Chapter 7 Benefit–Cost Analysis: Benefits

Hedonic pricing is feasible and most meaningful when property markets are active—there are a lot of sales, so these markets are competitive. It also requires potential house buyers to perceive the levels of environmental quality (either by sight, smell, or other means) in each neighbourhood they are thinking of living in. As with all techniques, there are some complications and challenges. Housing markets, and hence prices, may be distorted by too few sales (or housing bubbles where there is much speculation). The hedonic technique requires a large amount of data as well as advanced econometric skills to deal with statistical problems that can arise. A common problem is that the environmental variable may not be easily measured. Finally, individuals’ perceptions of environmental quality are subjective and may not translate into property valuation.

Despite these challenges many studies have been done, especially in the United States. These studies calculate WTP in terms of elasticities, the percentage change in house prices for a 1-percent change in ambient air pollution. Numerous types of air pollutants have been studied, with similar results found. For example, for sulphur dioxide pollution, a 1-percent decrease in ambient concentration is associated with a change in house prices of between .06 and .12 percent. For particulate matter the elasticities range from .05 to .22.

Surrogate Markets—Travel-Cost Approach<sup>18

18.</sup> We look only at travel costs as an example of surrogate markets in this chapter. See Chapter 10 for a discussion of green goods.

One of the first approaches that environmental economists used to estimate the demand for environmental amenities is a method of surrogate markets that takes travel costs as a proxy for price. Although we don’t observe people buying units of environmental quality directly, we do observe them travelling to enjoy, for example, recreation experiences in national and provincial parks, swimming and fishing experiences in lakes and streams, wildlife viewing, and so on. Travel is costly; it takes time as well as out-of-pocket travel expenses. These travel costs can be viewed as a proxy for the price that people must pay to experience the environmental amenity. The travel-cost approach can be used to derive a demand function for these amenities.

By getting travel-cost data for a large number of people, we can build up estimates of the aggregate willingness to pay for particular environmental amenities. Of course, we must get information on more than just their travel costs. Families will differ in terms of many factors, not just in terms of their travel costs to this park. They will have different income levels, they will differ in terms of the presence of alternative parks and other recreational experiences available to them, and so on. So, surveys have to collect large amounts of data on many visitors to be able statistically to sort out all these various influences on park visitation rates.

We can use this approach to estimate the benefits of improving the quality of the environment at the visitation site; for example, by improving the water quality at a recreation lake so that fishing is better or more wildlife abound. To do this we must collect information not only on the travel costs of recreators to a single recreation site, but also on the travel costs to many different sites with differing natural characteristics. From this, the analyst can derive a demand curve and use it to compute WTP for improvements in environmental quality by measuring changes in consumer surplus.

The steps in a travel-cost approach are as follows:

1. Sample visitors to various natural sites (parks, recreation, or wilderness areas) where the sites differ in terms of a measurable environmental quality variable. Visitors should be asked about

 where their trip started from (what city, country)

 number of visitors per travelling unit

 travel mode (car, airplane, bus)

 total travel time to site and at site

 frequency of visits, duration of journey

 socio-economic characteristics

 direct travel expenses (transport costs, food, lodging)

 motives for trip, tastes for recreation/sightseeing

2. Use regression techniques to estimate a demand curve for travel to each site. The demand curve shows the total number of visits as the quantity variable, with travel costs to the site as the price variable.

3. Compare the demand curves to see the impact of higher environmental quality at the site. Compute the change in consumer surplus between the sites.

Example: Seaweed contamination of lakes in Ontario.

Consider a hypothetical application. Suppose a travel-cost study has been done on two lakes in Ontario: Ahmic Lake and Eagle Lake. Ahmic Lake has been plagued with excessive plant growth due to the introduction of some non-native species by boaters who have transported exotic seaweeds from the United States on their motors and boat hulls.¹⁹ The seaweed produces a thick mat on the surface of parts of Ahmic Lake, killing native plants and fish. Boating, fishing, and swimming have become less desirable because of the seaweed. Eagle Lake is very close to Ahmic Lake, but because of boating restrictions does not have the exotic seaweed. The province wants to estimate people’s WTP for an improvement in Ahmic Lake’s water quality. It undertakes travel cost surveys at both lakes; the resulting demand curves are shown in Figure 7-6. The demand curve for Eagle Lake lies above that for Ahmic Lake. If these lakes are really very similar except for the difference in water quality, the analyst can interpret the difference in consumer surplus (as shown by the shaded area) between the two lakes as the visitors’ WTP for better water quality. There is no entry fee (price of admission) to these lakes, so no need to compute change in consumer surplus above any price. (Question: How would the computation change if an entry fee existed?) The change in consumer surplus is an annual value because the travel-cost estimation was done for number of trips per year. The consumer surplus estimate can then be used in a benefit–cost study (discounted for future years) of any government program designed to eliminate the offending seaweed.

Demand curves are derived from travel cost surveys done at Eagle and Ahmic Lakes. Eagle Lake has higher water quality than Ahmic Lake because it is not infested with seaweed. The value people place on higher water quality is the difference in their consumer surplus between the two lakes, shown as the shaded area. There are no entry fees for either lake.

The travel-cost method is best used when alternative sites have very similar characteristics (except for environmental quality indicators) and where many repeat trips are made each year. There are a number of difficulties encountered in the travel-cost approach. These include the following.

 Multi-purpose visits: The site may not be the final destination; for example, the purpose of visits may be job- or family-related, with a side trip for recreation. The analyst will have to separate out the costs associated with the recreation site—often a difficult task.

 Utility/disutility from travelling: Travel to the site may be an enjoyable part of the trip or very unpleasant. This means that travel cost estimates will not be a good proxy for willingness to pay. One way to address this is to ask people to indicate on their survey their subjective assessment of their trip to the site.

 Sampling biases in surveys: The biggest problem with the technique is that it samples only users of the site. This may over-estimate or under-estimate willingness to pay for environmental quality improvements. An over-estimate may occur if those not in the sample have no demand for the site whether environmental quality is high or low. If this is the case, they will not be willing to incur any travel costs. An under-estimate may occur if people put a value on a site whether or not they visit it. You may get utility from knowing that Ahmic Lake is weed-free even if you don’t intend to visit it. The idea that elimination of the exotic seaweed will lead to greater biodiversity and watershed protection may have value to people. In developing countries, natural areas can provide many goods and services to local inhabitants (fuel wood, game, food, and medicinal plants. These people may not be counted as travellers to the site, so their benefits are not counted.

Measuring the change in environmental quality is difficult. What one typically wants to measure is the value of changes in environmental quality at a site. The travel-cost approach only proxies willingness to pay for a given level of environmental quality at another site. Given these difficulties, travel costs are of limited general use in benefit–cost analyses.

The direct approach to estimating willingness to pay is called the contingent valuation method (CVM). CVM is based on the simple idea that if you would like to know the willingness to pay of people for some characteristic of their environment, you can simply ask them. The word “simply” is a little extreme because it turns out not to be so simple, even though the basic idea seems straightforward. The method is called “contingent” valuation because it tries to get people to say how they would act if they were placed in certain hypothetical situations. If the good in question were a market good, the analyst can observe people’s actions in the marketplace. But when there are no well-defined markets for something, like an environmental quality characteristic, we can only ask them to tell us how they would choose if they were placed in certain situations; that is, if they were faced with a market for these characteristics.

Contingent value studies have been done to date for a long list of environmental factors: air quality, the value of view-related amenities, the recreational quality of beaches, preservation of wildlife species, congestion in wilderness areas, hunting and fishing experiences, toxic waste disposal, preservation of wild rivers, willingness to avoid ill health due to pollutants, and others.²⁰ CVM has spread into non-environmental areas such as the value of programs for reducing the risks of heart attacks, the value of supermarket price information, and the value of a seniors’ companion program. Over time, the method has been developed and refined to give what we think are reasonably reliable measures of the benefits of a variety of public goods, especially environmental quality.

The steps in a CVM analysis are the following:

We can best appreciate the nature of CVM analysis by looking more closely at the questionnaire design phase.

The CVM questionnaire is designed to get people to think about and reveal their maximum willingness to pay for some feature of the environment. It has three essential components:

 a clear statement of exactly what the environmental feature or amenity is that people are being asked to evaluate.

 a set of questions that will describe the respondent in economically relevant ways, for example income, residential location, age, and use of related goods.

 a question, or set of questions, designed to elicit willingness-to-pay responses from the respondent.

The central purpose of the questionnaire is to elicit from respondents their estimate of what the environmental feature is worth to them. In economic terms this means getting them to reveal the maximum amount they would be willing to pay rather than go without the amenity in question. If they are answering truthfully, the number they reveal should be what they perceive as their net benefits from the amenity. A number of techniques have been used to get at this response. The most obvious is to ask people outright to provide the number with no prompting or probing on the part of the interviewer. Other approaches include using a bidding game, where the interviewer starts with a bid at a low level and progressively increases the value until the user indicates that the limit has been reached. Alternatively, the interviewer could start with a high figure and lower it to find where the respondent’s threshold value is located. Another method is to give the respondents printed response cards with a range of values, then ask the respondents to check off their maximum willingness to pay. A hypothetical example will illustrate a CVM questionnaire and how its results can be used.

The Greater Vancouver Region is attempting to reduce air pollution in the region.²¹ There are a number of possible policies that could be used to accomplish this objective, including encouraging people to take public transit rather than use their personal vehicles, levying fees on motor vehicles by vehicle type or weight, increasing gasoline taxes, putting tolls on roads and bridges, taxing parking facilities in the downtown core of the city, and so on.

The analyst wants to examine people’s WTP between two options: a tax on vehicles based on vehicle weight, and putting a toll on all of Vancouver’s bridges. The analyst designs the questionnaire shown on p. 151.

The analyst surveys 2,000 people and gets the following results. The mean WTP for a vehicle levy is $5 per 100 kg. Passenger vehicles (cars and light trucks) range from 1,500 to 2,500 kilograms in weight. The analyst examines the ownership of vehicles in British Columbia by type, obtains their weights from the manufacturer, and computes the aggregate WTP per year for the vehicle levy. It is $15-million.

The mean WTP for bridge tolls is $1. The analyst obtains traffic survey data from the TransLink engineering department and calculates that there average 100,000 trips across greater Vancouver bridges each day (weekdays have more trips than weekends). Revenue will thus be $100,000 per day or $36.5-million per year.

The analyst reports that the people surveyed are much more willing to pay for bridge tolls than vehicle levies. These numbers can then be used to help design effective policies for the region.

Critique of Contingent Valuation Methods

The major strength of CVM is flexibility. CVM can be designed for just about any situation and is thus applicable to a wide range of environmental amenities, not just those that can somehow be measured in conjunction with some marketable good. Virtually anything that can be made comprehensible to respondents can be studied with this technique. It is used worldwide to value environmental benefits. The major weaknesses of CVM are outlined in the bullet list below.

 Hypothetical character. When people buy a marketed good, they actually have to hand over the cash to the seller or they won’t get the good. It’s a real situation, and if the wrong choices are made people suffer real consequences. But in a CVM questionnaire the same real-world implications are not present. People face a hypothetical situation to which they may give hypothetical responses not governed by the discipline of a real marketplace. In thinking about this, two questions arise. First, will people know enough about their real preferences to be able to give valid responses? Second, even if they know their preferences, will they have incentives to misrepresent them to the investigator?

Everyone develops experience buying some things, but not others, on the market. In 17th-century New England, people were used to buying and selling pews in the church. In some countries, getting a building or parking permit from public officials requires monetary bribes. In contemporary society there are going prices for cantaloupes and cars. When people face market prices for a good or service over a period of time, they have time to learn about their values, adjust their purchases, and settle on a willingness to pay that accurately represents their preferences. But when asked to place a monetary value on something that does not normally carry a price, it may be much more difficult to state one’s true willingness to pay. What would you be willing to pay for 10 more beautiful sunsets per year? If you are not used to paying for environmental goods—and we are not—you may have no idea what sort of price you’d put on that good.

CVM Questionnaire

Setting the Scenario

The Greater Vancouver Region has a serious air-pollution problem. Every year, there are at least 15 days on which air-quality standards fall below the national guidelines set for smog. For at least 50 days per year smog is present, although within the national guidelines. Smog contributes to breathing difficulties in susceptible people, is especially injurious to young children and the elderly, contributes to lower crop yields in the Fraser Valley, and damages materials, especially plastic and rubber products. Scientists do not know the minimum amount of smog that is safe for all people. TransLink (the transportation authority for the Greater Vancouver Region) is considering a number of policies to help reduce the number of smog days. We would appreciate your assistance in answering a few questions about two of the policies.

The proposal is to levy an annual tax based on the weight of the vehicle. Vehicle weight is a proxy for tonnes of air pollutants discharged into the atmosphere. On average, heavier vehicles produce more pollution than lighter vehicles. The tax will be per 100 kilograms of vehicle weight. The objectives of this policy are to induce people to purchase lighter and more fuel-efficient cars and to make those who contribute the most to air pollution pay their fair share.

The proposal is to introduce electronic tolling of all bridges. The toll will be paid only on the inbound trip to Vancouver. Most commuter traffic to the city must go over a bridge. The toll will induce people to carpool, take public transit, and change their residence to be closer to their jobs.

1. Vehicle tax

Which amount would you be willing to pay each year for each 100 kg of vehicle weight (put an X beside the number you feel best represents your preferences).

 $ 0 __________

 $ 5 __________

$10 __________

$20 __________

$30 __________

$50 __________

Over $50 __________

2. Bridge tolls

Would you be willing to pay $ ______* in a bridge toll per trip to cross any bridge in Greater Vancouver?

Yes No (circle one)

*The analyst will pick a number of different values to be inserted into the blank. Respondents will get different numbers. These values will cover what the analyst thinks is a reasonable range of options.

 Incentives to misstate true willingness to pay. Environmental quality characteristics are public goods, as we saw in Chapter 4. People can be expected to understate their preferences for these kinds of goods when they expect that their answers will be used to establish payment schedules for the goods. But in CVM studies, there is no threat that responses could be used, for example, to set taxes to pay for the item being evaluated. So, perhaps, this source of bias is unlikely. The opposite bias may be more likely: people may be led to give an inflated estimate of their willingness to pay—hoping, perhaps, that others will do the same thing, realizing that their share of the cost of making the item available will, in any case, be very small.

 Practical problems. These involve possible biases the analyst can introduce into the survey (e.g., choice of payment vehicle, range of WTP options, setting the scenario, etc.), small sample sizes, self-selection problems in surveying (only those who really “care” about the environment will answer), and more. Economists are now using other techniques to help validate CVM studies. For example, they examine situations where people reveal their preferences through behaviour (e.g., purchasing fishing licences). This is called a stated preference approach.

While there are many critics of CVM, it continues to be a widely used and adaptable tool for benefit estimation.