uncongested motorway

3 Excludable by producers, but non-excludable by

consumers, and non-rival in consumption: somekinds of air pollution

4 Rival in consumption but non-excludable by producers:

an open-access fishery

External effects are flows of goods or bads that are

generated by the market economy, but are not traded

in the market

Some externalities are private in nature - one agent’sactivity affects the welfare of one other agent eg yourneighbour’s tree shades part of your garden This kind

of issue can often be resolved through negotiation

Many externalities are public in nature - they are publicgoods or bads eg air and water pollution

Why do we expect to see more public bads than publicgoods?

Excludability is largely a matter of cost This means that tosome extent producers can decide whether to limit

availability of the good or bad they produce It is in

their interests to limit availability of goods (which

they can charge a price for) but not to limit availability

of bads (from which they can derive no benefit).

Examples:

1 At some cost TV stations can limit access to their

services by accessing cable networks

2 If a carbon tax is introduced it will be in producers’

interests to reduce carbon emissions

In summary, the private market does not supply efficient levels of goods or bads which are non-excludable and/or non-rival Provision of public goods is one of the important activities of governments, and is one of the reasons for social benefit-cost analysis: proposed government programs or projects which supply public goods need to

be appraised Furthermore, because many private projects produce non-excludable external effects it cannot be assumed that because they are in the private interest of their proponents they are also in the public interest Social benefit-cost analysis is used

to appraise such projects from a public interest viewpoint before they are allowed to proceed To be of use the social BCA needs to be able to assess the project’s external effects in terms commensurate with its private net benefits Thus the market failure which provides the major rationale for social BCA at the same time poses one of its major challenges - that of valuation in the absence of market prices.

Benefit-Cost Analysis: financial and economic appraisal

using spreadsheets, Chapter 12, p 263

In order to illustrate the use of non-market valuation

techniques we will use environmental goods and services

as an example

Figure 12.1 Total economic value of coral reef ecosystems

Total economic value

Direct use values

Indirect use values

• Storm surge protection

In benefit-cost analysis we are not interested in the total

value of environmental assets, but rather in the likely

changes in total value as a result of a proposed project ie.

the project either increases the annual value derived from the reef by some amount (a project benefit), or it decreases

the annual value of the reef by some amount (a project cost)

Since the services of a coral reef are not traded in a market(because of their public good characteristics) the benefit-

cost analyst needs to employ non-market valuation

techniques to place dollar values on changes in the flow

of services generated by the reef

Dollar values are required to make the benefits or costs

associated with environmental changes commensurate with

the other project benefits and costs

Economists generally base non-market valuation techniques

on the analysis of supply or demand

Supply-side analysis: this approach generates values based

on the costs of either preventing or not preventing

environmental damage We will look at three approaches:

- the dose/response method

- the opportunity cost method

- the preventative cost method

Demand-side analysis: this approach generates values

based on consumers’ willingness-to-pay for environmentalservices There are two main approaches:

- the revealed preference approach

The dose/response method

Environmental attributes such as water quality and reef

area enter into the production functions for goods and

services For example, the production function for

commodity i might be:

Xi = fi(Ki,Li,Mi,Qi,Ai)

where X is the annual output flow, K,L, and M represent

the annual input flows, and Q and A represent water quality and reef area in the region in which production takes place

A change in water quality or reef area (as a result of a

proposed project) will cause changes in the level of output

Example of the dose/response method: a project to increasesugar production in FNQ is predicted to result in a

deterioration of water quality and a reduction in reef area

on the GBR The result will be to reduce the net value ofthe tourism and fishing industries The net value is

calculated as the change in value of output less the change

in the cost of the inputs K,L and M

Clearly the dose/response method can be applied only to

those use-values of the environment which are generated

by the market system It cannot be used to estimate non-usevalues, or to account for non-marketed use-values, such asprivate (ie non-commercial) recreation

The opportunity cost method

This method calculates the cost of preventing or limiting

environmental damage by either not undertaking or

modifying the proposed project Thus the opportunity costcould take the form of forgone project net benefits, or of

additional project costs

Once this information has been calculated it is left to the

decision-maker to judge whether the benefits of preventing

or limiting the environmental damage are large enough to

justify the cost

A threshold analysis calculates the minimum value the

environmental values would need to take to justify forgoing

or modifying the project to prevent or limit the

environmental damage associated with the project

The preventative cost method

This method assumes that the value of the environmentalresource is equal to the cost of preventing or mitigating theenvironmental damage, or replacing or restoring the

environmental asset (the replacement cost method), or

relocating the environmental activity

The replacement cost method is sometimes used in legalprocesses to estimate damages

It can be seen from Figure 12.2 that the preventative or

replacement cost method can overstate the extent of

environmental losses and lead to excessive levels of

The preventative or replacement cost methods might be areasonable approach if private individuals or groups wereobserved to be willing to incur these costs

Figure 12.2 Measures of Value using the Replacement Cost Method

Restoration Level

100%

QL

Qe0%

A

$

Restoration Costs (C)

Restoration Benefits (B)

Net Benefits

Demand-side methods of environmental valuation

Revealed preference approaches infer environmental values from observed consumer behaviour eg :

- travel cost method (TCM)

- random utility model (RUM)

- hedonic pricing model (HPM)

Stated preference approaches estimate environmental values by asking consumers what they are willing to

pay for the preservation of environmental assets eg.:

- contingent valuation method (CVM)

- discrete choice modeling (DCM)

The travel cost method (TCM)

By observing consumer behaviour in the market for travel(a related market) to and from a recreational site we can

estimate the annual consumer surplus generated by that sitefor its users

Example: two consumers have the same income, tastes, andface the same set of prices, except the cost of travel to a

recreational site This means they have the same demandcurve for the services of the site One consumer (B) livesfurther from the site and pays a higher travel cost per visit

We observe PA < PB, and QA > QB We can treat

(PA,QA) and (PB,QB) as points on the individual demand

curve and use the estimated curve to calculate the annual

Figure 12.6 Approximate Individual Demand Curve for Park Visits

Price/cost Per trip ($)

25 15 5

25 10

Number of trips per annum 20

The random utility model (RUM)

As with the TCM, the RUM uses trip data and travel costs,together with consumer characteristics such as income

level and tastes (level of education or experience) to

analyse consumer choice among alternative recreational

sites Unlike the TCM, which assumes the number of visits

is a continuous function of price (travel cost), the RUM is

a model of discrete choice among substitute sites

Since the RUM takes explicit account of site characteristics

in modeling choice among sites, it can be used to value

the individual attributes of a site, and changes in site valueper trip as a result of changes in these attributes However itcannot be used to predict changes in the number of visits

in response to attribute changes

The hedonic pricing model (HPM)

The hedonic pricing model (HPM) regresses observed

market prices against the levels of various attributes of a

good or service in order to place separate valuations on

these attributes It is widely used in product design eg.: whatare consumers willing to pay for each of the individual

attributes of a car - automatic transmission, air conditioning,air bags, anti-lock brakes etc.?

Using the HPM house price data can be used to value

local environmental assets such as air quality or city parks.The hedonic price function is expressed as:

Pi = f(Si, Ni, Qi)where Si = house and site characteristics, Ni - neighbourhoodcharacteristics, Q = environmental quality characteristics,

The contingent valuation method (CVM)

The contingent valuation method (CVM) proceeds by asking people what they would be willing to pay for the services of

the particular environmental asset in question It has the

advantage of applying to both use- and non-use values Its

disadvantage is the possible presence of various kinds of

bias in the results of the survey, including:

- hypothetical market bias - respondents are not

really paying for the services in question;

- strategic bias - respondents try to influence the

outcome of the study;

- design bias - the way the questions are phrased,

particularly the form of the notional paymentvehicle, can affect the results

Discrete choice modeling (DCM)

Discrete choice modeling (DCM) asks people to value a

range of options (unlike CVM which values a single option

relative to the status quo) The options may consist of

various types and levels of environmental protection as well

as levels of more conventional forms of economic activity, such as jobs The survey results can be used to calculate

trade-offs between various types and levels of protection

and other economic values Marginal values of types of

environmental protection can also be calculated and used towork out the relative value of each policy option

An advantage of DCM is that it may be less prone to bias because of its focus on choice among alternatives A

disadvantage is that there is no rule governing the range of

Alternative approaches to non-market valuation

The supply- and demand-side approaches to non-market

valuation try to mimic the market process in some way so as

to work out the information the market would have conveyedhad it existed These approaches are based on information generated by random samples of the consumers involved

Some alternative methods are based on sampling selected

groups and are regarded as being an integral part of the

decision-making process itself:

- deliberative value assessment (DVA) - groups of experts

investigate and discuss the use of environmentalresources and make recommendations;

- multi-criteria analysis (MCA) - groups of stake-holders

rank alternative performance criteria and the likely