Valuation of Non-Market Goods

1. Valuation of Non-Market Goods Lecture 5

2. Outline • Project Evaluation • The Need for Values of Non-Market Goods • Cost benefit analysis • Concepts of economic value • Valuation Technique: Contingent Valuation • Survey evidence • Valuation Technique: Inference from Market Behaviour • Travel Costs method • Avertive behavior • Hedonic Pricing

3. Valuation of a Private Project Step 1: Evaluate Monetary Costs and Benefits Year Benefits Costs Net Revenue 0 B0 C0 R0 = B0 - C0 1 B1 C1 R1 = B1 - C1 2 B2 C2 R2 = B2 - C2

4. Step 2: Add them up! R0+ R1+ R2+ R3+ ?????????????????????

5. Step 2: Add them up! You have to remember that money tomorrow is worth less than money today. If I invest £100 today I get back £100 x (1.02) = £102 next year if the interest rate is 2%. Thus £102 in a year’s time is worth £102/1.02 = £100 today Similarly, £R1 in a year’s time is worth £R1 / (1+interest rate) today.

6. Present Discounted Value PDV = R0+ R1+ R2+ R3+ (1+r)1 (1+r)2 (1+r)3

7. Decision Rule Undertake the project if PDV >0 Or NPV>0

8. Basically need to do the same thing for Public Projects but… 1. Many more costs and benefits – need to find them all not just how they affect a company. 2. Its hard to evaluated costs and benefits. Often cannot use prices. Need to find ways of valuing these things. Decision rule is again undertake project if PDV >0!!

9. Example Building a Road Costs: Materials 100m in first year. Labour 15m in first year. Maintenance 10m per year. At a 5% social discount rate 10m per year is (1.05/.05)*10m = 210m Total Discounted costs = 325m = 210+100+15

10. Building a Road Benefits Driving time saved: 500,000 hours per year. Lives Saved: 5 lives per year. Suppose we assess this as being worth y per year. Then the road should go ahead if y*(1.05)/.05>325m!

11. Cost Benefit Analysis This is the name for evaluation techniques for public projects. Examples of non-market price problems: • Improved public health? Costs are well know Benefits (longer lives & better health) • Improved Environmental Quality. Costs ? Benefits? Cannot just ignore things you cannot measure.

12. Where do the Costs and Benefits come from? Personal Use Values • Direct Use (Consumption of outputs) • Indirect Use ( Functional benefits) Flood control, climate etc. • Option values (Future direct and indirect use) Non-Use Values 1. Bequest Values: Value of passing assets on 2. Existence Value: Knowledge of continued existence.

13. Contingent Valuation Direct survey evidence on individual’s stated valuations. How much an individual would be willing to give up to have the specified improvement? Notes: • Similar tools used for market research, but market research can be checked against future behaviour. • Evidence of use and non-use values. • Controversial in US as it was used in Exxon Valdez suit. • NOAA panel has issued guidelines on its use.

14. Contingent Valuation Formats Willingness to pay vs. Willingness to Accept. WTP – What is the most you are willing to pay for 5 days without air pollution? WTA – How much would compensate you for ….? In theory they should be close to equal if they were small amounts. WTA>>>>WTP in practice. WTP seen as more reliable, less prone to protest.

15. Contingent Valuation Formats Open Ended vs. Closed Ended Questions . Open ended: What is the most you would be willing to pay for…? Popular early on and can be easily analysed. Closed ended: If it cost $20 would you be willing to pay this? Respondents find these q’s easier to answer. But requires more complex analysis.

16. Problems in CV studies • Treatment of Outliers – a source of bias • Strategic responses • Protest answers (refusal to answer)

17. Problems in CV studies • Treatment of Outliers – a source of bias • Strategic responses • Protest answers (refusal to answer) • Embedding Problem • Tendency for WTP answers to be similar across different surveys. • Part-whole bias – some people claim this invalidates the whole process

18. Problems in CV studies • Treatment of Outliers – a source of bias • Strategic responses • Protest answers (refusal to answer) • Embedding Problem • Tendency for WTP answers to be similar across different surveys. • Part/whole bias – some people claim this invalidates the whole process • Starting Point Bias • Structure of survey influences all responses and the order of magnitudes in responses. • Yes/No Q’s in ascending vs. descending order influences answers given.

19. Problems in CV studies • Treatment of Outliers – a source of bias • Strategic responses • Protest answers (refusal to answer) • Embedding Problem • Tendency for WTP answers to be similar across different surveys. • Part whole bias – some people claim this invalidates the whole process • Starting Point Bias • Structure of survey influences all responses and the order of magnitudes in responses. • Yes/No Q’s in ascending vs descending order influences answers given. • Instrument Bias • Proposed financing affects peoples’ answers.

20. NOAA Panel on CV Recommendations: • Sample: Statistician recommend size and type to ensure significance of results. • Non-responses High rate makes results unreliable. • Interviews Face to face are best, must test effect of interviewer. • Reporting Data and procedure used must be available to all. • Questionnaire design: Piloted + pre-tested • Cross-tabulations: Cross checks to assess interpretation of data • Elicitation procedure: WTP better than WTA, Yes/No Q’s • Accurate Description of issue • Expenditure implications

21. Inference From Market Behaviour 1. Travel Costs: How much does it cost to travel to Alaska – how many people do it. This gives a lower bound

22. Inference From Market Behaviour 1. Travel Costs: How much does it cost to travel to Alaska – how many people do it. This gives a lower bound. 2. Avertive Behaviour: What costs to people incur to avoid certain risks. This gives an upper bound.

23. Inference From Market Behaviour 1. Travel Costs: How much does it cost to travel to Alaska – how many people do it. This gives a lower bound 2. Avertive Behaviour: What costs to people incur to avoid certain risks. This gives an upper bound. 3. Hedonic Pricing: Use differences in market prices to impute a value for a hidden variable. (Shadow Pricing) Parking near a ball ground. House prices

24. Values for Life and Time Time: Opportunity Cost – if you gave up work then it is your wage. If you gave up leisure – how much would you pay to travel quicker? Life & Mortality: Implicitly this values health too. QALY = Quality-Adjusted Life Years This is a standard accepted measure. You can use CV evidence to assess this – life insurance contracts etc.

25. Examples of Implicit Values of Life Legislation imposes costs and achieves a reduction in lives lost. You can deduce a value of life from these costs: Legislation Implied 2005($) value of Life Childproof Lighters 0.1m Food labeling 0.4m Reflective devices for Lorries 1m Rear seatbelts 4.8m Asbestos 6m Gov Value 7.6m Cattle feed reg’s 185m

26. Time and Risk How should we assess future costs and benefits? • This really has a huge affect on very long-lived projects. • Could look at market rates or how individuals make these trade offs, but generally they vary with the population’s characteristics. • Maybe we should explicitly include future generations welfare in the benefits side? • How rich should we assume they are going to be? • Should we give them equal weight or less weight?

27. Risk? Most common route is to discount at a higher rate,??? Risk premium? Worst Case Scenario?

28. Distributional issues