Environmental Economics II

Dr. Anil Markandya

hssam@bath.ac.uk 01225 386954
Room 3E 4.31b

2
Valuing the Environment
Environmental Valuation
Enable environmental impacts to be
included in Cost-Benefit-Analysis (CBA)
To take account of environmental damage
in measuring economic performance
To take account of environmental benefits
of public programs
3
Categories of environmental
benefits
Use Value (UV)
Existence Value (EV)
Option Value (OV)(Option Price = Expected Use
Value + OV.
Quasi Option Value (QOV)
Bequest Value (BV)
Total Economic Value (TEV)
TEV = UV+EV+OV+QOV+BV

4
Non-market valuation techniques
Stated Preferences
Contingent Valuation
Choice Modelling
Revealed Preferences
Travel Cost Model
Hedonic Pricing
5
The Contingent Valuation Method
Stated preference technique
Questionnaire based
Direct method
Valuation of a hypothetical scenario
- It is called contingent valuation because the
valuation is contingent on the hypothetical
scenario put to respondents
Non Use Values + Use Values
Willingness To Pay (WTP) question


6
Stated Preference Techniques: CVM
An interview is used to create the hypothetical market within these questions are
asked. The hypothetical market comprises two key parts:
a statement of the proposed change; and
an institutional mechanism through which the proposed change is to be
provided/avoided and financed.
The challenge in conducting a CV is to make the market as realistic as possible.
The process of directly questioning a sample group to ascertain their valuation of a
change can be divided into six stages. These are (each with a number of steps):
definition of survey objectives;
design of the questionnaire;
surveying the sample population;
creating a database and performing an exploratory data analysis;
estimating WTP values; and
reporting the survey results.
7
CVM: Stage 1 - Project Definition - Theoretical Model
CV study should begin with a basic theoretical model: two purposes:
Identifies the information required from questionnaire
Generates predictions allowing results to be checked
Number of sources of information that can be used to construct the
model, including:
predictions of economic theory and existing literature,
discussion/meetings with focus groups/affected parties.
Participants discuss understanding of the context of the good/service in
question, the good/service itself, its value, who should provide it,
how it should be paid for, whether they would contribute, etc.
The information from the focus groups is particularly valuable in
designing the CV survey.
8
CVM: Stage 1 - Project Definition - Sample Design
For a site-specific resource, the sample may be drawn from:
Visitors to the site (on-site sample)
does not elicit information on the WTP of non-users;
interviews must be kept short; procedure is needed to select
among visitors to a site
Households within a certain radius of the site (off-site sample)
geographical boundaries need to be defined; a larger
sample required, many households may not visit the
site
It is also important to carefully select the size of the sample:
A larger means more confidence that the sample mean
WTP/WTA is a reliable estimate of the true mean
WTP/WTA. (Balance precision and cost)
9
CVM: Stage 2 - Questionnaire Design - Background Questions
General background: Questions on general characteristics of the
respondents information for checking the validity of the valuation
results
Respondents tastes and socio-economic characteristics (is the
sample representative?). Personal details - should , come at the end of
the questionnaire
Respondents knowledge of the commodity in question, e.g.
background questions concerning the respondents visits to a recreation
site should cover such issues as:
attitudes towards environmental issues; proximity of their
home to the site; frequency of visits; duration of trip;
reason for visit, etc.
These questions should be asked at the beginning of the interview as
they are relatively straightforward to answer, and will help to build-up
the respondents confidence.
10
CVM: Stage 2 - Questionnaire Design - Preparation Questions
To avoid bias, interviewer must make sure the respondent is aware of:
budget constraints (you cannot spend more than you have!)
their right to refuse to pay for the good
If the event of a negative response, the reason must be recorded
a zero valuation is implied if:
the respondent may not be able to pay anything; or
the respondent may not be willing to pay anything.
a protest bid is implied if:
the respondent may find it too difficult to establish a monetary
valuation;
the respondent may disapprove of the concept of expressing
environmental resources in monetary terms; or may be hostile
towards the institutional context.
11
Format of WTP question
Open Ended:
How much are you willing to pay for public good A?

Bidding Game:
1) Are you willing to pay X for public good A?
2a) If Yes to (1), Are you willing to pay Y for public good A? (Y>X)
3a) If Yes (2a), Are you willing to pay Z for public good A? (Z>Y).
4a) if Yes to (3a)
If No to (Na), WTP questions stop.
2b) If No to (1), Are you willing to pay T for public good A? (T<X)


Payment Cards:
choose a WTP point estimate from a list of values

12
Dichotomous or Discrete Choice CV (Referendum format):
Are you willing to pay X for public good A? => STOP

Dichotomous or Discrete Choice CV with follow-up:
1) Are you willing to pay X for public good A?
2a) If Yes to 1, Are you willing to pay Y for public good A? (Y>X)
=> STOP
2b) If No to 1, Are you willing to pay Z for public good A? (Z<X)
=> STOP

13
Respondent simply asked to state maximum WTP for a specific
environmental change
The advantages of the open ended:
Quick and easy to administer and analyse;
Can be performed with a smaller sample size;
Avoids anchoring effects - respondents influenced by
suggested starting value.
Main drawbacks:
Makes strategic bias, more likely
The respondent may need a reference point to bound value
judgement
Respondent must be familiar with the affected commodity in
question.
CVM: Stage 2 - Survey Design - Open-ended Elicitation Format






14
range of values for the max WTP of individuals pre-set.
sample of respondents is divided into sub-samples.
value within the pre-set range is assigned to each sub-sample (the
source of he so-called anchoring effect).
Each respondent asked whether WTP assigned value for proposed
change
Answer not the max WTP only consent or refusal to pay a given amount
Random utility theory (logit model) are required to estimate the
respondents mean and median WTP values. Requires large sample.
No Incentive to engage in strategic behaviour.
Easier to convey decision rule - >50% say yes change provided.
Realistic individuals typically make decisions faced with fixed
prices.
CVM: Stage 2 - Questionnaire Design - Dichotomous Choice or
Referendum Elicitation Format




15
CVM: Stage 2 - Survey Design - DC Format: An Example
After describing their illness, the respondent was given the following valuation
question:
We are now going to ask you a hypothetical question. Suppose you were told that,
within the next few days, you would experience a recurrence of the illness episode
that you have just described for us. What would it be worth to you that is, how
much would you pay to avoid the illness episode entirely?
Remember that you are paying to eliminate all of your pain and suffering, your
medical expenditure, the time you spent visiting the doctor or clinic, your missed
work, leisure or daily activities.
Bear in mind if you pay to completely avoid being ill this time, you have to give up
some other use of this money. For example, you may reduce your expenditures for
entertainment or education.
Would you pay dollars to avoid being sick at all?
[I f NO] Would you pay dollars to avoid being sick at all?
[I f YES] Would you pay dollars to avoid being sick at all?
300
100
1,000
16
suppose you were told that within the next few days you would have a
recurrence of the respiratory condition that you have just described.
Would you be willing-to-pay $10 to avoid the illness episode entirely?
1. NO, I would not be willing-to-pay $10.
2. YES, I would be willing-to-pay $10.
If NO, would you be willing-to-pay $
1.a $9 If YES, then stop; if NO, then go to 1.b
1.b $8 If YES, then stop; if NO, then go to 1.c
1.c $7 If YES, then stop; if NO, then go to 1.d
+ + +
1.k $0.25 If YES, then stop; if NO, then explain why

CVM: Stage 2 - Questionnaire Design - Iterative Bidding
Elicitation Format
17
NOAA Panel Guidelines
Conservative design => better to underestimate WTP
WTP, rather than Willingness to Accept (WTA)
Referendum format (i.e. Yes/No Questions)
Accurate description of the good/scenario => use of focus groups
and pretest of the survey instrument
Reminder of substitute commodities
Yes/No follow ups
Checks on understanding and acceptance
Cross tabulations
Sample size circa 500 is a minimum.
18
Other important aspects for questionnaire
development (1)
Mail / In Person / On the Phone interview
In person => costly, interviewer bias, time consuming,
more accurate, better option if it is difficult to explain the
scenario (need pictures), only users if on site
Mail => low response rate, sampling bias => who takes
the survey? Those who are interested in the topic?,
limited information, relatively inexpensive
Telephone => relatively inexpensive, limited information,
not accurate, response rate, developing countries?
Mail + Telephone
Internet
Computer based instruments
19
Other important aspects for questionnaire
development (2)
Introduction
Warm-up questions
Questions on the knowledge of the problem / experience with the
environmental good => USE values, etc
Description of the scenario
WTP question(s)
Debriefing questions => why did you vote in favour or against the
program
- Use and Non-Use values investigation => did you vote yes,
because (a) you will visit the national park, (b) even if you will never
visit the national park, you want future generations to visit the park,
etc.
Attitudinal questions
Socio demographic questions. Ask questions on Income at the
end of the questionnaire!!! => we dont want to irritate the
respondent


20
Other important aspects for questionnaire
development (3)
Identify protest respondents after the WTP questions (ask why the
respondent voted YY, NN, NY, YN)
Analyze the data for the full sample of respondents, then delete
those respondents that show protest behaviours
Income. Try to get an answer to the income question. In developing
countries, sometimes researchers (Cropper, Alberini) ask a list of
expenditures. If you have no information on income from some
respondents, dont loose those observations. Add a dummy equal to
1 for those that did not answer the income question, and 0
otherwise. Set equal to 0 the income of those respondents that did
not answer the income question. In your regression the coefficient of
the dummy for those that did not answer the income question tells if
they are statistically different from those that reported income. In this
way you dont loose the observations!
Clearly define the population of interest
Consider your budget constraint
Make sure that your referendum question avoids free rider
behaviours!
21
Payment vehicle
Whose welfare are we interested in?
=> Important for sampling plan
TAX => One time Tax is incentive compatible
How do we choose the tax level? Focus groups, previous
research, pretest, optimal bidding design literature, cost of the
public program



Percentage of YES responses to the bid
0
20
40
60
80
100
5 15 20 40 60 80 100 150
TAX
P
e
r
c
e
n
t
a
g
e

o
f

Y
E
S
If Data are not as
Shown, use Non-
Parameteric
Methods
22
CVM: Stage 2 - Questionnaire Design - Payment Vehicle
Valuation question needs a realistic institutional context - usually an
appropriate payment (or bid) vehicle (instrument). The payment vehicle is
the mechanism through which the WTP/WTA values are to be
raised/distributed.
Key considerations when selecting a payment vehicle are:
familiarity does the respondent understand the payment vehicle?
credibility does the payment vehicle represent a realistic situation?
empathy is the respondent favourably or unfavourably disposed
towards the recipient of the funds?
feasibility is the recipient of the funds capable of delivering the
improvement?
universality would all the respondents be affected by the payment
vehicle?
23
WTP and WTA
The goal of contingent valuation is to measure the compensating or
equivalent variation for the good in question. Both compensating
and equivalent variation can be elicited by asking a person to report
a willingness to pay amount. For instance, the person may be asked
to report his WTP to obtain the good, or to avoid the loss of the
good. Formally, WTP is defined as the amount that must be taken
away from the persons income while keeping his utility constant:


where V denotes the indirect utility function, y is income, p is a
vector of prices faced by the individual, and q
0
and q
1
are the
alternative levels of the good or quality indexes (with q
1
>q
0
,
indicating that q
1
refers to improved environmental quality). Z is a
vector of individual characteristics.

(Compensating variation is the appropriate measure when the
person must purchase the good, such as an improvement in
environmental quality. Equivalent variation is appropriate if the
person faces a potential loss of the good, as he would if a proposed
policy results in the deterioration of environmental quality.)
) ; , , ( ) ; , , (
0 1
Z Z q p y V q p WTP y V = 1)
24
Willingness to accept (WTA) is defined as the amount of money
that must be given to an individual experiencing a deterioration in
environmental quality to keep his utility constant:


Where q
2
indicates a deterioration in quality compared to the status
quo, q
0
.
In equations (1) and (2), utility is allowed to depend on a vector of
individual characteristics influencing the tradeoff that the individual is
prepared to make between income and environmental quality. An
important consequence of equations (1) and (2) is that WTP or WTA
should, therefore, depend on (i) the initial and final level of the good
in question; (ii) respondent income; (iii) all prices faced by the
respondent, including those of substitute goods or activities; and (iv)
other respondent characteristics.
Internal validity of the WTP responses can be checked by
regressing WTP on variables (i)-(iv), and showing that WTP
correlates in predictable ways with socio-economic variables.

) ; , , ( ) ; , , (
0 2
Z Z q p y V q p WTA y V = +
2)
25
Dichotomous-Choice Contingent Valuation
When dichotomous choice questions are used, the researcher does
not observe WTP directly: at best, he can infer that the respondents
WTP amount is greater than the bid value (if the respondent is in
favor of the program) or less than the bid amount (if the respondent
votes against the plan), and form broad intervals around the
respondents WTP. To estimate the usual welfare statistics, it is
necessary to fit binary data models.
The simplest such models assume that an individuals response to
the WTP question is motivated by an underlying, and unobserved,
WTP amount, which is normally (logistically) distributed. Formally,
let WTP* be the unobserved WTP:

Where is both mean and median WTP, c is a zero-mean normal
(logistic) error with mean zero. The model is completed by
specifying the mapping from the latent variable to the observables:
4) WTP
i
=1 iff WTP
i
*>B and WTP
i
=0 iff WTP
i
*B
where B is the bid that was assigned to respondent i, WTP = 1
means that the response is a yes, and WTP = 0 means that the
response to the payment question is a no.
i i
WTP c + =
*
3)
26
Because we observe discrete outcomes, we must derive the
probabilities of yes and no responses. When attention is
restricted to a normal latent WTP, the probability of a yes response
is, therefore:

Because c/o is a standard normal variate,


where u() is the standard normal cdf. If we define =/ and
=-1/, the probability of a yes response can be rewritten as:
6)
Equation (6) is the contribution to the likelihood by a yes
observation (or a one) in a probit model with the intercept and one
regressorthe bid. As long as | is identified and estimablewhich
requires that the bid amount be varied to the respondents in the
survey, so that it becomes a legitimate regressor in the probit
modelmean/median WTP is estimated as:
7)

) Pr( ) | 1 Pr( ) | Pr(
*
i i i i i
B WTP B WTP B yes > = = =
|
.
|

\
|
> = >
o

o o
c
c
i i
i i
B
B Pr ) Pr(
=
5)
|
.
|

\
|
+ u =
(

|
.
|

\
|
u
o

o o

o
i i
B B
1
) ( ) | Pr(
i i
B B yes + u = | o
| o

/ =
27
while the standard deviation of WTP is estimated as:
8)
The same formulae produce estimates of mean/median WTP and of
the scale parameter of WTP from the logit coefficient if WTP is
assumed to be a logistic variate.
A standard probit routine will automatically produce standard errors
for and , but not for and .
To obtain the covariance matrix of and , you can use the delta
method (Cameron, 1991).
First calculate the covariance matrix of and produced by the
probit routine V:
9)

where , and , with |(-) the
standard normal probability density function (pdf).
Next, compute the matrix G :
10) G =

| o

/ 1 =

o

|


o

o

|
V =

`
)
=

w z
B
B B
i
i
i i i
n
( )
1
2
1
1
z B
i i
= +

o | w z z z z
i i i i
( ) ( ) { ( )[ ( )]} = |
2
1 u u

(
(
1 0
1
2 2
/

/

/

|
o | |
28
Finally calculate the matrix product V
1
=GVG, with V
1
the covariance
matrix of and . Nb This can be done in LIMDEP.
If WTP is assumed to be a logistic variate, the steps required for the
delta method are the same, except that w(z) in expression (9) is
equal to {exp(z
i
) / [1 + exp(z
i
)]}.
in some studies, depending on the frequencies of the yes and no
responses to the payment questions, formula (7) produces a
negative mean/median WTP figure.
Perhaps a better way to avoid this problem is to work with a WTP
distribution that is defined only over the positive semi-axis. The
Weibull and the lognormal are examples of such distributions.
The cdf for a Weibull with parameters u (u>0) and o is
Mean WTP is where I(-) is the gamma function

Median WTP is
The log likelihood function becomes:
11)
where F is the cdf of the Weibull

o
F y e
y
( )
( / )
=

1
o
u
|
.
|

\
|
+ I 1
1
u
o
u
o
/ 1
)] 5 . 0 ln( [
| |

=
+
n
i
i i i i
B F WTP B F WTP
1
) , ; ( log ) 1 ( )) , ; ( 1 log( o u o u
29
median WTP is generally regarded as a robust, and conservative,
welfare statistic associated with the good or proposed policy. It is
usually estimated more precisely than mean WTP, and is interpreted
as the value at which 50% of the respondents would vote in support
of the program, and hence the cost at which the majority of the
population would be in support of it.

30
The Double Bounded Dichotomous Choice model
Double bounded models increase efficiency in three ways:
YN and NY answers bound WTP
NN and YY answers further constrain WTP
The number of observation is increased
The log likelihood function becomes:



where WTP
H
and WTP
L
are the lower and upper bound of the interval
around WTP defined above, F() is the cdf of WTP, and denotes
the vector of parameters that index the distribution of WTP. (Notice
that for respondents who give two yes responses, the upper bound
of WTP may be infinity, or the respondents income; for respondents
who give two no responses, the lower bound is either zero (if the
distribution of WTP admits only non-negative values) or negative
infinity (if the distribution of WTP is a normal or a logistic.))
| |
log log ( ; ) ( ; ) L F WTP F WTP
H L
i
n
=
=

u u
1
31
Non parametric models for contingent
valuation: the Turnbull estimator
1. Consider only the first bid answer
2. For bids indexed j=1,,M, calculate F
j
=N
j
/(N
j
+Y
j
) where N
j
is the
number of No responses to t
j
and Y
j
is the number of Yes
responses to the same bid, Tj= N
j
+Y
j
3. Beginning with j=1, compare F
j
and F
j+1
. Intuitively, % of Nos
should increase with the increase in the bid
4. If F
j+1
>F
j
then continue
5. If F
j+1
F
j
then pool cells j and j+1 into one cell with boundaries
(t
j
,t
j+2
], and calculate F
j
*=(N
j
+N
j+1
)/(T
j
+T
j+1
)=N
j
*/T
j
*. That is,
eliminate bid tj+1 and pool responses to bid t
j+1
with responses to
bid t
j
.
6. Continue until cells are pooled sufficiently to allow for a
monotonically increasing CDF
7. Set F
M+1
*=1, F
0
*=0
8. Calculate the PDF as the step difference in the final CDF:
f
j+1
*=F
j+1
*-F
J
* for each offered price. These represent consistent
estimates of the probability that WTP falls between price j and
price j+1.
32
9. Multiply each offered price (t
j
) by the probability that WTP falls
between it and the next highest price (t
j+1
)
10. Sum the quantities from step (9) over all prices to get an estimate
of the lower bound on WTP:


11. Calculate the variance of the lower bound as:


) ( ) (
*
0
*
1 j
M
j
j j LB
F F t WTP E

=
+
=

=
*
1
2
1
*
* *
) (
) 1 (
)) ( (
M
j
j j
j
j j
LB
t t
T
F F
WTP E V
33
Unrestricted Turnbull
tj N
j
T
j
F
j
F
j
* f
j
*
5 20 54 0.370 0.343 0.343
10 15 48 0.313 Pooled back Pooled back
25 46 81 0.568 0.568 0.225
50 55 95 0.579 0.579 0.011
100 106 133 0.797 0.797 0.218
200 82 94 0.872 0.872 0.075
300 72 81 0.889 0.889 0.017
300+ - - 1 1 0.111
E
LB
(WTP)=0*0.343+5*0.225+25*0.011+50*0.218+100*0.075+
+200*0.017+300*0.111=$56.50
V(E
LB
(WTP))=(0.343*0.657/102)*(5-0)
2
+(0.568*0.432/81)*(25-5)
2
+
+(0.579*0.421/95)*(50-25)
2
+(0.797-0.203/133)*(100-50)
2
+
+(0.872*0.128/94)*(200-100)
2
+(0.889*0.111/81)*(300-200)
2
=$29.52
34
Literature for this lecture
Haab-McConnell Valuing environmental and natural resources
chapters 1-5
Perman et al. Chapter 12
A good book for the CV: Mitchell-Carson Using surveys to value
public goods: the contingent valuation method Resources for the
Future, Washington, DC, 1989.
Read the paper Alberini, Rosato, Longo, Zanatta Information and
Willingness to Pay in a Contingent Valuation Study: The Value of S.
Erasmo in the Lagoon of Venice.
Ill post the slides and the paper on my website:
http://people.bath.ac.uk/al224/