1 Topic 4.c: Non-market Valuation Many policies and projects involve inputs and outputs for which...

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Topic 4.c: Non-market Valuation

• Many policies and projects involve inputs and outputs for which there are no formal markets. Important examples include public goods, such as environmental quality, health and safety, and human life.

• Measuring the value of non-market goods is a science still in its infancy, and one in which there is currently much research underway. Even the state-of-the-art techniques are still fairly crude. Nonetheless, they provide useful ways of putting a “ball park” values on important costs and benefits.

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Use and non-use value

• The value placed on an environmental good (whether measured by WTP or WTA) can be conceptually decomposed into use value and non-use value.

• Use value is the value to the agent from sensuous interaction with the environmental amenity. For example, hiking, sight seeing, wildlife viewing, etc. This includes vicarious use (for example, watching wildlife films).

• Non-use value comprises existence value, bequest value and option value

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• Non use value

– Existence value is the value gained purely from the existence of the environmental amenity at a particular quality. For example, an individual may derive utility from the knowledge that there are whales swimming in the oceans even if they never have any sensuous interaction with them.

– Bequest value is the value an individual places on preserving environmental quality for future generations. Bequest value arises out of intergenerational altruism.

– Option value is the value an individual places on preserving the option to make use of an environmental amenity in the future.

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Revealed preference approaches

• Revealed preference (or indirect) methods use observable market data to make inferences about non-market values. These methods are called “revealed preference methods” because preferences over the environmental good are revealed by observable actions by the agents concerned. We will examine four such methods

– averting behaviour approach– hedonic pricing approach– travel cost method– hedonic travel cost method

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• Averting behavior approach• The value of a small reduction in environmental quality can

in principle be measured by the amount an individual is willing to spend on some defensive (or “averting”) action to prevent it.

• The applicability of the averting behavior approach is limited to cases where market defensive actions are available. Nonetheless, there are some empirical studies that have produced valuation estimates based on this approach. For example,– Dickie (1991), “The health costs of tropospheric ozone

pollution”, Journal of Environmental Economics and Management, uses expenditures on respiratory and eye medications to obtain a lower bound on the cost of ozone pollution.

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• There are a number of problems with the approach:– individuals undertake averting behavior based on their

perception of how that behavior will avert damage, not to how it actually averts damage. It may therefore be difficult to identify averting behavior in practice.

– averting behavior may produce benefits other than mitigation of damage. Thus, the valuation of reduced damage may be less than the full cost of averting behavior.

– financial expenditures may substantially under-estimate the true cost of the averting behavior.

– in theory, individuals will engage in the averting behavior up to the point where the marginal cost equals the marginal benefit. Expenditure on the averting behavior will reflect the benefit only on the marginal unit or consumer. The true benefit is the surplus received from the behavior.

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• Hedonic pricing approach• The market price for a good can be decomposed into

hedonic prices on the characteristics of that good. For example, market house prices can be decomposed into hedonic prices on attributes such as size, proximity to schools and parks, views, noise levels, air quality, proximity to landfills, etc.

• The importance of environmental characteristics in the determination of house values can then provide a guide to the value of those characteristics.

• An hedonic price function can be estimated by running a (usually linear) cross-section of house prices (the dependent variable) against a vector of measured characteristics (the independent variables), including environmental characteristics.

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• The estimated coefficient on environmental attributes, such as the level of noise, or proximity to a park, can be used as a measure of the value of marginal changes in those attributes.

• The main shortcomings of hedonic pricing for environmental valuation are

– limited to applications involving valuing aspects of urban environmental quality

– cannot be used to value purely public amenities since these are by definition available to all households.

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• Travel cost method (Hanley and Spash (1993), Cost-Benefit Analysis and the Environment)

• The travel cost method (TCM) attempts to place a value on a non-market environmental good (such as a recreation site) by drawing inferences from expenditures made to “consume” the good, including the cost of traveling to the site, entry fees, on-site expenditures, and outlays on capital equipment.

• There are two types of TCM: the “individual demand approach” and the more common “zone of origin approach”. We will focus on the latter.

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• The main steps of a zone of origin TCM are the following.• Step 1

– The area around the site is partitioned into “zones”, usually concentric rings of increasing radius

– Data is collected by an on-site survey of site users. The key variables recorded

• zone of origin• time taken for the trip• expenditures en route• cost of any equipment used on site• entry fee or license fee paid• socioeconomic variables (including, income, age,

education, gender, etc.)

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• Step 2• “Travel cost” for user i is estimated from the survey data on

that user, using fixed values for time cost and distance cost per kilometer. “Travel cost” includes all costs incurred by the user to use the site, including on-site costs.

• Step 3• A trip generating function (TGF) is then estimated where

the number of visitors from a zone is explained by the average travel cost for visitors, average socioeconomic variables and the population from that zone

• Step 4• The estimated TGF can then be used to simulate a

demand curve for visits, by plotting the estimated number of visits against travel cost. The area under this demand curve is the total consumer surplus associated with the site, and as such represents a measure of the use value of that site. This is usually reported as a value per visit.

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• Problems and extensions• Multi-purpose trips. Visitors to a site are either “purposeful

visitors” or “meanderers”; the latter group visit the site in the course of a larger trip that includes visits to a number of nearby sites. Ideally, only a portion of the total travel cost for meanderers should be attributed to any particular site visited.

• Calculation of distance cost. The cost-per-kilometer assigned to the number of kilometers traveled could be calculated as either gasoline costs only, or as the “full cost of motoring”, which would include an allowance for vehicle depreciation, etc.

• Ideally, one should use the marginal cost of the trip, but calculating the full marginal cost of motoring (as opposed to average cost) is often prohibitively difficult.

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• The value of time. The appropriate measure of time cost is its opportunity cost. If time spent on a trip would otherwise have been spent at work, then the appropriate time cost is the value of foregone earnings.

• However, for most people, time spent on a trip would have been spent in an alternative leisure activity, that may be worth more or less than foregone earnings.

• This problem is further complicated by the fact that the trip itself may have a utility value, especially if the drive to the site is a scenic one.

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• Alternative sites. The demand for a market commodity depends not only on the price of that commodity but also on the prices of substitute and complementary commodities. Ideally, the cost of visiting close substitute sites should be taken into account.

• The TCM can only be used to measure use values, not non-use values.

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• The hedonic travel cost method• The TCM method described above provides a method of

putting a value on a particular recreation site. However, we are often interested in placing a value on changes in the quality of a site.

• Similarly, we may be interested in placing a value on an environmental enhancement project that improves water quality at a particular swimming site.

• To place a value on the characteristics of a site, rather than just on the site in its entirety, we can generalize the travel cost method. The basic idea is that the “price” paid to visit a site (the travel cost) can be decomposed into a set of hedonic prices on the characteristics of the site.

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• First, surveys are conducted at a number of different sites, collecting data at each site as per the travel cost method. In addition, data on a vector of physical characteristics is collected for each site.

• The characteristics of the site can then be viewed as shift parameters in the demand curve.

• The change in consumer surplus associated with a change in the value of one the characteristics can then be calculated as the area between two demand-for-visits curves, derived by simulating the change in the characteristic of interest.

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The stated preference approach: contingent valuation• Indirect methods of valuation are limited in their

applicability, and are confined to measuring use values. • A contingent valuation is a survey in which respondents

are asked to place a value on a specified change in environmental quality.

• The objective is to estimate the population WTP for a particular change in environmental quality from the responses of a sample group.

• CVM is controversial because it relies on stated preferences rather then revealed preferences, which may make it less reliable. It is nonetheless widely used because it is the only method available to obtain estimates of non-use values.

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• The key elements of a CVM survey are:– a description of the good to be valued– a method of hypothetical payment: the “payment

vehicle”. The most common payment vehicles are user fees and tax increases

– a set of questions to obtain data on preference and socioeconomic factors that are likely to affect valuation (including interest in nature, income, education, age, etc.)

– a “value elicitation” method. This refers to the procedure by which a stated value is elicited from the respondent.

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• The main distinction between different types of CVM surveys is the value elicitation method used. There are two main methods:– open-ended– closed-ended (discrete choice)

• An open-ended survey asks the respondent to state her maximum WTP (or less commonly, her minimum WTA) for a change in environmental quality. There is no limit imposed in the survey structure on the amount that a respondent could potentially state.

• A closed-ended survey provides the respondent with less latitude: the respondent is asked to choose from a discrete set of possible values.

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• These surveys are often called “discrete choice surveys”.• There are two types of closed-ended approaches: a

payment card format and a referendum format.• The payment card format provides the respondent with a

card with a list of possible payment amounts. The respondent is then asked to circle the maximum amount she would be willing to pay.

• The referendum format asks the respondent to state “yes” or “no” as to whether she is willing to pay a particular amount, called the “bid value”.

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• The referendum format is increasingly becoming the method of choice in most CVM studies because it most closely approximates a real market setting, in which consumers either buy or do not buy the good at a specified price, and so is more familiar to respondents. (Whether or not this a good reason for choosing the referendum format is an open question).

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Issues and shortcomings with contingent valuation

1. Strategic bias

• It is sometimes argued that survey respondents have an incentive to misrepresent their WTP depending on how they believe any actual payment will be tied to their stated valuation.

• If respondents believe that they may be actually required to pay an amount equal to their stated valuation, then they will have an incentive to understate their valuation. Conversely, if they believe that they will not have to pay then they will have an incentive to overstate their valuation to ensure that environmental quality is improved.

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• The theoretical basis for strategic bias in a survey context is weak and empirical work suggests that it is not a problem. Moreover, there are ways of designing the survey that can minimize this “preference revelation problem”.

2. Artificiality (or “hypothetical bias”)

• “If one asks a hypothetical question then one will get a hypothetical answer”. That is, because respondents in a CVM survey do not actually have to pay, they have little incentive to put much thought into their responses; there is no penalty for mistakenly overstating or understating their true value.

• Consumers in real markets have to pay real dollars, and so are likely to put more thought into their purchase decisions.

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• The problem can be minimized by setting up a well-controlled survey environment, in which the respondent is reminded of her income and other prices. However, the problem cannot be eliminated entirely.

• Although it is not a perfect methodology, it does at least provide some way of valuing environmental quality.

• Moreover, one could plausibly argue that many consumers do not put a great deal of thought into real purchase decisions, and in that respect, the CVM may not differ too much from real markets.

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3. Information provision

• Survey respondents often have very little prior knowledge of the amenity to be valued.

• How much information about the amenity should be provided to them?

• To the extent that the CVM is attempting to mimic a real market, one might argue that the information provided should be the same that the respondent would have acquired if the amenity had been offered on a real market. In general this will be less than “full information”, because information acquisition is costly. However, the theoretically correct approach to information provision is still an unresolved issue.

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The value of human life• There are enormous ethical difficulties associated with

placing a value on a human life.• Indeed, some would argue that it is “immoral” to place a

value on a life even in the abstract, and that no attempt should be made to calculate dollar values.

• This moralist perspective provides no guidance to decision-making since many policy decisions do involve an implicit (and sometimes explicit) trade-off between devoting resources to saving lives and devoting those resources to some other use (such as education).

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• In other instances (as with the allocation of health care resources) the tradeoff is between one type of life and another. For example, oncology treatments versus AIDS medication.

• To ignore the reality of these tradeoffs due to moral sensitivities is a bad way to make policy. Good policy must recognize these inevitable tradeoffs and attempt to assess relative values. In other words, is a tough decision, but someone has to make it.

Statistical lives versus specific lives• A specific life is the life of an identifiable individual. Placing

a value on a specific life is really beyond the realm of economics; the issue is one of property rights in the extreme: the right (or absence thereof) to life.

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• Consider an example. Suppose an individual (“John Doe”) is trapped in collapsed mineshaft. What is the value of saving him?

• If we assign property rights to the trapped John Doe and those who care about him, then our measure of the value of his life would be his WTA to die, plus the WTA of those who care about him to let him die. Presumably that total WTA is infinite.

• Conversely, if we assign property rights to those who have to pay to save John Doe, then the value of his life would be his WTP to be saved (presumably equal to his lifetime wealth), plus the WTP of those who care about him. This number is finite.

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• Since the assignment of property rights is not the realm of economics, the economist has very little to say about exactly what is the value of the life of John Doe. The question of whether or not to save him must be a political one.

• In most policy problems, the lives saved (or not saved) as a consequence of a policy decision are not ex ante specific lives; that is, before the fact, the lives saved (or not saved) are anonymous. These are statistical lives.

• For example, consider a highway upgrade project that is expected to reduce traffic deaths on the corridor from 4 per 100,000 trips to 3 per 100,000 trips. If there are 1 million trips per year, then on average the upgrade will save 10 people per year. These are statistical lives in the sense that the lives saved are not identifiable individuals.

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The value of a statistical life• The valuation of a statistical life is actually an exercise in

valuing small changes in the risk of death. From these we can extrapolate to the value of a statistical life.

• Suppose a motorist would be willing to pay $20 per year to reduce the risk of death by traffic accident on a particular corridor by 1*10-5 . It would take 1*105 such reductions to reduce the risk of death from one to zero.

• If we assume that the marginal valuation of reduced risk of death is constant (a strong assumption), -- the motorist is willing to pay the same amount for the for the reduction of risk independently of the level of risk--, then each of those 1*105 reductions has a value of $20.

• The implied value of a statistical life saved on a highway upgrade is (1*105)*$20 = $2m

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• There are two important shortcomings with this approach to valuing statistical lives.– First, the marginal valuation of reduced risk of death is

likely to be decreasing (rather than constant). That is, as risk of death approaches zero, the value of further reductions falls.

The assumption of constant marginal valuation could over-estimate or under-estimate the value of a statistical life, depending on the risk base.

– Second, people other than the highway motorist may be willing to pay for a reduction in the risk of death on the highway. This altruistic element to the value of life could be very large.

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• We are still faced with the ambiguity associated with WTP and WTA as the measure of the value.

• It may be that each of the highway travelers in our example has a minimum WTA of $30 to forego the reduction in risk of death. Then each statistical life saved is worth $3m.

• In practice it is common to assume that agents have a right to the status quo. That is, agents have no right to a reduction in the risk of death (so WTP is used to value reductions in the risk), but do have a right to no increase in the risk of death (so WTA is used to value increases).

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Methods for valuing statistical lives

1. Averting behaviour approach - same principle as for environmental valuation

2. Stated preference approach - The stated preference approach can in principle be used to obtain estimates of value for any non-market good

3. Hedonic wage estimates - The market wage for a particular labour type can be decomposed into hedonic prices on the characteristics of the job. One of the key job characteristics is safety, as reflected in risk of death or injury.

• Wages in a risky job have a premium for that risk of death or injury that could be calculated by the hedonic method approach.

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• The main shortcomings of hedonic pricing in labour markets are that the appropriate measure of health risk is perceived risk, but only statistical risk can be measured for the purpose of estimation; and relatively risk neutral workers tend to self-select into risky jobs (a sample selection problem).

• Hedonic pricing models can also be used to estimate the value of a statistical life by decomposing goods into their characteristics, some of which may be related to safety. For example, the price of a car can in principle be decomposed into hedonic prices, and from this a valuation of safety features can be obtained.

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4. Foregone earnings• Courts commonly determine compensation awards for

“wrongful death” using foregone lifetime earnings.• For example, the life of a 30 year old individual with

expected present value lifetime earnings of $1.2m is worth precisely that.

• There is no economic basis for calculating the value of life in this way, except in so far as it is an estimate of that individual’s WTP not to die (since he cannot pay more than the present value of his lifetime earnings).

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