Chapter Six

Valuation and cost-benefit analysis of the environmental

resources
Valuation of the Environment
• Environmental valuation is a very active and rapidly expanding field. it is also
somewhat controversial. Many-non economist regard putting price on
environmental services as totally misconceived.
• While most economist accept the desirability of environmental valuation, there is a
disagreement over the prospect for actually doing it in a satisfactory way.
• The origin and still the principal motivation for environmental valuation is its
impact to be included in cost-benefit analysis.
• Impacts can be favorable or unfavorable.
• Taking the latter first, suppose that there is proposed some development of a mine
or a tourist resort-in a wilderness area.
• The argument for valuing the services provided by the wilderness area, which
would be reduced and perhaps totally lost,
 Dimension of Value
• The total economic value of natural and environmental resources
(TEV)can be divided in to two
• TEV = Use Value(UV) + Non Use Value(NUV)
• Use value - is the value we attach for a good because we use it
currently or we expect to use it in the future
• Non use value - is the value that we attach to a resource even if we don't
use them
• Use Value = Direct Use Value + Indirect Use Value + Option Value
• Direct use value is the value that arise from direct use of a resource
• e.g. forest: the direct use value of a forest is the money we collect by selling trees
• Indirect use value is a value that we get it indirectly
• e.g.: forests can have an indirect benefit - they conserve soil
• Option value is a value we attach to resource expecting to use it in the
future, so it is attached to the future benefit.
• E.g. National parks: since we may have a plan to visits in the future,
we may oppose the destruction of national parks and pay some
money for the conservation of it.
 Cont…
• There are two types of non-use value
1. Bequest value
2. Existence value
• Bequest value: since we are paying for its conservation for future
generation
• Existence Value: It is a value that people attach because resources
exists even if they don't use it.
• This is mostly found in developed countries, they pay for instance for
African elephants so that they are preserved.
 Valuation Method
[Link] Contingent Valuation Method(CVM)
• The CVM works by directly asking from sample of consumers for
their willingness to pay(WTP) or willingness to accept (WTA) for a
change in the level of environmental service flow in a carefully
structured hypothetical market.
• Basically it is a survey method, we have to prepare a questioner to
ask respondents the amount of their willingness to pay or willingness
to accept.
• We ask people how much they are willing to pay for a certain
resource (state/quality) of environmental change and if the question is
WTA, ask how much compensation the respondent accept for a
certain project to be established in his/her plot.
• In WTP we take the maximum value and in WTA we take the
minimum value of the sample.
 Cont…
• Contingent valuation method (CVM) is a questioner based valuation
technique where by willingness to pay(WTP) or willingness to
accept(WTA) are directly obtained from the respondents with
respect to a specific good.
• As such a technique is applicable in all circumstances, CVM has mainly
been used with respect to non-market goods and in particular for
environmental goods/resources.
• In this context, a hypothetical market for a non-marketed good is
defined and the respondent is required to specify their WTP's or
WTA's.
• For example, a CVM study could examine the ex-ante value
obtained from project reducing air pollution for a specific area;
• the respondent in such a study would be asked how much they would
be willing to pay for the reduction in air pollution.
 Cont…
• A CVM study involves interview with the participant which can be
undertaken face-to-face, mail or telephone based.
• The typical CVM starts with informing the participant about the
environmental resource in focus (e.g. air quality) along with information
about the proposed change in the environmental resource and the
procedure to be used to finance the proposed change in the environmental
resource.
• This information is provided in order to familiarize the respondents about
the change to be evaluated such that the possibility for valid and reliable
answers is enhanced.
• On the basis of this information, the respondents are asked about their
willingness to pay for the proposed environmental change (improvement or
reduction).
• Usually a series of follow up questions are included in order to confirm the
given WTP or WTA as well as provision of socio-economic background
information (gender, age, employment, income...).
 Cont…
• This background information can be utilized to examine their relationship to WTP, e.g.
the extent to which willingness to pay depends on income could be tested.
• The questions concerning the willingness to pay can be structured in different ways,
where the amine forms include
• Open ended
• dichotomous choice
• bidding game
• payment card based form
• Open ended base WTP would be formulated as, what is the maximum you would be
willing to pay for (for the specific change in the environmental good)?
• Dichotomies choice formats involves two questions, where the first one concerns
whether or not there is a willingness to pay for a specific change in the environmental
good, this question should be answered with yes or no, if yes then a question is asked
concerning whether the WTP is equal to a specified amount.
• For a bidding game the participants are asked whether they are willing to pay a
specified amount. if yes then another question is asked about willingness to pay a
specified amount higher than the previous amount. This process continues until no
answer is obtained.
• Participants in payment card based form of CVM are shown a card in which a range
of payment is illustrated. The participants should then identify the payment on the card
which corresponds to their willingness to pay.
 Cont…
• The CVM is extremely flexible and can be used to value most any environmental
asset.
• Further, CVM and other none market methods are required accurately to capture
non-use value.
• The primary disadvantage of CVM is that it may not yield accurate result due to
biases that may be introduced in the survey or through respondents behavior.
• These bias include strategic bias, where the respondent belief that his answer may
be used to affect government policy leads him to intentionally understate or
overstate his willingness to pay to achieve the desired policy result.
• The payment vehicle cited in the questioner may also result in a bias due to an
aversion to certain tax or fees.
• The availability of information or misperception concerning environmental quality
can also result in bias.
• To minimize bias analysis must be extremely careful in how they design survey
and conduct interview.
• An extensive body of economic literature address the source of inaccuracy in
CVM studies and development of methods to deal with specific issues of survey
design and implementation.
 Cont…
[Link] Hedonic Pricing Method (HPM)
• The hedonic pricing method of environmental valuation use surrogate
markets for placing a value on environmental quality.
• The real estate market is the most commonly used surrogate/replacement
in hedonic pricing of environmental values.
• Air, water and noise pollution have a direct impact on property values.
• By comparing properties with otherwise similar characteristics or by
examining the price of property over time as environmental conditions
change and correcting for all non-environmental factors, information in the
housing market can be used to estimate peoples willingness to pay for
environmental quality
• HPM seeks to find a relationship between the levels of environmental
service and the prices of marketed goods
• Price of housing = f(structural characteristics of a house, neighbor
characteristics, environmental quality,..etc.)
• where structural characteristics include number of rooms, existence of
bathroom, etc. and neighborhood characteristics comprises of features
such as the existence of clinic near the house, police station, school,
road.....etc.
 Cont…
• Using such relationship we can come up with the indirect
measurement for the benefit of improvement in environmental quality.
• Other beings constant in a city, the price of housing in a polluted and
non polluted areas is different.
• So, if this is the case, we can come up with the benefit of
improvement in environmental quality (Q).
• So we can compute ɖp/ɖQ to get the change in the price of house
because of environmental quality.
• The contingent valuation method is conducted in many developing
countries like Ethiopia.
• But the hedonic pricing method typically employed in developed
countries because of lack of data, but it is employed in few developing
countries
 Cont…
[Link] Travel Cost Method
• is employed to measure the value of recreational site by surveying travelers on
the economic cost they incur.
• (e.g. time and out of pocket travel expenses) when visiting the site from some
distance away.
• These expenses are considered an indicator of society's willingness to pay for
access to the recreational benefit provided by the site.
• To better understand the travel cost method, consider the case of coastal
pollution resulting in closure of the recreational beach.
• To estimate the associated lost value of recreational benefit,
• the first step of a travel cost analysis would be to survey individual about the
number of trips and expenses incurred during each trip to the beach.
• The second step is to examine the relationship between the expenses incurred
and the total number of trips taken, thus the travel cost method enables the
analysis to develop an implicit demand curve for the recreational benefit offered
by the site per person, which can then be multiplied by the number of people in
each cost categories.
• In turn the demand curve can be used to measure consumer surplus and
monitories the direct use value of the site.
 Cont…
• The travel cost method can be used to measure
not only the elimination of a site but also
the impact of access restriction and change in environmental quality.
• The travel cost method however is limited in
• applicability and capture only direct recreational benefit and only when there are
measurable travel costs to examine.
• the travel cost method does not measure:
• non-use and intrinsic value or other source of value, such as commercial value.
• It is typically used to estimate the site typically national parks.
• In this method, the costs for consuming the service of the environmental asset
are used as a proxy/replacement.
• It is also a method used on survey (we prepare a questioner for tourists who visit
the area and relate it to the different characteristics of tourists).
• So, the method is to relate the number of visit to a site and the cost of travel
• Number of visit a person make to a certain site = f(travel cost of
the site) i.e. visit=f(travel cost)
 Cont…
4. The Production Function Approach
• this method uses estimation of production function to calculate the
estimates of agricultural products.
Y = f(L,K, soil fertility...etc.)
• It helps to see how much output changes to a change in the factor
e.g. soil fertility reduction
• If we represent soil fertility reduction by Q, then
• the measurement of marginal product (MP) is ∆Y/∆Q is the
change in output due to change in soil fertility and
• multiplying the change in marginal product with the market price
of the product (Pyx∆Y/∆Q), we can get the value of output we lost
because of change in environmental quality.
• The production function can be broadened to include other factors
like air quality on the health of people etc. in addition to agricultural
and industrial output factors.
 Environmental analysis
• Investment is a vehicle for economic growth. Because of this government
always strive to attract investors to put money in their land.
• However, investment have either positive or negative effect on the
environment.
• Hence, policy makers have to consider the trade off between economic
growth and the environment in their decision for project appraisal.
• In the mainstream economics in general and in environmental economics in
particular we do have three methods to do environmental analysis
i. Cost-Benefit Analysis
• mean the social appraisal of investment project.
• attempts to appraise investment project in ways that correct for market
failure.
• If there were no market failure, social and commercial criteria would
coincide
 Cont…
• Cost -benefit analysis relates to the environment in two main ways.
• First many projects intended to yield benefit in the form of :
• the provision of goods and services have environmental impact-consider
damming a river in a wilderness area to generate electricity.
• To the extent that such impacts are externality there is market failure and
they do not show up in privet, commercial appraisal.
• The cost of such projects are understated in ordinary financial appraisal.
• Secondly there are projects, the main purpose of which is to:
• have beneficial environmental impact-consider the construction of sewage
treatment plant.
• the impact typically involve external effect and so would not appear in an
ordinary financial appraisal.
 Cont…
• So that they are considered along with and in the same way as
the ordinary inputs (labor, capital, raw material) to output (goods
and/or services) from the project
• Algebraically, cost benefit analysis is calculated as
𝑡=𝑇 𝑡=𝑇
NBt Bt−Ct
NPV= ෍ =෍
𝑡=0 (1+r)t 𝑡=0 (1+r)t
NBt= the net benefit of the projct at time t
Ct=cost of the project at time t
Bt= benefit of the project at time t
• The project should go ahead if NPV>0
 Cont…
ii. Cost Effective Analysis
• It is difficult to measure benefit so the option is to measure only costs and try to
select the one with less cost.
• In short, cost minimization is used when we do not have to compute cost or
difficult to compute cost
• What can be done to guide policy when the requisite valuation for benefit-cost
analysis is either unavailable or not sufficiently reliable?
• Without a good measure of benefits, making an efficient choice is no longer
possible.
• In such cases it frequently is possible, however to set a policy target on some
other basis other than a strict comparison of benefits and costs.
• One example is pollution control.
• What level of pollution should be established as the maximum acceptable level?
• In many countries studies of the effect of a particular pollutant on human health
have been used as the basis for establishing that pollutant's maximum acceptable
concentration.
• Researchers attempt to find a threshold level below which no damage seems to
occur. That threshold is then further lower to provide a margin of safety that
becomes the pollution target.
 Cont…
• Cost-effective analysis frequently involves an optimization procedure.
• An optimization procedure in this context is merely a systematic method
for finding the lowest cost means of accomplishing the objective.
• This procedure does not in general produce an efficient allocation because
the predetermined objective may not be efficient.
• All efficient policies are cost effective but not all cost effective policies are
efficient.
iii. Environmental Impact Assessment/Analysis(EIA)
• What can be done when information needed to perform a benefit-cost
analysis or a cost effective analysis is not available?
• The analytical technique designed to deal with this problem is called
environmental impact analysis.
• An environmental impact analysis attempts to quantify the consequence of
various actions on the environment.
 Cont…
• In contract to Cost-benefit analysis, EIA makes no attempt to convert
all these consequences in to one dimension measure such as
birr/dollar to ensure comparability.
• In contrast to cost effective analysis, environmental impact analysis
place a large amount of relatively undigested information at the
disposal of policy makers.
• It is up to the policy makers to assess the importance of the various
consequence on the environment and act accordingly.
• Hence, policy makers evaluate the different impacts of a project on
the environment.
• Example, a project to cut tree-the impact may increase soil
degradation.
• This analysis is inter-disciplinary. It has to be done by different
disciplines.
 cont….

•End of the Chapter

•Thank u !!