Welfare economics Outline Expressing changes in human well-being (utility) in monetary terms Deciding between monetary measures that are equally theoretically.

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

Readings

• Hartwick & Olewiler, Ch. 1 (esp. pp. 7-19)

• Lesser et al., pp. 282-304

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

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)

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?

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?

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?

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?

Environmental change

Compensation (Reference welfare: without the change)

Equivalence (Reference welfare:

with the change) Deterioration WTA to incur WTP to avoid

Environmental change

Compensation (Reference welfare: without the change)

Equivalence (Reference welfare:

with the change) Deterioration WTA to incur WTP to avoid Improvement ? ?

Environmental change

Compensation (Reference welfare: without the change)

Equivalence (Reference welfare:

with the change) Deterioration WTA to incur WTP to avoid Improvement WTP to obtain WTA to forgo

• 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)

Issues

• Are they the same?

• If not, which one should we use?

• How can we estimate them?

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”)

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?

Utility maximization

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

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: P1C1 + C2 = Y0

– Price of water = P1, price of food = 1

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: P1C1 + C2 = Y0

– Price of water = P1, price of food = 1

• How do households determine how much of each good to consume?

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: P1C1 + 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

Impact of price fall

• Price of water falls, from P1 to P1– Price of food stays the same, equal to 1

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?

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

Compensating measure

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

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

Equivalent measure

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

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

WTA vs. WTP

• There is no geometric reason why

Y2 – Y0 = Y0 – Y1

• In fact: Y2 – Y0 > Y0 – Y1

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

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

Magnitude of discrepancy

• Is the good private or public?

Magnitude of discrepancy

• Is the good private or public?

• Characteristics of public goods1. Nonexclusive: no one can be excluded from

“using” the good

2. Nonrival: one person’s “use” does not reduce the amount available for anyone

Magnitude of discrepancy

• Is the good private or public?• Characteristics of public goods

1. Nonexclusive: no one can be excluded from “using” the good

2. 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

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

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

• Public (unpriced, nonmarket) goods– Discrepancy is often large – Many times

Choosing between WTP and WTA

• What is allocation of property rights?

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

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

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?”

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

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?

• Only approximately:

WTA > MCS > WTP

Valuing unpriced goods

• Two broad categories of approaches:

Valuing unpriced goods

• Two broad categories of approaches:1. 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

Valuing unpriced goods

• Two broad categories of approaches:1. 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

2. 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