Highlights of Chapter 14. Measuring the value of outcomes (or social surplus) Two basic methods – Revealed preference (observing what people actually.

Highlights of Chapter 14

Measuring the value of outcomes(or social surplus)

• Two basic methods– Revealed preference (observing what people actually do in

the market when price, quality and other attributes change)– Stated choice (asking what people would do in the market

under different prices, qualities and other attributes change).

• Social surplus = #’s affected x marginal social benefit (cost) of one unit

• Under perfect competition, P = MSC• The intersection of marginal social benefit and marginal

social cost is the shadow price of the outcome

Market analogies

• Use the private sector price as if it were the proxy for the price under perfect competition.

• This can be used as the shadow price for the publicly provided good if the private price is what the users of the publicly provided good would be willing to pay (if they could afford it).

• Targeting is an issue. If the publicly provided good (housing) is provided to middle income residents, they would actually be prepared to pay more and the estimated benefits of public housing would increase

Trade-off

• Opportunity costs reflects trade-off inherent in choice.• EG. Use of wages as a proxy for the value of time

– Wages do not include actual and psychic benefits of working

– Taxes distort wages– Some down time (travel) can be productive– Travel time may have values– Value of time depends on what else could be done– Wages depend on institutional constraints – hours of work

are flexible– Wages can reflect monopoly power

Value of statistical life

• Foregone earnings – Courts often use discounted present value of

lifetime earnings to estimate values of limbs lost and compensation for life.

– This assumes full-employment and that wage = marginal social product. Those who are paid are valued more than those who volunteer.

• Options include– Purchase test (insurance)– Wage premium accept increased risk of death

The prices and uptake in a comparable community is used as the basis for estimating a freely provided service in the subject community.

The CS for the free pool is the area under the demand curve

The revenue from the paid attendance pool underestimates the consumer surplus by a wide margin.

(p+w) ((life) - $300 = pV(life)(p+w) ((life) - pV(life) = - $300wV(life) = $300V(life) = $300/w

W=1/10,000 - likelihood of death from no airbags implies that the value of a statistical life is $3 million

Problems with simple consumer purchase and wage risk models

• Do workers have full information• Adrenalin junkies may obtain non-wage

benefits (risk averse people may avoid dangerous professions) – self-selection results in a lower premium for dangerous work

• Risk of death data may not be complete• Diminishing marginal utility for safety• Assumption of market efficiency

Intermediate market good• Useful for training/education programs• Compare incomes for those with and without training• Assumes that incomes accurately measure the benefits of training• Some credentials may be overvalued (Harvard MBA?)• Double counting (if the value is measured by reduced unemployment,

measuring increased earnings and combining the two double counts, unless one measures the increased employment and increased wages as an estimate of increased GDP – you cannot include both increased wages and increased GDP or increased hours and increased GDP.

• The example in the book, shows the benefits of irrigation as the increase in area under the demand curve for water – to also measure increased revenues by farmers is double counting.\

• One advantage of having clients pay a portion of the costs for a social program is that one more easily measures demand.

Asset Valuation

• Use the discounted or capitalized value of capital assets to track impacts

• This tracks valuations in secondary markets (land) as a reflection of primary markets (transportation)

• Natural experiments and using cross-sectional studies to show asset price variation as a function of a project/amenity are common.

Key weaknesses

• Omitted variables (measures of monopoly power, risk version, market efficiency…)

• Self-selection (when different people attach different values to attributes)– Hard of hearing or those with olfactory

deficiencies move into noisy/smelly neighbourhoods.

Hedonic pricing• Two step process to control for omitted variable and then to control for self-

selection.• Require that the capital value of asset reflects changes in the attribute (e.g.

travel time to work is the attribute and the value of the house is the capital asset.

• Step 1 – estimate the value of the house as a function of attributesP = f(travel time, view, age, size, …..) - this is the hedonic price function.P = B0travel timeB1viewB2ageB3sizeB4, B1,B2,B3, B4 are elasticities

• The hedonic price of an attribute is the change in price for a one unit change in that attribute…

rv = B2 P/view

Hedonic Pricing – cont’dStep 2 – we measure rv as a function of the attribute of interest

rv = A0 + A1View + A2 Age + A3 income

Notice that rv varies with scenic view level (this is the non-linear form of step 1).

Technically, rv should be a straight line in the second graph according to the equation above.

Value of statistical life - hedonics

ln (wage) = B0 + B1ln(fatality risk) + B2ln injury risk + b3ln(job tenure)… 1

rf = B1 wage/fatality risk

rf = A0 + A1(fatality risk) + A2(age) + A3(education) ……………………………….2

• Problems– People must understand the attribute in question(view, travel time, risk…)– The measurement of the variables (view, risk …) is important– The functional form is critical– Variation must exist in housing location, jobs …. to ensure proper statistical

fit– Econometric issues in the data– Assumption of efficient markets

Travel cost method(recreation - parks)

• Assume that remote sites cost time and money to visit• Willingness to incur these costs provide an estimate of

value• Demand

q = f(price, prices, Y, Z)

Where q = number of trips to the park, price is the total cost, prices is the price of substitutes, Y is income and Z is tastes.

• Key idea is that price varies depends on travel cost (time) which varies for each individual)

• Often the model surveys visitors and uses zones (FSA) to estimate costs

Defensive measuresKey idea – costs incurred to deal with a problem (the defensive measure) are a measure of the value of resolving the problem.

D is the demand for clean windows. S0 is the supply curve (marginal cost) of producing clean windows prior to the clean air policy. S1 is the supply (marginal cost) after the policy.

The change in consumer surplus (P0abP1) measures the value of the policy (at least from dimension of clean windows), but not health.The issue is that the demand elasticity may be low, and this means that defensive measures may underestimate the value.

Most important – clean windows are likely lower value than reductions in lunch cancer.