Welfare economics

1. Welfare economics Outline • Expressing changes in human well-being (utility) in monetary terms • Deciding between monetary measures that are equally theoretically sound but differ empirically • Estimating these measures empirically

2. Readings • Hartwick & Olewiler, Ch. 1 (esp. pp. 7-19) • Lesser et al., pp. 282-304

3. Main points • Economists value changes in the quantity or quality of goods by estimating monetary measures that have the same impact on utility • There are two theoretically sound measures, which depend on the reference utility level: compensation (utility without the change), and equivalence (utility with the change) • These can be related to ideas of willingness to pay (WTP) and willingness to accept (WTA) • These measures can differ a lot for public goods, and for private goods they can differ from ordinary consumer surplus • Property rights provide guidance on which to use • For unpriced goods, there are two broad categories of methods for estimating these measures: stated-preference methods and revealed-preference methods

4. Basic concept of valuation • A change in environmental quality (E0 E1) can affect an individual’s utility (U0 U1) • E.g., if environmental quality worsens (E0 >E1), then utility falls (U0 >U1)

5. Basic concept of valuation • A change in environmental quality (E0 E1) can affect an individual’s utility (U0 U1) • E.g., if environmental quality worsens (E0 >E1), then utility falls (U0 >U1) • Economists ask: what monetary change would have the same impact on utility?

6. Basic concept of valuation • A change in environmental quality (E0 E1) can affect an individual’s utility (U0 U1) • E.g., if environmental quality worsens (E0 >E1), then utility falls (U0 >U1) • Economists ask: what monetary change would have the same impact on utility? • Compensation—Assume the negative change occurs. How much money must the individual receive to maintain utility at U0?

7. Basic concept of valuation • A change in environmental quality (E0 E1) can affect an individual’s utility (U0 U1) • E.g., if environmental quality worsens (E0 >E1), then utility falls (U0 >U1) • Economists ask: what monetary change would have the same impact on utility? • Compensation—Assume the negative change occurs. How much money must the individual receive to maintain utility at U0? • Equivalence—Assume the change does not occur. How much money must the individual sacrifice to reduce utility to U1?

8. Willingness to accept and pay • For a worsening of environmental quality: • Compensation: what is the minimum monetary amount the individual is willing to accept (WTA) to allow the deterioration to occur? • Equivalence: what is the maximum monetary amount the individual is willing to pay (WTP) to prevent the deterioration from occurring?

12. In sum: for any environmental change (deterioration or improvement), there are two equally valid conceptual measures of the value of the change (compensation and equivalence)

13. Issues • Are they the same? • If not, which one should we use? • How can we estimate them?

14. Issues • Are they the same? • No • If not, which one should we use? • Depends on property rights • How can we estimate them? • Two classes of methods: stated-preference (“what people say”), revealed-preference (“what people do”)

15. Example: priced good • Suppose an improved water supply system is introduced to a village, thus causing the price of water to decline • What is the benefit to households, expressed in monetary terms?

16. Utility maximization • Households’ utility is a function of consumption of two goods, water (C1) and food (C2): U(C1,C2)

17. Utility maximization • Households’ utility is a function of consumption of two goods, water (C1) and food (C2): U(C1,C2) • Households spend all their income on the two goods: P1C1 + C2 = Y0 • Price of water = P1, price of food = 1

18. Utility maximization • Households’ utility is a function of consumption of two goods, water (C1) and food (C2): U(C1,C2) • Households spend all their income on the two goods: P1C1 + C2 = Y0 • Price of water = P1, price of food = 1 • How do households determine how much of each good to consume?

19. Utility maximization • Households’ utility is a function of consumption of two goods, water (C1) and food (C2): U(C1,C2) • Households spend all their income on the two goods: P1C1 + C2 = Y0 • Price of water = P1, price of food = 1 • How do households determine how much of each good to consume? • Maximize utility, subject to budget constraint

21. Impact of price fall • Price of water falls, from P1 to P1 • Price of food stays the same, equal to 1

22. Impact of price fall • Price of water falls, from P1 to P1 • Price of food stays the same, equal to 1 • What is the impact on amount of water consumed? on utility?

23. Impact of price fall • Price of water falls, from P1 to P1 • Price of food stays the same, equal to 1 • What is the impact on amount of water consumed? on utility? • Water consumption rises from C1 to C1  • Utility rises from U0 to U1 • Equilibrium changes from a to b

25. Compensating measure • What is the maximum the household would be willing to pay (WTP) to obtain the lower water price?

26. Compensating measure • What is the maximum the household would be willing to pay (WTP) to obtain the lower water price? • Y0 – Y1: this decrease in income would reduce utility to U0, even though the household pays the lower price

27. Equivalent measure • What is the minimum the household would be willing to accept (WTA) to forgo the lower water price?

28. Equivalent measure • What is the minimum the household would be willing to accept (WTA) to forgo the lower water price? • Y2 – Y0: this increase in income would raise utility to U0, even though the household pays the higher price

30. WTA vs. WTP • There is no geometric reason why Y2 – Y0 = Y0 – Y1 • In fact: Y2 – Y0> Y0 – Y1

31. WTA vs. WTP • There is no geometric reason why Y2 – Y0 = Y0 – Y1 • In fact: Y2 – Y0> Y0 – Y1 • For an improvement: WTA to forgo > WTP to obtain

32. WTA vs. WTP • There is no geometric reason why Y2 – Y0 = Y0 – Y1 • In fact: Y2 – Y0> Y0 – Y1 • For an improvement: WTA to forgo > WTP to obtain • For a deterioration: WTA to incur > WTP to avoid

33. Magnitude of discrepancy • Is the good private or public?

34. Magnitude of discrepancy • Is the good private or public? • Characteristics of public goods • Nonexclusive: no one can be excluded from “using” the good • Nonrival: one person’s “use” does not reduce the amount available for anyone

35. Magnitude of discrepancy • Is the good private or public? • Characteristics of public goods • Nonexclusive: no one can be excluded from “using” the good • Nonrival: one person’s “use” does not reduce the amount available for anyone • Public goods are usually unpriced • Environmental quality is usually a public good

36. Private (priced, market) goods • Discrepancy is typically small • A few %

37. Private (priced, market) goods • Discrepancy is typically small • A few % • Public (unpriced, nonmarket) goods • Discrepancy is often large • Many times

38. Choosing between WTP and WTA • What is allocation of property rights?

39. Choosing between WTP and WTA • What is allocation of property rights? • If households are entitled to improved water service, WTA is appropriate measure • They should be paid to give it up

40. Choosing between WTP and WTA • What is allocation of property rights? • If households are entitled to improved water service, WTA is appropriate measure • They should be paid to give it up • If not, choose WTP • Households have no right to the service • They should pay to get it

41. Example: ANWR • If ANWR belongs to public, then appropriate question is, “How much would you be WTA to allow oil drilling?” • If ANWR belongs to oil companies, then appropriate question is, “How much would you be WTP to prevent oil drilling?”

42. Marshallian consumer surplus • If we know (or can estimate) the market, or Marshallian, demand curve for water, then we might calculate the benefit as the increase in consumer surplus • Area under the demand curve and above price • Difference between the amount consumers are willing to pay and the amount they actually pay

43. Marshallian consumer surplus • If we know (or can estimate) the market, or Marshallian, demand curve for water, then we might calculate the benefit as the increase in consumer surplus (MCS) • Area under the demand curve and above price • Difference between the amount consumers are willing to pay and the amount they actually pay • How is this linked to the change in utility?

44. Only approximately: WTA > MCS > WTP

45. Valuing unpriced goods • Two broad categories of approaches:

46. Valuing unpriced goods • Two broad categories of approaches: • Stated preference methods: ask people to state how much they are WTP to obtain a hypothetical environmental improvement or how much they are WTA to forgo it

47. Valuing unpriced goods • Two broad categories of approaches: • Stated preference methods: ask people to state how much they are WTP to obtain a hypothetical environmental improvement or how much they are WTA to forgo it • Revealed preference methods: infer WTP, WTA from people’s actual behavior, in particular their expenditure on priced goods that are substitutes or complements for the unpriced good • E.g., incurring travel costs to visit a park, or paying more for a house because it’s in a less polluted area