Environmental Economics

Definition:
Undertakes theoretical or empirical studies of the economic effects of national or
local environmental policies around the world. Particular issues include the
costs and benefits of alternative environmental policies to deal with air pollution,
water quality, toxic substances, solid waste and global warming.

Subfields of EE-
Sustainable development
Anti-globalisation movements
Resource conservation
Environmental finance and natural capitalism
Topics in subfields of EE-
Externalities
Public goods and pareto optimality
CB analysis as a tool for policy analysis
Valuation of environmental resource
Over the past decades, study of Envtal and Resource Economics has evolved
from an application of “welfare economics” to a field of economics in its own
right. Combines elements from industrial organisation, public finance, micro
economic theory and many other areas.
.
 Why Study Environmental and Resource
Economics?
• The cause of virtually all environmental problems in a
market economy is economic behaviour, economics offers a
valuable perspective for viewing environmental problems
and a powerful set of tools (analytical) for designing and
evaluating environmental policy.
Eg. Benefit cost analysis can be a key method for
consistently promoting efficient policies
• The social and economic systems are not separate from the
physical and natural environment, but contained within it.
• A good understanding of environmental and resource
economics requires the development of an understanding of
how physical and natural sciences contribute.
• Resources are not “free” anymore but increasingly scarce,
so valuation assumes importance.
• Economics becomes even more significant when integrated
into this interdisciplinary overview.
 Environmental Policies

Principal objective is the protection of public health and improved quality of life.
• Polluter pays- often cost of abatement is passed down to the consumer
through increased costs that are incurred in production.
• Govt subsidy for pollution abatement – but, often the tax payer pays the
cost of abatement.
1. Environmental policies that are designed to protect health, benefit
most the least favoured social groups as they are most exposed to
health hazards.
2. Measures /standards that seek to improve the quality of life benefit
the middle and upper income groups.
3. Measures of conservation of non-renewable resources benefit
future generations at the expense of present generations.
In short, envt policies have effects on redistribution of income between
economic sectors and social groups.
Envtal Planning is the integrated approach to development planning which
takes into account the impact of development progs and projects on the
envt, in particular the use of non-renewable resources and the impairment
of envtal quality, as well as their effects on economic and social
conditions. At the project level, application of envtal planning is the EIA.
The objective is to predict all potentially significant effects of the project,
both beneficial/adverse, long term/short term on envtal resources, socio-
eco conditions etc.
 Environmental Laws
A. National
Basic envtal laws
Envtal standards
Air quality laws/”ambient air quality standards”
Emission standards
Resource conservation laws
B. International
Trans-boundary pollution
Resource shared between 2 or more states
Resource beyond national jurisdiction,but which provide non-use values to persons
in other countries.
International Benchmarks:
1. OECD adopted (in 1972) polluter pays principle for envtal policy, ie prices should
reflect the social cost of production.
2. Publication (in 1987) of “Our Common Future” or the Brundtland Commission
Report. Notion of Sustainable Development and merging economics and envt in
decision making.
3. UNCED (1992) at Rio recognised production and consumption in develop
countries as major contributer to envtal degradation. “Agenda 21” specified,
endorsed the application of PPP.
 Some major declarations under Agenda 21 in Rio
conference are:
• Encouraging macro eco policies conducive to envt and dev.
• Reducing health risk from envtal pollution and hazards
• Promoting sustainable dev through trade liberalization
• Making trade and envt mutually supportive.
• Promoting patterns of consumption and production that reduce
envtal stress and to meet basic needs of humanity.
• Assessing human vulnerability in ecologically sensitive areas and
centres of population to determine the priorities for action at all
levels
• Integrating envt and dev at the policy, planning and management
levels
• Establishing a system for integrated envt and eco. accounting.
 International Benchmarks (contd)

4. Montreal Protocol (1985) on substances that deplete

the ozone layer.
5. Convention on Climate Change- IPCC (1988)- its
objective is to achieve stabilization of GHG
concentrations at a level that would prevent dangerous
anthropogenic interference with the climate system.
6. International Climate Policy Regime (1997) under the
Kyoto Protocol- quantified emission limitations or
reduction commitments. Introduced international
emission trading, clean development mechanisms-
which will allow emissions reduction beyond the
geographical borders of the countries making the
commitment.
 Environmentally Sound technologies:
• Technologies which permit to sustain development in the
long run. Includes simultaneously how to increase
production, improve NRM and decreasing pollutant
emissions to a minimum.

• Strategy to rely on pollution abatement system when

necessary, devise new processes preventing pollutants
being formed, Modifying process technology and
recycling wastes. Restricting permissible emission levels
progressively.

• Also involves consultations between envtal agencies,

planners and industry for arriving at possible control
strategies.
 India- Existing policy Response to Envt Protection
• Economic Reforms in India aim at liberalization and opening up of Indian
economy to foreign trade and capital. Govt has amended the Constitution to
incorporate envtal concerns, passed envtal legislations and set up
institutions for envtal protection, but relies heavily on CAC instruments for
envtal protection.

• The 73rd and 74th Constitutional Amendments in 1992 recognized the 3 tier
structure of govts. 11th schedule contains envtal activities (soil conservation,
water management, social forestry etc) that Panchayats can take up.

• GoI has come out with policy statements on Abatement of pollution, on

Forestry and National Conservation strategies, on Conservation and
Development. There are Laws for the protection of envt and belong to CAC
category. The Envt Protection Act (1986) provides the basis for the
formulation and implementation of policy at the national level. Institutional
structures include the PCBs at the Center and State levels. Economic
incentives for pollution abatement equipment/devices allow for depreciation
allowance, waiver of water cess, custom and excise duty concessions, soft
loans and subsidies. Small scale units can receive financial assistance and
subsidies to set up common effluent treatment facilities.
 India- Existing policy Response to Envtal Protection
1.Legislation
– Air (Prevention and Control of pollution ) Act, 1981
– Environment (Protection) Act 1986
– Adopted Male decleration on Control and Prevention of air pollution.
– Public Liability Insurance Act, 1991
– National Envt Tribunal Act, 1995
2.Ambient Air Quality Standards
Both short term and long term have been laid down for industrial, residential, rural, other areas w.r.t to
pollutants such as SO2, NOx, SPM, RPM, Pb and CO and also NH3.
Emission Standards (concentration based, equipment based and load/mass based standards). Noise
standards are also prescribed.
3. Guidelines for siting industries.
4. EIA- mandatory for 29 specific activities/projects, and also for some activities identified as the coastal
zones, valleys etc.
5. MoEF- does carrying capacity based regional planning studies in selected areas.
6. Emission n standards for Industries- CPCB and SPCBs lays down the maximum permissible limits for
pollutants for many categories of industries that contribute to air pollution (under the Act of 1986).
7. Environmental Audit- submission of environmental statement by polluting units to the SPCBs.
8. Zoning Atlas for siting industries- taken up by CPCB.
9. Development of pollution prevention technologies
10. Beneficiated coal for thermal power plants
11. Control of vehicular pollution through
– Stringent emission norms (Euro I & II)
– Cleaner fuel quality
– Inspection and maintenance (of vehicles)
 Policy Gaps
Many policy gaps prevail. Also, despite the elaborate legal framework,
programmes/economic instruments are either ineffective or inadequate in achieving
sustainable development. The barriers are:

• Principal legislation is repetitions and poorly drafted, not backed by sound policy
pronunciations. Emphasis is on punitive rather than pro-active and preventive measures.

• Another lacuna in the law is that some areas like groundwater pollution remain outside the
purview of the pollution control laws. Consolidation and codification of the law may help.

• There are envt related laws that are anti-poor.

• Many of the deficiencies related to the use of natural resources are an outcome of
divergence between private and social interests. Laws are inadequate in the changing
economic envt. There is a need for evolving markets for envtal resources, be it land,
forest or energy services, that set prices close to the resource criticality.

• Institutional mechanisms need to be evolved. PCBs should be provided necessary teeth

to implement laws. State-of-art monitoring technology should be provided to measure
pollutants and the technical skills of the manpower need to be upgraded.

• Environmental degradation, rapid population growth and stagnant production are closely
linked with the fast spread of acute poverty in many countries of Asia. Rural occupational
diversification could be a solution to rural poverty and sustainable use of resources
through reduction of demographic pressure on land.
 Terminology

Social Cost: This cost includes both the private costs of production and the
externalities cost generated by its production.
Market equilibrium: Is the price at which quantity demanded equals to quantity
supplied.
Market Failure: Market Failure occurs when the market does not allocate
resources efficiently. One possible cause of market failure is a divergence
between private and social costs.
Eg: A production process which reflects all the private costs of production but
does not reflect all the social costs associated with production (for example, if the
process generates air pollution).
Marginal value: the change in the value of a resource that is due to an
incremental change in its quantity. How much people are willing to pay for an
additional unit of a good/service is marginal cost.
Free Rider: Someone who consumes a good or service without paying for it
Property Rights: The right to own a good or service and the right to receive the
benefits of the goods or service
Public Goods: Goods whose benefits are not diminished even when additional
people consume it and no one is excluded from its benefits eg roads.
Pareto Optimal Solutions: no alternative situation or solution can make all other
members of the society better-off without making at least one of them worse-off.
Individual rationality with competitive conditions then makes the society reach the
Pareto optimum.
 Externality
Externality: Unintended costs or benefits of an economic transaction that are
imposed on unsuspecting people / external parties receive and that result
from the economic activity of others. Is unpaid or uncompensated “side
effect”, or, free benefits of production or consumption suffered/enjoyed by
other producers and consumers.

• Each decision by an economic agent will have an impact on himself and

also on other members of the society-called externality. eg pollution is an
externality- an unintended consequence of market decisions, which affects
individuals other than the decision maker.

• A market left on its own will not address the problem of externalities. Is
perhaps the most important class of market failures for the field of
environmental and resource economics.
• The value of effects of externality is difficult to calculate & determine, as all
parties may influence the policy response to their own benefit.
• Externality can be at the stage of :
Production: Eg. industries dumping polluted water in the rivers w/o treating
effluents.
Consumption. Eg. Urban households dumping kitchen waste on the roads.

.
 Types of Externalities
Negative externality, or external cost/ diseconomy: A situation in which no
single individual feels responsible to bear the cost of the damages done to the
envt due to her actions in production or consumption is called negative ext. (eg
pollution, tragedy of commons). Externality is generated by the lack of property
rights (or the inability to enforce property rights). Uncontrolled use leads to
destruction or damage of the resource.

Positive externality or external benefits/ economy: eg., residents enjoying

fresh air coming from a nearby green patch, effects of education, vaccination,
insurance.
Positional externality- depends on relative rankings of actors in a situation.

Effects:
•Externality can bring in a divergence between the social costs and private
costs (eg. costs for medical remedies on health effects) and/or social and
private benefits.
•In the presence of negative ext. the social marginal costs are higher than the
pvt marginal costs. It leads to a lower level of production and a higher social
value or price. In other words someone will have to bear the social cost.
•If there is positive ext. the social marginal benefits would be higher, but the
additional benefits will have to be paid (as value or price).
Solutions advocated to correct externality include-

• Better defined property rights

• Taxes and tariffs on pollution (advocates shift of taxation

from income and sales taxes to taxes on pollution or the
“green tax shift”). Govt should impose a tax on emissions
equal to the cost of the related damages.

• Quotas on pollution

• Envtal regulations - the economic impact has to be

estimated by the regulator. This is done by using Cost-
benefit analysis. Regulations are also called “command
& control instruments”.
 Environmental Regulations
Government is the institution to market and manage the envt. Can use :
A. Non market policy instruments or
B.Market based (MBIs) /economic instruments.

The former include command and control (CAC). These are fines, penalties and
threats of legal actions, imprisonment.
The latter (MBIs) include pollution taxes, marketable pollution permits. Such
economic instruments further can be :
a.Price based - Taxes and subsidies to deal with the externalities eg. Pollution
taxes on production or consumption or on polluting input. Subsidies on
commodities which generate envtal benefits. Excise duties on certain
commodities.
b.Quantity based – Permits system- permits are defined in terms of emissions.
c.Mixed instruments – Mix of both C&C and economic instruments. It is the most
cost minimising strategy to realize given envtal standards.
These are called market based as they complement market processes to achieve
pareto efficiency, even with presence of externalities. Hence are regarded as best
instruments.
There is gradual tilt in favour of MBIs in many countries, primarily due to demise
of central planning, high transaction and administrative expdt in enforcing taxes
etc.
 The Role of Command and Control Policies
• When the optimal level of pollution is zero or at zero,
direct controls make sense.
• This is the case for extremely dangerous pollutants, such
as heavy metals and radioactive waste.
• Damages associated with these pollutants are quite
severe.
• Direct controls also happens where initial damages are
quite high compared to initial marginal abatement costs.
– An example is CFC‟s, where accumulated amounts
are dangerous but there are low cost alternatives.
• Emergency situations may make direct controls the
preferable policy instrument, when events occur in
random and unpredictable fashion.
• Examples include smog alerts and droughts.
Pursuing Envtal Quality with Economic Incentives

• Economists advocate policies based on economic

incentives for two primary reasons:

– Economic incentives minimize total abatement costs

by equating marginal abatement costs across
polluters and encouraging a broader array of
abatement options.

– Economic incentives encourage more research and

development into abatement technologies and
alternatives to the activities that generate the
pollution.
 Marginal Abatement Cost

• Abatement Costs are those costs associated

with reducing pollution to a lower level so that
there are fewer damages.
• Abatement costs include:
– Labor
– Capital
– Energy needed to lessen emissions
– Opportunity costs from reducing levels of production
or consumption.
 Supply and Demand Functions

• Law of Demand

• A decrease in the price of a good, all other

things held constant, will cause an increase in
the quantity demanded of the good.

• An increase in the price of a good, all other

things held constant, will cause a decrease in
the quantity demanded of the good.
Change in Quantity Demanded

Price
An increase in price
causes a decrease in
quantity demanded.
P1

P0

Quantity
Q1 Q0
Change in Quantity Demanded

Price
A decrease in price
causes an increase in
quantity demanded.

P0

P1

Quantity
Q0 Q1
 Changes in Demand

• Change in Buyers‟ Tastes

• Change in Buyers Incomes
• Change in the Number of Buyers
• Change in the Price of Related Goods
– Substitute Goods
– Complementary Goods
Change in Demand

An increase in demand
Price
refers to a rightward shift
in the market demand
curve.

P0

Quantity
Q0 Q1
Change in Demand

A decrease in demand
Price
refers to a leftward shift
in the market demand
curve.

P0

Quantity
Q1 Q0
 Law of Supply

• A decrease in the price of a good, all other

things held constant, will cause a decrease in
the quantity supplied of the good.

• An increase in the price of a good, all other

things held constant, will cause an increase in
the quantity supplied of the good.
Change in Quantity Supplied

A decrease in price
Price causes a decrease in
quantity supplied.

P0

P1

Quantity
Q1 Q0
Change in Quantity Supplied

An increase in price
Price causes an increase in
quantity supplied.

P1

P0

Quantity
Q0 Q1
 Changes in Supply

• Change in Production Technology

• Change in Input Prices
• Change in the Number of Sellers
 Change in Supply
An increase in supply
refers to a rightward shift
Price in the market supply curve.

P0

Quantity
Q0 Q1
 Change in Supply
A decrease in supply refers
to a leftward shift in the
Price market supply curve.

P0

Quantity
Q1 Q0
 Market Equilibrium
• Market equilibrium is determined at the
intersection of the market demand curve
and the market supply curve.
• The equilibrium price causes quantity
demanded to be equal to quantity
supplied.
Market Equilibrium

Price

D S

Quantity
Q
 Market Equilibrium

Price

D0 D1 S0
An increase in demand
will cause the market
P1
equilibrium price and
P0 quantity to increase.

Quantity
Q0 Q1
 Market Equilibrium

Price

D1 D0 S0
A decrease in demand
will cause the market
P0
equilibrium price and
P1 quantity to decrease.

Quantity
Q1 Q0
 Market Equilibrium

Price An increase
in supply
D0 S0 S1 will cause
the market
equilibrium
price to
P0 decrease and
P1 quantity to
increase.

Quantity
Q0 Q1
 Market Equilibrium

Price A decrease in
supply will
D0 S1 S0 cause the
market
equilibrium
price to
P1 increase and
P0 quantity to
decrease.

Quantity
Q1 Q0
 Valuation of Resources
• Most envtal problems stem from the limitation of
the pricing system.
• Problem lies in the organisation of the economy
which permits individual firms and govt agencies
to use up and damage society‟s resources but
escape the resulting social costs.

• Policies of govt (“polluter-pays” principle,

pollution taxes and emission standards) have
drawbacks, so the need to move towards
modern concepts of Envtal Eco.
 What is Value?
• Value has an anthropocentric view, meaning
value is determined by people and not by either
natural law or government.
• Second, value is determined by peoples‟
willingness to make trade-offs. When an
individual spends money on one good, there is
less available for other goods.
• For market goods, the inverse demand curve
represents a marginal willingness to pay
function. The area under the curve at each
price/quantity combination represents the total
willingness to pay.
 What is Value?
• Eco theory makes distinction bet value & price.
• Value based on „theory of utility‟. Price of a
commo./service emerges from interplay of demand &
supply factors. Or if there is a market.
• Value and price may not be the same.eg. Urban water
supply.
• This can happen also to
– Water resources (no well defined market)
– Minerals (under monopolistic conditions)
– Forest produce (externalities not internalised into pricing)
– Things of beauty, eg. tigers in WS (no market)
– Architectural monuments (being a public good).
 Marginal Willingness to Pay & Accept Function

• Value of goods may not always be revealed as

a commod. may not have a market.

• Value of non-marketable goods/services can be

assessed in terms of consumers WTP to
acquire it or his willingness to accept (WTA)
compensation for foregoing them.

• WTP does not measure the total benefit

associated with producing a good. It is based on
the principle that resources used to produce the
good could be used to produce other goods that
would benefit society.
 Marginal Willingness to Pay & Accept Function

• Hypothetical example:
• To avoid polluted water, consumer (c) installs water
purifier. If polluter (p) is forced to install ETP, c no longer
incurs expdt, so has real income gain.
• This expdt saved is equivalent to max amt c is willing to
pay to p to induce him to set up ETP. Is called
„compensating surplus‟.
• If p stops running ETP, c has to install purifying device,
therefore his expdt to maintain himself to previous level
increases.
• This income loss is the min amt which c is willing to
accept from p (as compensation) to remain indifferent to
water quality change. This is notion of „equivalent
surplus‟.
 Value of Non-market Goods

• While money is one thing that people give-up or

trade-off to obtain goods, it is not the only thing.
• Time and other opportunities are sacrificed in
order to obtain both market and non-market
goods.
• Examining these trade-offs can serve as a basis
for valuing non-market goods.
 Use Values
• Natural res provide a variety of goods and services to users for their future
or current benefit and welfare. Hence they have use values. Current use of
these goods and services can be either direct or indirect, hence use values
classified as:
• Direct use value: refers to current use/consumption of res. and services
provided, directly by nat. or envtal res. Eg., use of timber and non timber
forest produce and services. It can be either consumptive or non
consumptive. Eg of first is fuelwood, medicinal plants, fruits, fodder etc.
Recreation, education, research etc are egs of second.
• Indirect use value: refers to ecological functions that nat.envts provide.
Such as watershed values, ecosystem services and evolutionary
processes. Wateshed values are flood control, regulation of stream flows,
recharging ground water etc. Ecosys services are fixing of N2, assimilation
of waste, carbon sequestration, gene pool etc. Evolutionary processes are
global life support, biodiversity preservation etc.
• Option value: Is associated with benefits received by retaining the option of
using a res in future by protecting or preserving it today, when its future
demand and supply is uncertain. Eg in Narmada basin the option value is
the amount that the individuals would be willing to pay to postpone the
decision on building a dam on the river. The people do not have the
intention to use the dam in the present but the same use may emerge in the
future.
 Non Use Values
• These are generated without direct link with the use of
natural res. Eg., can be kinds of values people of a Sn
state would put for the Himalaya mountains. These
values are revealed through people‟s perceptions and
concerns towards conservation, culture, aesthetics etc.
• Bequest values: Originates when people are willing to
pay to conserve a res for the use of future generations.
By doing so, people do not have the intention to use the
benefits during their own life span, but are bequesting
those benefits to the future generations.
• Existence value: Associated with people‟s willingness to
pay simply for the pleasure they derive from knowing
that a natural area/species, exists, w/o having intention
to use this res in any way. Eg.people‟s willingness to pay
for the preservation of endangered species.
 Total Economic Value of Mangroves
• Use Value
• Direct Use value Direct consumptive fodder, fuel, timber,
use value medicine, food
• Industrial input
• Onsite & offsite fishery
• Direct non consumptive Recreation, tourism
• use value
• Indirect use value Functional benefits Flood control, protect
• from winds, cyclones,
• Biodiversity,
shoreline
stabilization,
Carbon sequestration
• Option value Future direct and Biodiversity,
• indirect values Conserved habitats
• Non Use values
• Bequest Value Preservation of mangroves for future gentn
• Existence Value Value from knowledge of contd existence
 Total Economic Value
Therefore the Total Economic Value (TEV) can be:
TEV=UV+NUV= (DUV+IUV+OV)+ (BV+EV)
 Whenever a market exists for a nat res, the prices as revealed

from the market can be an indicator of the value of those res.

Eg timber prices, mineral or water prices.
Why valuation?
 Sometimes there are missing mkts, eg., watershed functions,

carbon sequestration. Here value of goods/services cannot be

revealed.
 What if there is no market for a particular use of a res? (eg, mkt

for use of timber for hh purpose not there, but exists for
industrial use, or use of fuelwood, mangroves for fuel or
fodder).
 Also for most goods/services, alternative options exist. Methods

used then are opportunity or replacement costs. These draw

upon market data and info of prices and values for alternative,
replacement uses (eg kerosene used in hhs instead of timber).
 Total Economic Value
• Sometimes there is uncertainty in demand/supply of
natural resources, especially in future. Economic
markets capture only current preferences of buyers and
sellers. Future preferences may change affecting
demand.
• Lastly, for natural resource accounting and arriving at
'Net Present Value', resource valuation is a must.
 Actual Methods
of Estimating
Value

User Value Non User Value

Actual market
Existence value Option value
based Valuation

Objective Subjective
standard based Preference Future use value Bequest value
Valuation based Valuation

Revealed Stated
Preference Preference
based Valuation method

Travel cost Hedonic Price Constructed

Method theory Market

Hypothetical Experimental
market Market

Contingent
Valuation
Method
 Actual Methods of Estimating Value
• The actual methods of estimating the value follow above
stated concepts and empirical feasibility. Several different
approaches and methods can be mentioned.
• Market Approach: includes productivity change, opportunity
cost, replacement cost, shadow price etc.
• Surrogate market approach: Hedonic prices, property values.
Surrogate prices are hypothetical market prices taken from
such goods and services, that are close substitutes for res.
• Shadow prices: used for resource having many alternatives
uses. These reflect the optimal values of resources, by taking
account of all alternative use of the resource & their
combinations.
• Artificial market or stated preference approach: How to value
res for which there is neither market nor surrogate? Then
alternative user or non user based methods are devised.
Through consumer surveys, user of such res is made to state
or reveal his preferences and reflects a statement of value.
Eg. travel cost method, contingent valuation etc.
 Hedonic Pricing Techniques
• Hedonic pricing techniques are based on the theory of consumer
behavior that suggests that people value a good because they value
the bundle of attributes/characteristics of that good rather than the
good itself.

• Resource is defined in terms of services it yields or an attribute it

embodies, and the attribute is linked with other goods and services
that are marketed and priced. Belief is that price of some marketed
goods or service is a function of different characteristics , and an
implicit price exists for each characteristics.

• The technique is used commonly in valuing characteristics of

housing based on land quality, landscape and locational qualities.
• An examination of how the price of the good varies with change in
the levels of these characteristics can reveal the prices (value) of the
characteristics.
 Hedonic Pricing Techniques

• Assume that all the characteristics of

houses and neighborhoods are the same
throughout the city.
• Houses with higher air quality would have
higher prices.
• This positive relationship can be
represented by the following equation:
– H = a + bQ,
– where H is housing price, Q is air quality and
“b” tells the researcher how many units H will
increase with each unit of air quality.
 Hedonic Pricing Techniques
• In reality prices of houses are dependent on many different
characteristics, all of which need to be reflected in the calculation of
the price of housing. Hence Hedonic price function is estimated from
a regression model.
• The regression analysis can be expanded to include many right-
hand side variables. By regressing the property values on key
attributes, the hedonic price function is estimated:
P = f (x,z,e), where
P is housing price (including land)
x is vector of structural attributes
z is vector of neighbourhood attributes
e is envtal attributes of concern.

• Two types of variables have traditionally been included as

explanatory variables in the hedonic housing price functions.
– Characteristics of the house itself
– Characteristics of the neighborhood
 Travel Cost Model
• The travel cost model is a method for valuing
environmental resources associated with recreational
activity (Harold Hotelling 1947).
• TCM captures only direct use value of envtal goods,
other components of TEV cannot be quantified through
this method.
• The basic premise is that travel cost to a site can be
regarded as the price of access to the site.
• Multiple observations on travel cost and quantity of visits
can be used to estimate a demand curve.
• The travel cost demand curve is often expanded to
include other explanatory socio-economic variables such
as age, income, family size, education level, etc.
• Thus, TCM estimates following demand function:
V=f(TC;X), where V+number of visits to the park, TC=
travel cost to reach the park and X=vector of relevant
socio-economic variables.
 Travel Cost Model
• Steps involved:
• Preparation of questionnaire (incl. Travel cost, time,
data on socio-economic status of respondent, their
perceptions regarding environmental issues)
• Selection of sample and sampling technique.
• Specifying dependent variable (visitation rate)
• Estimating travel cost and other independent
variables.
• Estimating demand function:
Visitation rate= f(travel cost, income, education,....).
 Contingent Valuation
• Contingent valuation is the most widely used stated preference
valuation technique.

• This method ascertains value by asking people their willingness to

pay for a change in environmental quality.

• The questions used in contingent valuation can take both open-

ended and close-ended form.

• In open-ended questions, respondents are asked to state their

maximum willingness to pay.

• In close-ended questions, respondents are asked to say whether or

not they would be willing to pay a particular amount.

• Although the contingent valuation method has been widely used for
two decades, there is considerable controversy over whether it
adequately measures people‟s willingness to pay.

• These arguments are based on informational issues and on the fact

that people may be indicating their value of something other than the
particular environmental issue.
 Economic Efficiency
• Criteria on which to base public policy decisions is
difficult.
• One key criteria, is, economic efficiency.
• Other relevant criteria can be:
– Equity
– Sustainability
– Environmental Justice
– Ecological impact
– Ethics
– Public participation
– Advancement of knowledge
• Economic efficiency means maximizing the difference
between the social benefit and social cost of an
economic activity, policy, or project.
 Economic Efficiency: Pareto Criteria
• What constitutes an improvement in economic efficiency? One option is Pareto
improvement.

• V Pareto (1896) postulated the criterion for judging whether a social

change/allocation makes the world better off. If atleast one person is made better off,
without making any individual worse off, then the change leads to pareto
improvement. A change is “pareto efficient” if no further improvements can be made.
Thus outcomes that are not pareto efficient are to be avoided.

• A common criticism of a state of Pareto efficiency is that it does not consider equity of
resource allocation. It may not result in a socially desirable distribution of resources,
(it makes no statement about equality; notably, allocating all resources to one person
and none to anyone else is Pareto efficient).

• Eg. It may be that one economic agent owns all of the world's resources; it would be
impossible to make anyone else better off without making said agent worse off, so
this situation is described as "Pareto optimal", even though it is inequitable.

• N Kaldor (1939) and John Hicks postulated a more pragmatic criterion that
identifies “potential pareto criterion” ie, a change is welfare-improving if those who
gain from the change could in principle fully compensate the losers, with (atleast) one
gainer still being better off. This is Kaldor-Hicks criteria, a test of whether total social
benefits exceed total social costs.
 Methods of Evaluation
•How to decide on projects requiring natural resources? 3
issues are relevant:
–Rate and use of resource has to be „valued‟
–Use of resource may create externalities
–Issues of appropriate discount rate to evaluate project performance.
•While designing envtally relevant projects, no. of options:
–Choice between development and preservation
–Choice between benefits to different stakeholders
–Choice between different techniques of project design (big vs. small
dams, organic vs. chem ferti)
• To make decisions on above choices 4 major techniques in
EE:
– Cost Benefit Analysis
– EIA
– Stakeholder Analysis
– Multi-Criterion Analysis
 Cost Benefit Analysis

• Pareto efficiency forms theoretical foundation for the use of the analytical
device called Cost-Benefit (or net present value) Analysis.

• The objective is to maximise the difference between benefits and costs (or net
benefits), (or marginal benefit be equated into marginal costs). Then the related
level of envtal protection (pollution abatement) is considered as efficient level of
protection.

• Benefit of preservation of an asset must be weighed against the net benefit from
development (eg. Using a forest for logging or not).

• Thus the net benefit of any project is the excess of user benefit over the user
cost. The net benefit of projects is-

Net benefit= B(D) + C(D) – B(P),

Where, B(D) is user, C(D) is user , B(P) is net benefit of
benefit cost preservation
 Cost Benefit Analysis
• Envtal costs and benefits arise over a finite period of time and must be discounted to their
present values to render them comparable. These have to be converted to real prices/
adjusted for inflation.
• Real prices may rise over time, requiring use of adjustment factor- the time value or time
preference of money has to be noted.
• The choice of discount rate adopted for evaluation of development projects is critically
important because it represents the relative importance of the future. (eg. Rs 100 today
would be preferred over Rs 100 recd a year later due to time preference)
• The cost/benefit flows of projects have to be adjusted for time preference values. Done thru
„discounting‟ of present values of cash flows of benefits & costs.

• What is appropriate discount rate?

– The market rate of interest is not appropriate because it includes inflation rates and risk
components.
– Other view is that it should reflect the opportunity costs of the capital (not easy task
due to market/insttnal rigidities).
– Also to consider the borrowing cost of capital (project selection may be biased in favour
of that with best financial terms).
– Another view is that it should reflect the social time preference rate, ie the rate at
which the society weighs future consumption vis a vis present consumption.

• As long as the sum of benefits outweighs the sum of the costs, even if a small group of
people get the benefits and a whole community suffers the costs, the society as a whole is
assumed to be better off.

• Eg, where people are displaced by the building of a dam, their land, livelihood and culture is
taken away to provide electricity to others. CBA hides the distributional consequences and
appears neutral when in fact a certain section of the community is benefiting while others
are loosing.
 Discounted Present Value Benefits:
• Net Present Value: Any stream of costs or future benefits from an economic activity are understood after aggregating with
certain weights to arrive at an index of overall net benefit. The weights are called the “discount factors”.
1. Net Present Value Benefit (NPVB)- the present value of benefits minus the present value of costs at constant prices.

NPVB= ∑Tt=1 { (Bt - Ct) / (1+ r) t }

where, Bt are benefits at time t,

Ct are costs at time t,
R is the discount rate,
and T is the terminal year of the analysis.

2. Benefit-Cost Ratio (BCR) - is the present value of benefits expressed as a ratio to the present value of costs

BCR= ∑Tt=1 { (Bt ) / (1+ r) t

________________
∑Tt=1 ( Ct) / (1+ r) t

3. Internal Rate of Return (IRR)- is that discount rate which equates NPV to zero. Indicator of efficiency or quality of an
investment. Or, the IRR for an investment is the discount rate that makes the net present value of the investment's income
stream total to zero/break-even

IRR is when . ∑Tt=1 { (Bt - Ct) / (1+ r) t } = 0

• A project is selected if its IRR greater than the rate of return that could be earned by alternate investments. If the choice
is bet projects, rule is to select project offering highest NPV.

• Sensitivity Analysis with different discount rates are done for project evaluation.

• If the present value net benefit is positive (>0) , the project is sustainable. A positive PVNB means that policy or project
has the potential to yield a Pareto Improvement.
 Cost Effectiveness Analysis
• CEA is a tool that can help to ensure efficient use of investment in sectors
where benefits are difficult to value in monetary terms. It is a tool for selection of
alternative projects with the same objectives.

• CEA is an approach to identify the cheapest way /lowest cost way among
competing alternatives of achieving a stated objective eg., lower IMR, reducing
a certain diseases etc.

• It is not helpful in case of projects with multiple objectives.

• CEA is also used as an alternative to CBA when social benefits / costs are
difficult to monetize, but with serious limitations. Is used most commonly in
evaluation of projects in health sector.

• It is expressed as an “Incremental Cost Effectiveness Ratio” (ICER), the ratio of

change in costs to the changes in effects.

• CEA does not attempt to compare the costs of measures with potential benefits,
but is used to decide which alternative maximizes the benefits for the same
costs.

• This task of comparing costs and benefits for deciding on possible alternative
objectives is undertaken by “Disproportionate Cost Analysis” (done after CEA).
 Cost Effectiveness Analysis
Two approaches of undertaking CEA:

a. Quantitative approach, is more rigerous

• An indicator that best describes the outcome of

the intended activities is identified and cost of
achieving a unit of that indicator for different
competing alternatives is computed.
• The alternative that has the lowest cost/unit
indicator would be identified the most cost
effective means of achieving the stated
outcome.
 Cost Effectiveness Analysis
b. Qualitative approach,

• The stated outcome (s) may not have an indicator (s) that best describe it or
the outcome may not be quantifiable.

• Various means to achieve the outcome are assessed and the cheapest and
most feasible/pragmatic is identified as the most cost effective means of
achieving the outcome. Alternative project approaches are considered and
discarded.

• Often purely quantitative approach has difficulties:

– It is difficult to identify one meaningful quantitative outcome indicator tht reflect
the outcomes of the project
– Some indicators cannot be meaningfully quantified and assigned a value
– Sometimes direct relations between outcome and resource application may not
be there.

• CEA is based on the economic concept of “marginal analysis”. It examines

the additional output produced from using an additional amount of input. A
level may be reached when it becomes too “costly” to achieve any outcome.
 Implementing cost effectiveness analysis
The steps followed are:

1. Programme objectives are determined.

2. Total public sector resource costs of the program are assessed.

– Only direct monetary res. are incl, sometimes opportunity cost for allocating
res. to some other project are also measured).

3. The impact is measured.

– Sometimes empirical approaches based on collection of primary data
is used to gather information on the positive effects of the prog.
– Secondary data or modelling may also be done.
– Difficult to accurately evaluate effects.

4. Finally, the cost per unit of output and outcome are assessed, through
simple division of costs by outputs.
 Challenges

In practice the above steps involve challenges, in the

nature of:

• Scale- at which level, national or below

• Costs- which costs to be included
• Effectiveness- how can it be assessed
• Monetary and non-monetary costs can be involved. Data
on costs would be in different forms.
• Time consuming and requires specialized training.
• Focusses on direct results that occur over the short or
medium terms. Does not look at long term impacts.
 Advantages
• Because CBA compares the welfare among stakeholders, methods
to translate welfare into a common denominator (i.e., money) may
strike as artificial.
• For this reason, CEA is conceptually and operationally simpler. It is
also more applicable to evaluation and performance measurement
of public programs. (When a cost-benefit study is specified, a cost-
effectiveness study is most often what is really desired).
• CEA can be aligned with “value-for-money” concepts in public
policy. In terms of :
– Economy (the unit cost of an activity can be minimized)
– Efficiency (spells out the relation between the output of goods
and the res used to produce them or the concept of “money
spend well”)
– Effectiveness (spells out the relation between the intended and
actual results of projects/programs or concept of “money is
spend wisely”)
 Differences between CBA and CEA
• Many studies claim to be to be CBAs, but are in fact CEAs
• CEA calculates the direct financial cost of reaching specific
outcome/output levels and requires one other alternative for
comparison
• CBA compares all benefits to all costs and can “stand alone.”
If the benefit/cost ratio exceeds 1, the program is socially
valuable
• Both CBA and CEA examine the costs of producing net
outcomes
• CBA assesses the net value of achieving social outcomes.
In other words, CBA measures the full (social) costs of the
full (social) benefits resulting from an intervention
• CEA measures the financial cost of producing a specific net
outcome or the direct programme costs.
 Risk Analysis
• Estimates the probabilities of rare and damaging events.

• Risk is defined as the probability of some hazardous event or catastrophe, the

chance that something bad will happen. Principal concern is low probability, high
consequence events (that lead to damage, loss, injury, death, envtal impairment).
It is an aid to decision making.

• Envtal risk analysis is the set of procedures that have evolved over time to
describe envtal hazards, potential adverse effects of being exposed to hazards,
the likelihood of each effect, event or condition that may lead to or modify
adverse effects, populations that influence or experience adverse effects.

• The tool used is “Catastrophe Model”- is a set of databases and computer

programs designed to analyze the impact of different scenarios on hazard prone
areas. End result of risk analysis is a rate rather than a probability.

• Extensive use of computing science, substantive subject matter and statistical

methods, GIS, decision tools, data base management

• A formal Risk Analysis includes-

1.Estimation of probabilities
2.Determination of statistical distribution of damage
3.Preparation of products like formulas, graphics, hazard risk maps.
 Risk Analysis

• Demand for risk analysis is increasing, because of :

– costs of replacing destroyed structures are growing and
– also because of the steady increase in the population living in
hazardous areas.

• Over the past two decades, risk analysis has emerged as a major
field of inquiry across a range of natural, health and social sciences.

• Theories/ methods of risk analysis have been used to wide array of

risks including :
– human health,
– hazardous materials, chemicals in the envt,
– floods,
– global climate change etc.
• Basic goal is to analyze a potentially hazardous technology, human
activity or envtal change in an accurate manner.

• “Vulnerability Analysis” is an important component, delineating

places, human groups and ecosystems that are at highest risk,
sources of vulnerability and how it can be ameliorated.
 Environmental Impact Assessment

• EIA is an iterative process of assessing the various envtal

dimensions, incorporating improvements & mitigation measures in
the development of a project, commencing at its very outset. EIA can
thus prevent future liabilities or costly alterations in project design.

• EIA offers a decision aid to planners to delineate envtal

consequences of a proposed dev. Objective is to foresee the
potential problems that would arise and address them in the planning
and design stage.

• Challenge is to achieve a situation that will enable envt & dev to

complement one another and exist in harmony.

• Many countries have a formal process to carry out EIA. First used in
India to examine the river valley projects from an envtal angle. Is
mandatory under Envtal (Protection) Act 1986 for projects in mining,
power plants, river valleys, infrastructure, certain industries etc. Is
mandatory for new projects proposed (under 29 sectors) and also
expansion and modernization of existing projects.
 Environmental Impact Assessment
EIA cycle comprises of following phases:

1. Screening: to rule out projects that do not require detailed EIA. This
determines whether to continue to the next phase of the process. Based
on screening projects are assigned to 3 categories- A, have sigt adverse
envtal impacts. B, will have some adverse effects but of lesser degree. An
initial envtal examination (IEE) is required. C, unlikely to have adverse
effects, no EIA or IEE is reqd.

2. Scoping: allows the EIA to focus on most sigt envtal issue, in the context of
affected region, interest, society, locality, given the res constraints.

3. Baseline determination: baseline status determined for the area to be

impacted. Also involves determination of all other relevant parameters of
the envt that would be useful in impact prediction.

4. Impact prediction: mapping the envtal consequences of the sigt aspects of

the project and its alternatives. For each component, covers the spatial
region that will have impact. Done for all the alternatives of the project-
makes assumptions, projections about the regional eco growth. Requires
use of quantitative and qualitative models.
 Environmental Impact Assessment
5.Assessment of alternatives and delineation of mitigating
measures: alternatives compared, ranked and selected based upon
the best envtal option in relation to the level of accrual of eco
benefits. Then a mitigation plan is outlined for the selected option.
The alternatives should sigtly differ in their envtal impact and there
should be genuine search for eco & envtal trade-off .

6. Envtal Impact Statement: The document assists decision making

agency to assess the suitability of a proposed project. The EIS
should provide info to the decision maker on the envtal conditions
w/o the project and with the project and with alternatives. Sigt
impacts have to be quantified for all the alternatives considered.

7. Public Consultation: Public should have access to the EIA. Gets

involved in making oral/written suggestions to the SPCB through a
public consultation programme. Consultation should also identify
and involve local representatives of potential PAP, groups, NGOs
etc.

8. Post project monitoring and auditing: monitoring carried out

during construction phase. It must be observed that the prediction
and agreement made in the EIS are complied with. If this is not the
case and impacts are more than predicted, corrective action needs
to be taken.
Process Flow of EIA Process:
 Sustainable Development
• Mooted in 1980s with the idea that continuous eco growth cannot be ecologically
sustainable. In the mid 80s the World Commission on Envt & Dev (WCED)
redefined it in its report “Our Common Future” also called Brundtland Report. In
1987 the concept of SD was accepted by the govts of 100 nations and approved
in the UN General Assembly. WCED (1987) defines SD “as development that
meets the need of the present without compromising the ability of the future
generations to meet their own needs.”

• SD is one of the many processes of dev. Production & distribution of goods &
services requires human capital, man-made capital, renewable res. & non ren.
res. The manner in which these are used sets the contours of dev, one of which
is SD.

• SD models take note of both eco & ecol aspects of res & something more. The
latter incl apart from neo-classical notion of “efficiency”, also concepts like proper
valuation of res, waste, equity, ren/non ren res as national capital stocks and
resilience of eco-system. Also add the dimensions of direct utility of natural
resources in the form of aesthetic beauty, social security and inter-generational
equity (use of resources will have to be appropriately designated over
generations).

• The res base should be maintained intact or even enhanced in some cases. The
link between maintaining the overall capital base of the economy and inter-
generational equity is an important aspect. Conservation of natural envt has to
be built into the project appraisal mechanisms along with techno-economic
feasibilty.
 SD & carrying capacity
• SD addresses Q of resilience of production and consumption system.
Entropy law- Beyond capacity and enhanced waste assimilation requires
additional investments. Waste disposal is not cost free.

• Associated with SD is the notion of “carrying capacity”, ie. Defined as the

level of human or animal population that can probably be supported in the
long run. For renewable natural res, same concept is used to define Max.
Sustainable Yields (MSY).

• Carrying Capacity: It means (in terms of animal husbandry) the max no. of
species that can be supported indefinitely by a particular habitat, without
degrading the envt and without diminishing its capacity in future. Exceeding
the CC can result in serious and irreversible consequences. One of the
consequences of exceeding the human CC is the loss of biological diversity.

• Ecological Footprint: A different way of expressing CC. How much land and
water is necessary to support a particular human pop- given the current
levels of technology and consumption. The EF is a tool for measuring and
analyzing human natural resource consumption and waste output within the
context of nature‟s renewable and regenerative capacity. If limits are
exceeded, “overshoot” then res are used faster than they can be renewed
and envt becomes degraded and ability of earth to sustain life further
reduces. EF of cities, developed countries very large.
 Equity
• The equity criterion for evaluating policy considers how costs and benefits
are distributed among members of society

• Implies a need for fairness in the distribution of gains and losses and the
entitlement of everybody to an acceptable quality and standard of living.

• Equity is not the same as equality. Distribution of rewards and burdens may
be deserved on the basis of a person‟s efforts, choices and abilities, but
those rewards and burdens should not be out of proportion to the actions or
qualities of that person.

• Also means that there should be a minimum level of income and envtal
quality below which nobody falls. Equity concept is fundamental to SD.
Equity can be applied across communities, nations and across generations.

• Intragenerational equity: is concerned with equity bet people of the same

generation. Covers justice and distribution of res bet nations.
• Intergenerational equity: refers to the need for a just distribution of rewards
and burdens between generations, and fair and impartial treatment of future
generations. Improving the condition of the current generation without
compromising the ability of future generations to meet their needs and
improve their quality of life.
• Inter-generational equity has been recognised in various international
agreements
Equity Measures - Lorenz Curve
 Equity Indicators
• Income is one component of equity.

• Two different measures are the primary tools for considering the inequality
of the distribution of income, the Lorenz curve and the Gini coefficient.

• The curve illustrates the percentage of income received by a given

percentage of the population. Equity is illustrated by the diagonal line
bisecting the origin. Along this line the two percentages are equal.

• Inequity in income distribution is illustrated by a curved line.

• The farther the Lorenz curve is skewed away from the diagonal line, the
more inequitable the income distribution.

• This curve can be transformed into a single variable, the Gini coefficient. Is
calculated by taking the area between the diagonal line and the Lorenz
curve and dividing by the entire area under the diagonal line. This value is
then multiplied by 100.

• The Gini coefficient can range from 0 to 100, where greater numbers are
associated with greater inequity.
 Operationalising Sustainability
• Daly (1990) provides some guidelines on operationalising
sustainability. He gives 4 basic rules:

1. Limit the human scale (throughput) to a level, which if no optimal,

is atleast within the CC & therefore sustainable.
2. Technological progress for SD should be an increase in efficiency
rather than increase in throughput.
3. Harvesting rates should not exceed regeneration rates and waste
emission not exceed assimilative capacity of envt.
4. Non ren res. should be exploited at a rate equal to creation of
renewable substitutes.

• Daly hinted at pop control & efficiency in using ren res.

• The above rules bridge the gap between efficiency in
production process and externality.
 Indicators of SD
• Defining indicators is complicated. No single indicator can give a perfect &
complete picture about the state of welfare.

• 3 types of indicators to monitor the process of SD can capture all aspects of

ecol and envtal changes:

– Pressure Indicators: refer to flows or changes in envt, ecological and

other attributes that bring about some pressures on the state of envt.
Express the burden placed on the stock of envtal goods and services.
Pressures can emerge from the same geog region or outside it. Eg. Co2
emissions, pop growth, forest degradation.

– Impact indicators: represents the effects of envtal pressures on the

receptors in a predetermined region. Eg. Rise in morbidity, mortality,
increase in hedonic prices of real estate, water and air pollution etc.

– Sustainable indicators: the net result of the pressures and impacts of

envtal changes is the state of dev. These relate pressure or impact with
predetermined reference values. Eg Carrying capacity, quality of life,
human development index, life expectancy etc .
 Indicators of SD
• Example of Sustainability Indicators:

Issue Pressure Impact Sustainable

Climate Co2 emission Concen. of GHGs Global mean

Change Energy intensity temperature

Water Intensity of Short duration Depletion of surface &

Resources use of water morbidity ground water

Soil degradation Deforestation, Water logging, Decline in land

Erosion Intensity of use salinity, floods productivity
of chem ferti.
 Sustainable Accounting
• NNP & GNP associated with income generation attributable to the use of all
factors of production (wages, rentals, profits etc). But natural res are left out.
Income accounting that accommodates all res (ren & non ren) is called
“sustainable accounting”.

• Main objective of Envtal & Eco Accounting is to expand existing system of

national accounts (SNA) in order to integrate envtal & social dimensions in
accounting framework.

• Conventional SNA defines GDP as:

Domestic production-Intermediate use consumption = Private consumption
+Public consumption +Gross investments +Exports- Imports.

• Alternatively, satellite system of accounts for natural res need to be developed to

arrive at “Green GDP”. The United Nations Statistical Division recommends the
development of a system of environmental satellite accounts to monitor
environmental change.

• Environmental costs, benefits, and natural resource assets, as well as

expenditures for environmental protection, are presented in flow accounts and
balance sheets in a manner consistent with National Income and Product
Accounts.