Environment in Decentralized Decision Making
Economic Rationale in Caring for the Enviroment
Module 017
Environment in
Decentralized Decision
Making
Economic Rationale in Caring for
the Environment
Environment in
Decentralized Decision
Making
Economic Rationale in Caring for the
Environment
By
Vito Cistulli, Agricultural Policy Support Service, Policy Assistance Division, FAO,
Rome, Italy
for the
Food and Agriculture Organization of the United Nations, FAO
About EASYPol
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Environment in Decentralized Decision Making
Economic Rationale in Caring for the Enviroment
Table of Contents
1
Summary ................................................................................... 1
2
Objectives.................................................................................. 1
3
Introduction ............................................................................... 2
4
5
6
7
8
3.1
Target audience ..................................................................... 2
3.2
Required background .............................................................. 2
Environmental Scarcity: value and cost .......................................... 2
4.1
Two views on finite availability of natural resources ......................... 3
4.2
Economic concept of welfare ..................................................... 4
4.3
Accounting for natural capital depreciation .................................... 5
Misestimation of environmental values ........................................... 6
5.1
Market failures ...................................................................... 6
5.2
Policy failures .......................................................................10
5.3
Concept of total economic value ................................................11
Methodological approaches to monetary valuation ..........................14
6.1
Basic concept: willingness to pay or accept ..................................14
6.2
Revealed and stated preferences ...............................................15
6.3
Environmental valuation: using market prices ...............................15
6.4
Environmental valuation techniques: absenceof markets..................16
Policy implications for decentralized decision making.......................17
7.1
Role of economic analysis at decentralized level ............................... 17
7.2
Inclusion of non-economic criteria .................................................. 18
7.3
Addressing Capacity and Institutional constraints ............................. 19
Readers’ notes...........................................................................20
8.1
9
Easypol links ............................................................................... 20
References and further readings...................................................20
Appendix 1 - Economic analysis of provision of common pool goods..............202
Appendix 2 – Brief description of some monetary valutation......................24
Module metadata ................................................................................29
Environment in Decentralized Decision Making
1
Economic Rationale in Caring for the Enviroment
1
SUMMARY
This module focuses on the economic dimension of the environment. It revisits the
issue of resource scarcity and its link with the concept of economic welfare1. Factors
which lead to misestimation of environmental values, both from market and policy
failures are next discussed, and the concept of total economic value, inclusive of
various use and non-use environmental values, explained. The methodological
approaches to valuation of environmental goods and services, based on the underlying
concept of willingness to pay or accept are then outlined.
Valuation techniques both with and without complete markets for goods and services
are discussed; a brief description of the main techniques available are provided in the
appendix. Special attention is given to the situation where markets are absent. This is
because analysis using market prices is more readily catered for by conventional tools,
such as cost-benefit and cost effectiveness analyses, whereas environmental goods and
services, which tend to be public goods, lack market prices, and pose additional
conceptual and practical challenges.
The importance of integrating economic rationale into environmental decisions at the
decentralized level, along with non-economic criteria, and the need to address capacity
and institutional constraints at the local level are next discussed, and their policy
implications reviewed
2
OBJECTIVES
This module is intended to bring out the importance of integrating economic rationale,
along with other non-economic criteria, into environmental decisions at the
decentralized level. Economic considerations are central to many decisions impinging
on environmental and natural resources, hence ought to be properly appreciated and
factored routinely into planning and implementation processes by all development
professionals.
The module is meant to help sensitize the reader to basic economic concepts and
possible methodological approaches to environmental valuation. This is considered an
important step in fostering an inter-disciplinary approach that brings together
economists and non-economists in analysis of environmental issues. After reading this
module, the reader should have the necessary background to proceed, if so desired, to
study in greater depth specific analytical tools in other modules, as shown in the
EASYPOL links. To find relevant materials, the reader can follow these links included
in the text to other EASYPol modules or references2.
1
Highlighted in the EASYPol module 016:
Environment in Decentralized Decision Making: An
Overview.
2
EASYPol hyperlinks are shown in blue, as follows:
2
EASYPol Module 017
Conceptual and Technical Material
3
INTRODUCTION
An overview of the relevance of environmental issues in decentralized decision making
processes is given in the EASYPol Module 0163. The present module goes on to
examine why economic rationale is important to such processes. It is meant to provide
an introduction to some basic economic concepts which underpin environmental
valuation, in particular that of total economic value, and possible methodological
approaches that might be used. This is expected to equip the reader with the necessary
background to undertake further study of specific analytical tools on monetary
valuation of environmental goods and services, presented in other modules of the
training path.
Target audience
This module is intended for a wide audience, ranging from policy analysts and decision
makers, to development practitioners, training institutions, and media. It is of particular
relevance to senior and mid level officials and professional officers in ministries of
agriculture, livestock, forestry, rural development, and cooperatives, including line
departments and training institutes/units. It should certainly be of enormous interest to
officers of environmental agencies, local governments, and NGOs/CBOs. Suitably
adapted, it may also be used as a reader in undergraduate courses in natural resource
management, environmental sciences, and in agricultural and rural development.
Required background
This module does not require any specialized technical background. However, it is
recommended that the trainer reviews, as a matter of good practice, the background of
the trainees, in terms of their technical discipline, work experience, and current level of
responsibility. This would help determine the pace at which delivery could take place,
and guide the focus of the discussions. Discussion in sub-groups of trainees with
different backgrounds is a useful device for drawing out and sharing their experiences,
and should be facilitated where practicable.
4
ENVIRONMENTAL SCARCITY: VALUE AND COST
The functional role of environmental resources in creating utility or welfare, and the
concept of an environment-economy system has been discussed in EASYPol module
0163. It was evident that the balance between use of raw materials, production and
consumption processes, and the absorption capacity of the waste sink could impact both
positively and negatively on welfare and the natural resource base. These relationships
underscore the scarcity value of natural resources. Use of a depletable resource for a
given purpose may preclude its use elsewhere or for future generations. Environmental
costs may also be involved where a potentially renewable resource is used or treated in
training paths are shown in underlined bold; b) other EASYPol modules or complementary
EASYPol materials are in bold underlined italics;
c) links to the glossary are in bold; and
d) external links are in italics
a)
3
EASYPol Module 016:
Environment in Decentralized Decision Making: An Overview.
Environment in Decentralized Decision Making
3
Economic Rationale in Caring for the Enviroment
a manner that reduces its quantity or quality. There are thus powerful economic
arguments in caring for the environment at all levels of the system.
4.1 Two views on finite availability of natural resources
The question of finite availability of natural resources has been addressed by various
thinkers, advocating two main views.
The first claims that an expanding economic subsystem (internal sphere in Figure 1),
relative to environmental goods and services provided by the ecosystem, is putting
environmental resources under stress. Supply then becomes limiting in relation to the
demand4. This occurs for raw materials but also and increasingly for the sink and the
amenity services of the ecosystem. Although some of these limits can be overcome (for
example, substitution of solar energy for oil based energy), many of them are not (for
example, landfills) and will pose a real threat to welfare improvement. This view
concludes that the economic growth conflicts with environmentally sustainable
development.
The second puts forward a more optimistic view5 arguing that economic growth
remains feasible without necessarily exhausting natural resources because:
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Technological progress allows the replacement of renewable resources for
exhaustible ones as well as the reduction of the quantity of natural resources
required per unit of economic output;
There is possibility of substitution of man-made capital for natural capital, though
within some limits ; and
New sources of exploration are possible.
It argues, however, that the above is possible on condition that the price system reflects
the real total value (i.e. the value incorporating all the value components of
environmental resources and adjusted for the market failures) of the goods and services
used and produced by the economic system, including those supplied by the
environment. Since prices reflect the scarcity value of goods and services, the advocates
of this view also recognize implicitly that environmental resources are limited.
4
5
Meadows, 1974, and, subsequently, others such as Rees, 1990, Hardin, 1991, Goodland, 1991.
See for instance, Pearce and Turner, 1990.
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Conceptual and Technical Material
Figure 1 - Growing Economic System compared to the Environmental
Ecosystem
Environm ental Ecosystem
RM
RM
S
E
SE
P
Î
C
ECONOM IC
SUBSY STEM
P
Î
C
R
R
W
W
SE = Solar energy
R = Recycling
W = W astes
RM = Raw M aterials (exhaustible and non exhaustible)
P = Production
C = Consumption
But regardless of the emphasis on environmental resource limitations, and policy
implications of their conclusions, the various schools of thought all acknowledge that
problems of scarcity and declining quality of environmental resources have increased
dramatically in the last few decades, particularly in the developing countries.
Environmental considerations in decision-making today are of far greater economic
significance than had been the case in the past.
4.2
Economic concept of welfare
The term welfare is often used interchangeably with well-being and utility. The
economic concept of welfare is founded in Neoclassical economics, as developed in the
1920s and 1930s by Pigou and Hicks6. This is concerned with the total welfare of
society, and provides an important basis from which to assess policy decisions.
Important assumptions implicit in the approach are7:
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Society welfare is the sum of individual welfare.
Individual welfare can be measured (originally conceived as units of utility or
‘utiles’ but, more conveniently, as reflected in prices paid for goods and services).
Individuals maximize their welfare by choosing the combination of goods, services
and savings that yields the largest possible sum of total utility, subject to income
constraints.
An important corollary to the above is that utility and welfare can be obtained from
goods and services even if they are provided free or at minimum cost. The difference
between the amount paid (for a good or service) and the total utility enjoyed is called
consumer surplus. Total utility is then the combination of the amount paid for the good
6
7
Seminal works include: A. C. Pigou, 1920, and J. R. Hicks, 1939.
Adapted from J. A. Dixon et al, 1986.
Environment in Decentralized Decision Making
5
Economic Rationale in Caring for the Enviroment
or service plus any consumer’s surplus. (A similar reasoning can be applied to
producers of goods and services, leading to the concept of a producer’s surplus).
4.3 Accounting for natural capital depreciation
The concept of economic welfare can be related to Hicks’ definition of income8, who
maintains that a man’s income can be defined as “the maximum value, which he can
consume during a week, and still expect to be as well off at the end of the week as he
was at the beginning”. Following this definition, welfare decrease or increase is
generally measured as the amount of goods and services consumed by households in
one year divided by the population to obtain the consumption per capita. If
consumption per capita increases, the average member of the population is better off; if
it decreases, then he or she is worse off.
Various objections have been raised to this measure of welfare. The two most important
are that: i) the standard national account system, from which consumption indicators are
derived, fails to account for the depreciation of natural capital and; ii) it does not
account for equity or income distribution, thus leading policymakers to undertake
unsustainable development strategies.
For human-made capital (dams, roads, buildings, plants, etc.), national accounts set
aside an amount called depreciation to compensate for the decline in value as the capital
wears out; increase in economic activity is recorded as an increase in income only after
depreciation has been subtracted from gross returns. Generally, no such adjustment is
made in the national accounts for natural capital. This follows that we can deplete our
natural resources and the associated economic activities will be recorded only as
income, without reflecting any decline in natural capital endowment.
Attempts have been made in recent years to correct for such limitations in the system of
national accounts and to alter or augment these to take into account the effect of
economic growth on natural resource and environmental assets. Efforts towards
incorporating environmental assets into national accounts have been made by a number
of countries, notably France, Norway, Canada, Netherlands, and Japan and the USA.
The United Nations Statistical Office has also developed guidelines on preparation of
such accounts, known as System of Environmental Economic Accounting (SEEA)9.
Developing countries like Mexico and Thailand have prepared integrated environmental
and economic accounts based on the SEEA.
For most countries, however, environmental accounting of physical and monetary flows
related to the overall economy is hampered by inadequate data systems, and by the lack
of agreement on methodologies for estimating the depletion of natural capital. Despite
8
J. R. Hicks, 1947.
This is essentially is a satellite system of the System of National Accounts. It brings together economic
and environmental information in a common framework to measure the contribution of the environment
to the economy and the impact of the economy on the environment. It provides policy-makers with
indicators and descriptive statistics to monitor these interactions as well as a database for strategic
planning and policy analysis to identify more sustainable paths of development.
9
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Conceptual and Technical Material
these difficulties at the macro level of the national economy, the scope and prospects of
undertaking environmental analysis, based on economic principles, at the micro and
local levels are considerably better. This is due in part to the vast amount of theoretical
and empirical work done in this area in recent years. This has provided a useful
methodological basis for incorporating economic rationale into addressing the issues of
natural resource management and environmental protection at the decentralized level.
5
MISESTIMATION OF ENVIRONMENTAL VALUES
One reason why environment is seldom considered in policy appraisal stems from the
fact that environmental goods and services are not marketed. They therefore do not
have prices that can be comparable with development costs and benefits. Economic
theory explains the absence of markets for these goods and services in terms of: a)
market failure; and b) policy failure.
5.1 Market failures
The dominant economic theory maintains that free and perfectly competitive markets10
will lead to optimal allocation of resources, including environmental goods and
services, or to economic efficiency.
Market failures are defined as those circumstances that prevent the perfect competition,
and therefore economic efficiency, from being achieved. The major sources of market
failures related to natural resources are summarized below.
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Presence of externalities
Nature of public goods
Lack of property rights
Ignorance, uncertainty and short-sightedness
Irreversibility of use11.
Externalities these occur when an economic activity affects technology, consumption,
or preferences of someone who is neither the producer nor the consumer (i.e. a third
party). These effects can be either positive or negative12. In the first case the third party
will be better off and in the latter it will be worse off. In neither case externalities will
be included in the financial price paid for the good produced. In other words, the market
does not signal the costs/benefits of externalities to the perpetrator, who will therefore
not change his/her behaviour accordingly.
10
Perfect competitive markets means that markets are characterised by a large number of
buyers/consumers and sellers/producers who are perfectly informed and engage freely in transactions for
private goods. As it is pointed out in this section, these conditions are often missing in the markets of
both developed and developing countries.
11
For a more detailed discussion on this issue the reader is referred to Buchanan and Stubblebine (1962),
Ward et al. (1991), Carlson et al. (1993), Panayotou (1993).
12
Though this work considers mainly negative environmental externalities, the same analytical approach
can be used for positive environmental externalities.
Environment in Decentralized Decision Making
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Economic Rationale in Caring for the Enviroment
An example of negative environmental externality (sometimes also called external
diseconomy) is the case when the aerial dispersion of chemical sprays applied by
farmers contaminate nearby livestock operations, increasing their production costs in
the form of additional veterinarian’s bills and medication. The perpetrator of
environmental costs will not be informed by the market about the costs generated to
livestock producers, so he/she will not receive incentives to reduce pollution. If farmers
were obliged to internalize the pollution costs generated, the resources may be allocated
to alternative and more efficient uses.
Externalities may also occur over time, thus affecting future generations. But the links
between humans and environment are often not known a priori nor can the preferences
of future generations be known vis-à-vis environmental resources. In general, only
when environmental damages occur will these linkages become known. Such
externalities are thus associated with uncertainties and poor knowledge.
Nature of public goods. As can be seen in Table 1 below, goods and services can
generally be divided into four categories on the basis of two main characteristics:
excludability and rivalry. The definition of these categories is given in Box 1.
Environmental goods and services are often thought of as being public goods or
common pool goods either because they are: a) non-excludable and non-rival, or b)
because they are non-excludable but rival. Belonging to one or another category of
goods may however vary according to the circumstances.
Table 1 - Goods and Services Classification
High
Rivalry
High
Low
Excludability
Low
Private Goods Common
Pool
Goods
Toll Goods
Public Goods
To the category of public goods belong, for example, sunlight, weather, biodiversity,
flood control services of forests and coral reefs. Other environmental services are also
generally classified as public goods, notably: scenery, clean air, clean water. However,
the latter services can be subject to increasing rivalry or excludability as they approach
a congestion point. Beyond this point they may assume the characteristics of either
common pool, toll, or private goods and services.
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Box 1 - Classification of Goods
Private Goods: goods for which there is high rivalry and high excludability. Moreover,
private goods are also generally divisible in smaller exchangeable units (e.g. square meter of
land).
Common Pool Goods are resources used by multiple individuals regardless of the type of
property rights involved. Excludability for such goods and services is low but rivalry is high.
Examples are common land, fisheries, wildlife, and rivers.
Toll Goods (also called Club Goods) are non-rivalrous, at least up to the point where
capacity constraints may influence the marginal cost of further provision, but which are
excludable. A typical example is roads, but national parks could also be considered toll
goods.
Public Goods: goods and services that are non-excludable, non-rival, and indivisible. In
other words public goods (sometimes also called collective goods) are those that each
individual can consume simultaneously in equal amounts. Typical examples are public
information, defence.
Take the case of an open access site with charming scenery. As long as the number of
visitors enjoying the site is low, scenery service of the site can be considered a public
good. If demand for the site increases, congestion problems may arise and users’
benefits decrease up to a point where marginal costs become higher than marginal
benefits, which will push many users to search for alternative sites. Moreover, if the
number of visitors exceeds the carrying capacity of the site, degradation effects will
most likely occur. This scenario would suggest a situation much closer to common pool
goods than public goods.
The category of pool goods includes all the renewable natural resources, notably
forests, water, wildlife, fisheries. It is worth pointing out here that many times this
category of resources is used interchangeably with open access resources or common
property resources. The latter categories entail a property right regime regulating the
access and use of the natural resources. Open access resources mean there are no
common rules at all regarding the access to and use of common pool resources.
Common property resources, on the contrary, are subject to property rights based on
enforceable rules all the users agree upon and comply with. The degree of exploitation
and degradation of common pool goods very much depends on whether a property
rights regime exists or not, and on the effectiveness of the rules and rights established.
In the extreme case of an open access resource, say grazing land, the use by one herder
will not exclude the same use by another herder. If herders behave rationally (i.e. all
aim at maximizing profits) they will use as much as they can of the environmental
resource (herders, for example, will bring to the grazing area the highest number as
possible of animals and leave them on the area as long as possible) simply because
exploitation cost of the resource is zero. It is clear that by doing so the grazing land will
deteriorate very quickly. But, since the herders have no incentive to reduce their use of
pasture they will not change their behaviour and land will be overexploited. This case,
which is often referred to as the ‘Tragedy of the Commons’13, highlights the problem of
the property rights, discussed below. An economic analysis of the reason why open
access resources may not lead to efficient exploitation is provided in Appendix 1.
13
Hardin, 1968.
Environment in Decentralized Decision Making
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Economic Rationale in Caring for the Enviroment
Property rights are any kind of legal acts defining the rights of individuals to use
natural resources. These rights can be ownership rights, lease, or use rights conferred by
law (e.g. the right to use water passing over one’s property). The underlying assumption
is that well defined, exclusive, secure, transferable, enforceable, and clear property
rights allow to create markets for public goods and externalities, and consequently to
place an economic value (price) on them. If these conditions are not met, like in the
open access situation, the incentives to conserve, protect, and manage natural resources
in a sustainable manner will be undermined. The need of property rights is tightly
linked to the perception of ecological risk. The higher the risks of degradation of the
natural resources, the more incentive there is to manage them collectively and to create
rules ensuring the rights as well as the duties towards the resource (Wade, 1986).
Take the case of farmers disposing their waste waters in a lake. The absence of property
rights will generate a situation where farmers believe that they have the right to pollute.
If the lake is also used by others who claim the right to use clean water for swimming, a
conflict will emerge between the two parties as to who actually has the right to the
resource. If conflicts are not settled, the resource will deteriorate very quickly, since all
polluters will behave as in the open access situation. If, on the contrary, the parties
involved are aware of and concerned about the value of the resource and the risk of
deterioration, they will concur in the definition of rules toward the access to and use of
the lake. Whatever the instrument used to overcome the dispute (negotiation,
government intervention with laws or economic incentives, courts), the outcome will be
the setting up of property rights.
The problem of property rights is particularly important in developing countries where
modernization of the tenure systems in agriculture has often been accompanied by the
removal of local traditional and custom-based rights to the use and management of
environmental resources, without substituting them with effective alternatives. The
disruption of traditional tenure and management systems have in many cases led to
situations very close to open access resources, and therefore to overexploitation of
resources.
Ignorance and uncertainty may also hinder the functioning of markets. The limited
knowledge of some environmental processes does not help providing the users of
natural resources with the required information on the possible impacts in terms of
quantity, quality and time of occurrence in order to adjust their behaviour. Shortsightedness adds on the market failures in that individuals or countries (particularly
lower income ones) have usually short time horizons, thus preferring investments
yielding benefits in the short to medium term rather than in the long term. In other
words, the marginal value of a US dollar one now is worth more than the same in the
future. This time preference is reflected in positive discount rates of benefits generated
in the future (see Box 2). The effect of positive discount rates is that the present value
benefits occurring in the future will be less attractive than the benefits obtained in the
short term.
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Let us assume that we have to decide between two possible options for rehabilitating an
abandoned area: the first is an industrial development project; the second is
reforestation. The industrial plant will most likely yield benefits in the first years,
whereas the investment in reforestation may generate benefits only after 30 years. Let
us assume for simplicity that both projects yield all its benefits in one period but in
different years: the industrial plant in Year 3 and the reforestation project in Year 30.
We assume also that the net benefits of the industrial plant are worth US$3 000 and
those of the reforestation project US$15 000.
Box 2 - Discounting the future benefits and costs
Discounting is the computational technique that measures the preference of the individuals
for the present. It calculates the velocity of loss of value of money in the future. The larger
the discount rate, the higher the velocity of loss of value. So, for example, a discount rate of
10 percent to a benefit of US$10 received in 10 years time will be worth US$3.85 now. If the
discount rate is 3 percent, the same amount of money received in 10 years time will be
worth US$ 7.44 now. The formula to calculate the present value (the value now) of the
benefits received in the future is:
A*1/(1+i)n
where: A = amount of money received; i = discount rate used and; n = the year the amount
will be received from now. In the examples above, the formulas will be:
US$10*1/(1+0.1)10 = US$3.85 and US$10*1/(1+0.03)10 = US$7.44
With a positive discount rate of 8 percent, the present value of the two investments,
using the formula of Box 2 will be US$2 381 and US$1 491 respectively. It follows that
despite the higher benefits generated by the reforestation project, the industrial project
has a higher present value. The above is an example of time preference by people , and
explains why environmental investments are seldom put first on the development
agenda.
Irreversibility is a typical element of environmental market failure. Some development
investments may determine the irreversible loss of natural assets both for the present
and future generations. This will reduce the options available to future generations to
use the asset in question. Since preferences of future generations cannot be known, it is
difficult to state whether it is worth destroying a resource or to conserve it indefinitely.
5.2 Policy failures
One rationale behind government intervention is to correct for the various forms of
market failure outlined above. It may also be to influence the distribution of market
outcomes and the social morality of markets. Governments can intervene to achieve
efficiency objectives (internalizing externalities in the production processes or defining
property rights, for instance). But it may also intervene in relation to objectives not
related to efficiency, such as poverty alleviation, income redistribution between social
groups and regions (equity issue); in controlling proliferation of ‘unethical’ goods, such
as construction of materials hazardous to human health or genetically modified seed
varieties (moral issue); or stockpiling strategic food stocks (political issue).
Failure to intervene in situations of market failure means environmental problems are
perpetuated. This is one obvious form of policy failure. Even where there is
Environment in Decentralized Decision Making
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Economic Rationale in Caring for the Enviroment
intervention this may either fail to achieve an internalization of environmental
externalities or do so only partially – making the market failure worse. Where no
market failure is apparent, the wrong policy interventions can distort an otherwise well
functioning market. Thus, government interventions can sometimes contribute to and
even exacerbate the mismanagement of natural resource by giving the wrong signals to
individuals and firms.
Many examples can be cited of distortions in the allocation of natural resources induced
by poorly designed government interventions. Some of the major sources of policy
failures affecting the environment in developing countries include:
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Low tariffs of environmental resources’ use, such as irrigation water
Subsidized energy-intensive inputs, such as fertilizers and pesticides
Poorly defined property rights
Poorly designed investments
Subsidies for environmentally depleting activities (e.g. ranching)
Low royalties charged on natural resource mining.
Nationalization of natural resources can also be a policy failure in certain instances,
notably when high transaction and management costs are involved. This is the case, for
example, of forest resources of many developing countries where governments are
unable to control access to forest lands under public ownership and lack financial
resources for their efficient management. In Nepal, where the government decided to
change the forest property regime and protect forests as a state-owned resource,
communities were excluded from the management of the forests. This modified land
use incentives and led individuals and communities to view state-owned forests simply
as open-access resources14.
5.3 Concept of total economic value
As was stressed earlier, although it is generally agreed that environmental resources
have a scarcity value, their goods and services are generally not priced. In addition,
their value is generally underestimated due to lack of scientific information on the
various possible services they can supply. Absence of price signals as to the true value
of natural resources can lead to policy decisions that are detrimental to the environment.
Efforts to tackle this problem led to the field of environmental economics, which is
underpinned by the concept of total economic value of environmental resources. This
issue was first addressed by environmental economists in the 1960s (Weisbrod in 1964,
and Krutilla in 1967), who proposed a classification of economic values, which
encompass some of the major externalities of natural resources exploitation. Although
14
Pradhan and Parks, in Hanna and Munasinghe, 1995.
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there is not yet complete agreement on this classification15 it is now widely accepted
that two broad categories of values exist: "use values" and "non-use values".
Use values are the benefits that derive from the actual use of the natural resources.
Forests, for example, can be managed to provide benefits such as erosion prevention,
recreation, landscape view, etc. Use values are sometimes further divided, according to
various authors, into:
ƒ
ƒ
Primary values or marketed goods and services, also known as consumptive value;
and
Secondary values or non-marketed goods and services16, including ecological
benefits, such as services provided by forests that contribute to the preservation of
ecological integrity (such as soil, water and air quality).
Non-use values correspond to those benefits which do not imply a contact between the
consumers and the good. That is, people do not require to use the good they are willing
to pay for. One example is the willingness of people who will probably never visit
Africa to pay for the protection of elephants in Africa. Non-use values are by many
authors also defined "existence value". The arguments behind existence value are
intrinsic value and bequest motive:
ƒ
ƒ
Intrinsic value relates to the existence of a landscape or a particular habitat (i.e. the
satisfaction of preserving the forest for itself and not as a function of any human
use); and
Bequest value involves altruism such as, for example, the desire to preserve forests
for the enjoyment of other people both now (intra-generational) and in the future
(inter-generational).
In addition to these values, environmental economists have introduced another value:
the option value. This is the value placed on environmental assets by those people who
want to secure the use of the good or service in the future. The classification of this
value is controversial in so far as some authors consider it as a use value, whereas
others regard option value as a non-use value. Option values can be either positive or
negative.
Figure 2 provides an illustrative but incomplete list of the values that make up total
economic value, attributed to forests by economists17.
15
Other classifications have been devised, for example, by Filion, 1993; Sarker and McKenney, 1992;
Mc Neely et al, 1990.
16
Pearce and Turner, 1990; Young, 1991; OECD, 1994; Sharma, 1992; Bateman, 1993a; Pearce and
Warford, 1993.
17
Ecological economists suggest a different classification, where life-support and ecological values are
considered primary services and consumptive and non-consumptive goods and services are secondary. In
substance, ecological economists invert the classification of mainstream economists by placing higher
importance on ecospheric values such as sunlight, lithospheric energy, soil, water, landforms, climate,
atmosphere, and organisms, to which it is difficult to assign monetary values.
Environment in Decentralized Decision Making
13
Economic Rationale in Caring for the Enviroment
Figure2 - Total Economic Value of Forests
Total Economic Value
Use Value
Existence Value
Direct
Indirect
Direct
Consumption of
Primary Goods
Secondary Goods
and Services,
Including
Ecological
Future
Consumption of
Goods and Services
No Consumption of
Goods and Services
•
•
•
•
•
•
•
•
•
•
•
•
•
•
Timber
Fruits, nut,
herbs, latex,
gum arabic,
litter, etc.
Fuelwood
Forage and
fodder
Developed
recreation
and hunting
•
•
•
•
•
•
Scenery
Recreation
Community
integrity
Wildlife
Climate
mitigation
Air quality
Soil quality
Water cycle
Biodiversity
Option
•
•
Biodiversity
Wildlife
Community
integrity
Scenery
recreation
Air, soil and
water quality
Existence
Biodiversity
Scenery
Wildlife
Others
Bequest values
•
•
•
•
•
Biodiversity
Scenery
Recreation
Wildlife
Air, soil and
water quality
The total value of an environmental asset is therefore obtained by summing up all the
value components: use values, including option value, and existence value. Of course
when summing up the goods and services, caution should be used in order to avoid
double-counting. Indeed, before proceeding with the aggregation of these values, the
analyst should be sure that they are not mutually exclusive (for example, benefits of
clear-felling cannot be added to recreation or soil protection) or that they are not already
captured by other value components (for example, option values can be captured partly
by use values and existence values).
Assume, for example, that a railway line is planned to pass through a valuable forest
area and will cause its destruction. Whether the development project is worth doing will
depend on an accurate analysis of the flow of costs and benefits it generates. The
formula for cost-benefit analysis is:
Box 3 - Formula cost-benefit analysis
∑(B − C ± E)
1
≥0
n
(1 + i )
where: B are the benefits of the development project, including generally the primary
goods of fig.2; C are the development costs (investments and operating); E are net
14
EASYPol Module 017
Conceptual and Technical Material
environmental costs or benefits, including secondary and ecological goods and services,
as well as option values and existence values; i is the discount rate and n is time.
The problem exists however of how to place an order of magnitude/importance on these
values. Ideally these values should be expressed in monetary terms so that they can be
compared with all the other costs and benefits of policy decisions. In practice, as
already mentioned, many environmental goods and services cannot be priced. In the
past decades, several tools and techniques have been developed to measure the total
economic value of natural resources. Approaches based on monetary valuation of
environmental goods and services are outlined below.
6
METHODOLOGICAL APPROACHES TO MONETARY VALUATION
6.1 Basic concept: willingness to pay or accept
The monetary valuation of an environmental good is usually based on the monetary
value individuals place on it. The maximum amount of money an individual is willing
to pay for obtaining a benefit or avoiding a loss in most situations reflects the intensity
of its preferences for such a benefit or loss18. His preferences in turn are based on the
values he attaches to goods. The maximum willingness to pay (WTP) can be considered
therefore an expression of the individual’s values. Analogously, the minimum
Willingness To Accept (WTA) an amount of money as compensation for foregoing a
benefit or for incurring a loss reflects the value of such a benefit or loss.
When an individual buys an asset paying for it the market price, the price paid directly
reveals a lower bound of his maximum willingness to pay. It indeed reveals that the
willingness to pay for such an asset is "at least" equal to the price paid. For example, if
we observe an individual paying 10 monetary units for a kilogram of sugar, this means
that he is willing to pay at least 10 monetary units for each kilogram of sugar of that
quality, otherwise he would not buy it at that price. His/her maximum WTP must be
equal to or greater than 10 MU.
Similarly, when an individual sells an asset and receiving for it the market price, the
amount of money received directly reveals an upper bound for his minimum
willingness to accept for foregoing such an asset. For example, if we observe an
individual selling a kilogram of sugar at 10 monetary units, it means that his minimum
willingness to accept a compensation for foregoing one kilogram of sugar is not greater
than 10 MU (Figure 3).
18
It is common sense to say that if we are willing to pay more for the asset A than for the asset B, then
we prefer A to B. See Markandya et al, 2002.
Environment in Decentralized Decision Making
15
Economic Rationale in Caring for the Enviroment
Figure 3 - Price as lower bound to Max WTP and Upper Bound to Min WTA
Price (P) in
MU
5
10
15
20
Max WTP
Min WTA
E.g. A kilogram of sugar is traded at P=10 M.U. It means that the Lower bound to Max WTP to
get a kilo of sugar is 10 M.U. Besides, 10 M.U is the upper bound to Min WTA to give up a kilo
of sugar. Max WTP and min WTA are somewhere above 10 MU and below 10 MU,
respectively.
When there is no market for an asset, obviously there is no market price that reveals the
lower bound of individual’s maximum WTP and the upper bound of the minimum
WTA. There is therefore no useful yardstick for the value that individuals attach to
such an asset. To evaluate people's WTP or WTA, i.e. for obtaining a money measure
of the value individuals attach to non-marketed assets, alternative ways of obtaining the
necessary information is needed, as discussed below.
6.2 Revealed and stated preferences
One of the major issues in welfare economics is how to derive the measures of change
in welfare. Two main approaches are practicable:
ƒ
ƒ
One can analyse the actual consumer behaviour, the consumer’s reactions in
adjusting the bundle of goods consumed in response to changes in the set of prices
faced or in the quantity change of an enjoyed environmental good/service. In such
cases the analyst looks at the so called “revealed preferences”, that is s/he recovers
from the actual behaviour the consumer’s preferences, and uses this information to
work out money measures of the consumer’s welfare changes.
Asking the consumers directly their willingness to pay or willingness to accept for a
proposed price change or for the envisaged quantity change. This approach utilises
the family of techniques sometimes called “stated preferences techniques”, that is
based on what the consumer states when directly asked to express his value
judgement.
In either case, reactions of the consumer to changes in prices or quantities of
environmental goods or services provide the basis for approximating the economic
values attached.
6.3 Environmental valuation: using market prices
Where market prices exist, for instance on a physical output affected by a decision or
action on the environment (say, loss of wild honey production from clearing of a
forest), the valuation of the environmental impact can be assessed using fairly
conventional economic tools. These are related primarily to cost-benefit or cost
effectiveness analysis approaches, as commonly used in project appraisal. These are
16
EASYPol Module 017
Conceptual and Technical Material
underpinned by Neoclassical economics (see above), which give special emphasis to
the incremental changes in outputs and inputs, and the opportunity cost of alternatives
foregone. The most well know techniques include incorporating loss of earnings or
changes in productivity into assessment of the costs and benefits of a given action,
project or programme.
The implicit assumption in using market prices to determine value is that these prices
reflect economic scarcity and are hence efficiency prices. If there are distortions in the
market prices (for example from taxes, subsidies or exchange rate policies), these will
need to be adjusted and ‘shadow’ or accounting prices used instead.
6.4 Environmental valuation techniques: absence of markets
Many environmental goods are public or common pool goods in nature. As such,
market prices are often not available. The value of an increase or decrease in supply is
then equal to the sum of the marginal willingness to pay or accept. Information on these
may not be easy to obtain. In the absence of complete markets, a number of different
techniques for placing a value on non-marketed goods and services may be used,
depending on circumstances. These techniques have been classified in several ways,
according to the objective pursued.
One classification19 is based on: (i) whether the data come from observation of people
acting in the market (revealed preferences) or come from people’s responses to
hypothetical questions on their willingness to pay for a change of the environmental
services (stated preferences); and (ii) whether the methods yield monetary values
directly or indirectly. Another distinguishes three possible approaches: (i) conventional
market; (ii) implicit market; and (iii) constructed market20. The OECD classifies the
valuation methods according to their appropriateness in the measurement of the various
types of impacts21.
A number of tools of varying degrees of sophistication, based on the Munasinghe
classification are listed in Table 2. The conventional market is understood here as to
utilize actual market prices, inclusive of direct proxies for costs and prices that
approximate the values of environmental externalities. Revealed preferences apply here.
Implicit markets also imply revealed preferences. But here only indirect proxies are
used for valuation. The assumption is that the non-marketed environmental good or
service affects the preferences expressed by consumers about other goods and services.
For example, the cost of air pollution is estimated by calculating the impacts of
pollution on the market prices of houses. The constructed market approach requires
information on peoples’ stated preference, through simulation hypothetical markets of a
good or service (say, scenery). It generally entails asking people (questionnaire or
19
Mitchell and Carson, 1989.
Munasinghe, 1993.
21
Four categories of impacts are identified for different sectors, namely: (i) productivity; (ii) health; (iii)
amenity; (iv) existence values. This classification is particularly useful to identify the most appropriate
techniques to place a monetary value on the environmental impacts according to the sector generating the
impact. OECD/EDI/ODA, 1995.
20
Environment in Decentralized Decision Making
17
Economic Rationale in Caring for the Enviroment
through experimental techniques) what they are prepared to pay (for a benefit) or
receive (as compensation for damage caused).
Table 2 - Some monetary valuation techniques under different approaches
Conventional market
Implicit market
Constructed market
Productivity change method
Preventive or defensive
expenditures
Replacement costs
Restoration or reclamation costs
Opportunity cost method
Shadow projects
Substitute costs method
Travel cost method
Wage differential
Hedonic pricing
Artificial market
Contingent valuation
method
Source: Adpated from Munasinghe, 1993.
ƒ
7
A brief description of some of the tools listed above is given in Appendix 2.
POLICY IMPLICATIONS
MAKING
FOR
DECENTRALIZED
DECISION
The foregoing indicates that there are important economic rationale as to why one
should care for the environment. In principle, focusing on the economic dimension of
environmental related decisions or actions makes explicit what quantitative values are
being assigned to particular environmental goods and services, from both benefit and
cost perspectives. This can help make the basis of such decisions more transparent and
amenable to public scrutiny. At the same time, however, the pertinence of other noneconomic criteria for decisions at the decentralized level cannot be ignored. Potential
difficulties posed by limited capacity in economic analysis and institutional weaknesses
should also be recognized. Policy implications of these are discussed below.
7.1 Role of economic analysis at decentralized level
Integrating economic criteria into environmental decisions can take place at various
levels of decision making within the micro-macro continuum. Economic criteria are of
course already central to many policy decisions at different levels of development
planning and implementation. Inclusion of environmental values may simply mean an
extension of existing procedures, which can take place at any point in the planning
process. However, two main functional areas at the decentralized level where the
economic concepts and valuation techniques outlined have particular relevance are:
Appraisal of the merit of specific development interventions, such as projects and
programmes, that directly utilize environmental resources in an area (such as a district
or county), or can otherwise affect these quantitatively or qualitatively.
18
EASYPol Module 017
Conceptual and Technical Material
Formulation of location specific policies or strategies relating to use/exploitation or
conservation/ protection of an environmental resource (this may be within an
administrative area or span a number of areas).
Development activities can deplete as well as degrade environmental resources, the
value (cost or benefits foregone) of which need to be properly reflected within the
appraisal framework. Both on-site and off-site benefits and costs (i.e. inclusive of
externalities) need to be valued. An agro-processing plant may lead to loss of earnings
for freshwater fisheries if raw effluent is discharged say into a lake. Whereas, increased
fuelwood supply from forestry projects may improve productivity of nearby farms if the
dung from livestock, previously used as fuel, is now utilized on crops. Value of the
decreased fish catch or increased crop output need to be accounted for in the costbenefit balance. Other indirect or non-use values may also be involved. Such possibility
ought to be examined and an assessment made as to the need and feasibility of
accounting for these in the analysis of development projects and programmes.
Understanding of the full economic value of specific environmental goods or services is
necessary when assessing policy options and the type of measures or instruments for
natural resource management at the local level (such as a lake of exceptional beauty or
a forest with valuable non-timber forest products). This would also help in determining
fiscal arrangements required, including decisions on taxes, revenue generation, user
charges for resource exploitation/ extraction, and for identifying cost effective measures
for environmental protection and mitigation. They also provide a rational basis for
setting rules and regulations for use of a given environmental resource22.
7.2 Inclusion of non-economic criteria
Application of economic criteria in environmental decisions pre-supposes that policy
concerns are for achievement of economic efficiency. In practice, other objectives such
as social equity, employment generation, national security, or the provision of goods
and services through the ‘merit goods’ aspect, may be given equal if not higher priority
by local people and administrations. These criteria are often factored into environmental
decisions at local as well as national levels. They can be catered for through, for
instance, the use of a multi-criteria decision matrix for examining options and criteria
simultaneously. What weight to give different criteria is however often a socio-political
issue, and beyond the remit of economic analysis. Nonetheless, by setting out explicitly
the monetary values involved, decisions to accept or reject a particular option could at
least be rendered more transparent to all concerned.
The question of non-economic criteria cross-cuts with the issue of potential conflicts
between different stakeholders affected by a given development intervention or policy
decision. This is particularly so where externalities are involved, since there are likely
to be losers as well as gainers in economic and social terms (women having to walk
further for potable water, or increased risk of disease). The principle of ‘the polluter
pays’ is not always easy to apply, especially when there are large disparities in income
22
Refer EASYPol Module 016 : Environment in Decentralized Decision Making: An Overview: for
a discussion on entry points for environmental decision making, including introduction of regulatory and
economic instruments.
Environment in Decentralized Decision Making
19
Economic Rationale in Caring for the Enviroment
between groups affecting or being affected by an environmental decision or action,
common in many developing countries. There will be need for resolution of the
situation, either through negotiation or by government interventions at various levels.
7.3 Addressing capacity and institutional constraints
One important factor impeding incorporation of economic rationale into development
planning processes, in general, and environmental decision making, in particular, is
human resource constraints at the local level. Whilst country situations vary, there is
often a shortage of personnel skilled in economic analysis within deconcentrated or
devolved government agencies. This can be severe where many sub-sectoral
departments with different remits (livestock, food crops, tree crops, and forestry for
instance) are represented within a small geographical area like a district.
There is a general need to improve the human resource situation at different levels of
the administrative hierarchy, and various countries are taking general or specific steps
in this regard. However, this is often hampered by inadequate financial provision as
well as the low priority accorded economics and social science disciplines in staffing at
the decentralized level. In many instances, communication and cooperation between
different sub-sectors agencies is rendered difficult by inter-departmental rivalry.
Addressing these human resource and institutional issues can prove challenging. While
specific prescriptions are not attempted, a number of broad approaches are worth
considering:
ƒ
ƒ
ƒ
ƒ
The application of economic concepts should not be seen primarily as the task of
designated ‘economists’ within the development planning and management system.
Economic considerations are all pervasive: they are as relevant to the aquaculture
specialist as it is to the forester when analyzing the merit or otherwise of a given
policy or action. An attempt thus needs to be made by all development professionals
involved in a particular issue to include economic rationale in decisions on
environment related issues.
There is no need to always attempt precise and sophisticated analyses. Where the
situation dictates, a rough back-of-envelope estimate could provide an invaluable
starting point. This could be refined over time. A decision could later on be made as
to whether there is need for more specialized environmental economics assistance,
which can come from external institutions or through consultancy contracts.
Adopting an inter-disciplinary approach which brings together different technical
skills in analysis of environmental issues is essential. Even where well qualified
economists are available, it is unlikely they would have the breadth of knowledge,
on production and ecological processes or their social ramifications, to
comprehensively cover all critical aspects. Formation of inter-disciplinary planning
teams or task forces at the local level provides one means of seeing that economic
and non-economic perspectives are properly catered for.
There are important benefits from sustained enhancement of human resources at
sub-national and local levels. This may be done through training courses, exchange
20
EASYPol Module 017
Conceptual and Technical Material
field visits, cross-sector fora for information sharing, and through direct
participation in planning teams or tasks forces. This would need to be supported by
the government at various levels, as an ongoing process of capacity development.
Besides skills in economic and environmental analysis, providing an appropriate
institutional environment to apply those skills in an integrated and collaborative
manner is also essential.
8
READERS’ NOTES
8.1 Easypol links
This is one of several modules of a thematic overview nature in the training path
Decentralization and Agricultural Development.
This module should be used in conjunction with, and be preceded by the module
EASYPol Module 016: Environment in Decentralized Decision Making: An
Overview.
Other training paths closely related to the present module include:
ƒ
Analysis and monitoring of socio-economic impacts of policies
ƒ
Investment planning for rural development
9
REFERENCES AND FURTHER READING
Buchanan, J. M. & Stubblebine, 1962. Externality, Economica, pp. 371-384.
Coase, R. H., 1960. The Problem of Social Cost, Journal of Law and Economics, 3,
pp.1-44.
Daly, H. E., 1991. Sustainable Development: From Conceptual Theory Towards
Operational Principles, Population and Development Review.
Dixon, J. A., Carpenter, R. A., Fallon, L. A., Sherman, P. B., and Manipomoke, S.,
1986. Economic Analysis of Development Projects, Earthscan, London, UK.
Freeman, A. M. III, 1985. Supply Uncertainty, Option Price, and Option Value in
Project Evaluation, Land Economics, 61, pp. 176-181.
Hanna, S. & Munasinghe, M. (edrs). 1995. Property Rights and the Environment:
Social and Ecological Issues, World Bank, and Stockholm, Beijer International
Institute, Washington, DC, USA.
Hardin, G. 1968. The Tragedy of the Commons, Science, 162 (December), pp.12431248.
Hicks, J. R., 1947. Value and Capital (2), London, Oxford University Press, Oxford,
UK.
Hicks, J. R., 1939. Foundations of Welfare Economic, Economic Journal 49 (196).
Environment in Decentralized Decision Making
21
Economic Rationale in Caring for the Enviroment
Johansson, P.O., 1991. An Introduction to Modern Welfare Economics, Cambridge
University Press, Cambridge, USA.
McNeely, J. A., Miller, K. R., Reid, W. V., Mittermeier, R. A. & Werner, T.B. 1990.
Conserving the World Biological Diversity. IUCN, WRI, CI, WWF-US, &
World Bank, Gland, Switzerland & Washington, DC, USA.
Markandya, A., Harou, P., Bellu, L.G., Cistulli, V., 2002. Environmental Economics for
Sustainable Growth: A Handbook for Practitioners. The World Bank, Edward
Elgar, Cheltenham, UK.
Mitchell, R. C. and Carlson, R. T. 1989. Using Surveys to Value Public Goods: The
Contingent Valuation Method. Resources for the Future, Washington, DC, USA
Munasinghe, M., 1993. Environmental Economics and sustainable development. World
Bank Environment Paper No. 3, Washington, DC, World Bank, USA.
OECD, 1995. The Economic Appraisal of Environmental Projects and Policies: A
Practical Guide. OECD/EDI/ODA, Paris, France.
OECD, 1994. Project and Policy Appraisal: Integrating Economics and Environment,
Paris, France.
OECD, 1989. Environmental Policy Benefits: Monetary Valuation, Paris, France.
Panayotou, T. 1994. Economic Instruments for Environmental Management and
Sustainable Development. Harvard Institute for International Development,
Cambridge, USA, and International Center for Economic Growth, San
Francisco, USA.
Pearce, D. W. & Warford, J. J., 1993. World Without End: Economics, Environment
and Sustainable Development, Oxford University Press, New York, USA.
Pigou, A. C. 1920. The Economics of Welfare, Macmillan, London, UK.
Repetto, R., Magrath, W., Wells, M., Beer, C. & Rossini, F., 1989. Wasting Assets:
Natural Resources in the National Accounts. Resources for the Future,
Washington, DC, USA.
Sarker, R., & McKenney, D., 1992. Measuring Unpriced Values in Ontario’s Forests:
An Economic Perspective and Annotated Bibliography, Ministry of Natural
Resources Sault St. Marie, Ontario, USA.
Tietenberg, T. H., 1996. Environmental and Natural Resources Economics,
HarperCollins College Publishers, New York, USA.
Wade, R., 1986. Common Property Resource Management in South Indian Villages.
National Research Council, Proceedings of the Conference on Common
Property Resource Management, pp. 231-258, National Academy Press.
Washington DC, USA
22
EASYPol Module 017
Conceptual and Technical Material
APPENDIX 1 - ECONOMIC ANALYSIS OF PROVISION OF COMMON POOL GOODS
Let us assume the case of a hunting activity. Harvest is obtained by using some
production factors, say labour.
Let us also assume that the cost of labour (marginal cost corresponding to the
opportunity cost of labour in the economy) is constant and is worth 4 units.
Assume finally that the production function is of the following form:
Y = - l2 + 8l
From the economic point of view, the efficient exploitation of animals is where the
Marginal Value Product (MVP) of harvest equals the Marginal Cost (MC) of labour.
The MVP is obtained by calculating the first derivative of the production function, i.e.:
MVP = - 2l + 8
At this stage it is possible to calculate the efficient level of exploitation of animals. In
the table below are reported the values of harvest (Y) and MVP given the MC of labour
(MCl).
If l=
Y
MVP
MCl
0
0.5
1
1.5
2
2.5
3
3.5
4
4.5
5
5.5
6
6.5
7
(-02 +8*0)=0
3.75
7
9.75
12
13.75
15
15.75
16
15.75
15
13.75
12
9.75
7
(-2*0+8)=8
7
6
5
4
3
2
1
0
-1
-2
-3
-4
-5
-6
4
4
4
4
4
4
4
4
4
4
4
4
4
4
4
AVP=Y/l except
for the 1st
8
7.5
7
6.5
6
5.5
5
4.5
4
3.5
3
2.5
2
1.5
1
Environment in Decentralized Decision Making
23
Economic Rationale in Caring for the Enviroment
The above data are used to draw the graph below:
P
P: prices
MVP : marginal value product
AVP : average value product
MC : marginal cost
AC: average cost
H: harvest
MC
AC
AVP
MVP
12
16
H
The level of output that makes the MVP equal to the MC of labour is 12. This is also
the point where hunters maximize their benefits or, which is the same, marginal benefits
are just equal to marginal cost.
Let us assume now that resources are open access. In this case, there will be no
restrictions to hunting. New hunters will be attracted by this activity as long as the
Average Value Product (AVP), that is the total value of production divided by the total
harvest, is higher or equal to the Average Cost (AC) of labour (also equal to the
opportunity cost of labour in the economy). The values of AVP are reported in the table
above and the corresponding curve is depicted in the graph by the curve AVP. It can be
seen from the table and the graph that the new harvest level (16 units) is higher than the
previous efficient situation, thus resulting in excess exploitation. It is also worth noting
that marginal productivity is zero.
In an open access situation, the main reason why hunters will overexploit the resources
stems from the fact that the benefits derived from restricting harvest to the efficient
level by one hunter would not be captured by the same hunter but by other hunters.
24
EASYPol Module 017
Conceptual and Technical Material
APPENDIX 2 - BRIEF DESCRIPTION OF SOME MONETARY VALUATION METHODS
Productivity change. The environment is considered here as a production factor.
Changes in environmental quality lead to changes in productivity and production costs
which in turn lead to changes in prices and outputs. The environmental benefit of the
project will be the additional benefit in terms of crop production generated by the
reduction of soil erosion in the "with" project situation as compared to the "without"
project situation. One important criticism to this method is that it does not take into
account behavioural and market responses to changes in the quantity or quality of the
environmental attribute. Farmers, for example, can react to soil erosion either by
changing cultivation practices or by applying different quantities of organic and
inorganic fertilizers. Moreover, the prices of agricultural crops may change because of
changes in crop supplies. And it may be that welfare effects of price changes are higher
than yield effects.
Box A2.2 - A simple application of the productivity change method to land
degradation
The productivity change approach measures the production lost as a result of land
degradation. A simple formalization of this method is as follows:
Production loss = production from non-degraded land – production from degraded land
With the condition that there is no change of technology and management practices.
Let us assume that 500 000 ha of our land is under cereals. Let us also assume that all
the land under cereals is affected by strong degradation effects, which generates 75% of
production loss. If the average yield of cereals is 2 t/ha, the total production of cereals on
non-degraded land would be 1 000 000 tons, but since strong degradation causes a
reduction of 75% of production, the total production on degraded land will be only
250 000 tons (i.e. 1 000 000 – 75% 1 000 000 or 1 000 000*0.25).
Now assume that the price of cereals is on average US$150. The total value of the
potential production on non-degraded land would be US$150 million (150*1 000 000)
and the actual value is US$37.5 million (150*250 000). The difference, US$112.5 million,
is the total damage cost due to land degradation.
Defensive or preventing expenditures. Often individuals and communities spend
money for mitigating or eliminating damages caused by adverse environmental impacts.
This is the case, for example, of extra-filtration for purifying polluted water, etc. These
expenses can be considered as the minimum estimates of the benefits of mitigation,
since it is assumed that the benefits derived from avoiding damages are higher than the
costs incurred for avoiding them. The advantage of this technique is that it is easier to
estimate than the environmental damage.
Shadow projects. This method refers to the costs of providing an equal alternative
good or service elsewhere. The possible alternatives are: asset reconstruction (i.e.
providing an alternative habitat site for a threatened wildlife habitat); asset
transplantation (i.e. moving the existing habitat to a new site); asset restoration (i.e.
enhancing an existing degraded habitat). The cost of the chosen option is added to the
basic resource cost of the proposed development project in order to estimate the full
cost. Inclusion of shadow-project costs gives an indication of how great the benefits of
the development project must be in order to outweigh the losses it causes. In other
Environment in Decentralized Decision Making
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Economic Rationale in Caring for the Enviroment
words the shadow project approach provides a minimum estimate of the presumed
benefits of programmes for protecting or improving the environment.
Sometimes, asset reconstruction (replacement) and asset transplantation (relocation) are
classified separately from shadow projects approach although the rationale is similar23.
The underlying idea is that the reconstruction cost approach, by measuring the costs of
reconstruction, gives an idea of what would be the benefits from measures taken to
prevent damage from occurring. The same example as before can be used. If a
development project leads to the destruction of the habitat, one way to measure the
benefits from preventing this damage from occurring would be to estimate the cost for
reconstruction.
If reconstruction costs are higher than the benefits of the productive resource destroyed
(habitat), it would not make sense to replace the resource lost. But if reconstruction
costs are lower than the value of the resource destroyed, it would be efficient to let the
damage occur and to replace the productive resource. In other words, reconstruction
costs are considered as the “upper limit” of benefits. This rule however holds when
benefits and costs can be estimated in quantitative as well as in monetary terms. In the
particular case of the habitat, the estimation of the benefits are rather complex. Given
the important component of non-use values (option and existence values), it would be
wiser to look at reconstruction costs as the “lower limit” of benefits and to choose the
alternative with the lowest level of uncertainty
Substitute costs. The substitute or alternative cost approach refers to the cost of
available substitutes for the particular unpriced service or good. For example, manure
may be considered as a substitute for fertilizers. If the two alternatives provide the
identical service, the value is the saved cost of using the substitute. An example is
provided by Misomali (1987) reported by Price (1989). In a study on fuelwood
plantations in Malawi, the author priced fuelwood on the basis of the saved kerosene
imports. Newcomb (1984) looked at fuelwood as a substitute for dung for domestic
heating. Dung was thus made available as a fertilizer, and the cost of chemical fertilizer
imports (in fact imports plus internal marketing costs) was saved. Therefore, the
resulting shadow price for fuelwood was the saved cost of imports of chemical
fertilizers.
The validity of this approach depends upon three main conditions being respected: (i)
that substitutes can provide exactly the same function of the good or service substituted
for, which is seldom true especially in the case of environmental goods; (ii) that the
substitute is actually the least-cost alternative; and (iii) that willingness to pay (WTP)
evidence indicates that per capita demand for the service would be the same.
Wage differential approach. This technique assumes that the wage rate paid for a job
reflects a set of attributes, including environment and health safety. It follows that other
things being equal, employees will seek higher wages to compensate for higher risks.
The price for safety (also called Hedonic wage) is the difference between what would
23
Dixon et al., 1994.
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be the wage with the same attributes but risk and the wage including safety risk. The
assumptions required for this technique to work are that: (i) labour markets functions
freely; (ii) labour is mobile; (iii) it is possible to isolate the exclusive impact of risk on
wages; (iv) perfect comparability between different types of risks; and (v) good quality
of information on risks.
Hedonic pricing method (HPM). HPM seeks to estimate some assets by linking real
estate prices or wages to environmental attributes. It estimates the differential premium
on property value derived from proximity to some environmental attributes. In order to
obtain a measure of how the environmental attribute affects the value of houses, all
other variables of houses (number of rooms, central heating, garage space, etc.) are
standardized. Moreover, any unit of housing is completely described by locational,
neighbourhood and environmental attributes.
Assume, for example, that one wants to assess the landscape improvement value of a
forest. HPM will first estimate the marginal WTP of individuals/households who decide
to buy or rent a house with the same attributes but the quality of landscape. Then it will
specify the demand function for this attribute and estimate individual/household
consumer surplus. The last step will be to aggregate all the individual consumer
surpluses in order to obtain the total value of the landscape improvement.
Although it has been widely used, this method has several limits in its application. The
most important of them may be the quantity of variables required, which are seldom
recorded in the official statistics even in developed countries. Brookshire et al. (1982)
identified no less than eighteen variables necessary in the analysis of housing market,
most of which must be estimated. Another disadvantage is the huge amount of data
required (time series or cross section).
The quantity of data required increases when the demand function must be estimated on
the basis of income and other socio-economic data as well as the supply of houses on
the market. Reliability of data is also considered a shortcoming of this method. House
prices, for example, are often distorted and owners of houses frequently accept to sell or
rent at lower prices than the maximum offer received, therefore the observed price may
not correspond to the marginal WTP. Finally, this method does not capture non-use
values and does not take into account the effect on prices of individuals/households’
expectations on the future quality of landscape (Ablest et al., 1985).
Travel cost method (TCM). The basic model developed by Trice and Wood (1958)
and Clawson (1959) is based on the expenditures incurred by households or individuals
to reach a site as a means of measuring willingness to pay for the recreational activity.
The sum of cost of travelling (including the opportunity cost of time) and any entrance
fee gives a proxy for market prices in demand estimation. By observing these costs and
the number of trips that take place at each of the range of prices, it is possible to derive
a demand curve for the particular good.
Two main variants of TCM exist: the Zonal Travel Cost Model (ZTCM) and the
Individual Travel Cost Model (ITCM). The main difference being that whereas the
ZTCM divides the entire area from which visitors originate into a set of visitor zones
Environment in Decentralized Decision Making
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Economic Rationale in Caring for the Enviroment
and then defines the dependent variable as the visitor rate (that is the number of visits
made from a particular zone in a period divided by the population of that zone) the
ITCM defines the dependent variable as the number of site visits made by each visitor
over a specified period.
There is a general agreement in considering TCM as one of the most effective
approaches in valuing recreation services (Bockstael et al., 1991; Smith, 1989; Ward
and Loomis, 1986), nevertheless, as Smith (1993) points out, this model has been used
so far to define “the demand for and value of services provided by specific types of
recreation sites and not to estimating the value people place on changes in the sites’
quality features”. Furthermore, the decision to use either zonal or individual TCM
approaches is likely to have a significant impact on the results obtained.
Finally, similarly to the other techniques addressed above, TCM only measures the “use
value” of recreation sites. Other potential problems encountered with this method are
the following: (i) determination of the opportunity cost of on-site and travel time; (ii)
treatment of substitute sites; (iii) choice of the appropriate functional form and its
impact upon consumer surplus estimates.
Contingent valuation method (CVM). This technique is by far the most widely used
among those belonging to the expressed preferences methods. Basically it consists of
asking people (usually via a questionnaire or by experimental techniques24) what they
are willing to pay for a benefit or what they are willing to receive for compensation for
the damage received. In fact, the questionnaire simulates an hypothetical (contingent)
market of a particular good (for example, landscape quality) in which individuals (the
demand) are asked to reveal their willingness to pay for a change (better/lower quality)
in the provision (the supply) of the good in question. The questionnaire also provides
information on the institutional context in which the good would be provided and on the
payment vehicle.
The major advantage of this approach when compared with the others is that it may in
theory be applicable to all goods and services (use and non-use values), whereas it is
the only possible technique in the evaluation of non-use values. Another attraction of
this method lies in the fact that it does not require the huge amount of data (often not
available or unreliable) necessary to the other techniques. Several criticisms have
however been moved to the accuracy and reliability of consumer preferences resulting
from CVM.
The major one concerns the biases inherent in the techniques25 (mainly strategic bias or
the free rider problem, starting point bias, information bias, vehicle bias, hypothetical
bias). Another source of skepticism about this method is the disparity emerging in
empirical studies of CVM between willingness to pay and willingness to accept
(Mitchell and Carson, 1989; Knetsch, 1990; Pearce and Turner, 1990). Although many
of these problems are not yet totally solved, steps have been taken in the last decades,
24
25
People are asked to respond to stimuli in laboratory conditions.
For a detailed discussion on biases in CVM, see Mitchell and Carson (1989).
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Conceptual and Technical Material
particularly in the design of questionnaires and in the interpretation of results, which
have considerably improved the findings (Brookshire and Coursey, 1987). As pointed
out in a review by Kerry Smith (1993), the comparison between findings obtained with
CVM and other methods are substantially consistent.
Environment in Decentralized Decision Making
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Economic Rationale in Caring for the Enviroment
Module metadata
1. EASYPol module
017
2. Title in original language
English
French
Spanish
Other language
Environment in Decentralized Decision Making
3. Subtitle in original language
English
French
Spanish
Other language
Economic rationale in caring for the environment
4. Summary
This module focuses on the economic dimension of the environment. It revisits the issue of
resource scarcity and its link with the concept of economic welfare. Factors which lead to
misestimation of environmental values, both from market and policy failures are next
discussed, and the concept of total economic value, inclusive of various use and non-use
environmental values, explained. The methodological approaches to valuation of
environmental goods and services, based on the underlying concept of willingness to pay
or accept are then outlined.
Valuation techniques both with and without complete markets for goods and services are
discussed; a brief description of the main techniques available are provided in the
appendix. Special attention is given to the situation where markets are absent. This is
because analysis using market prices is more readily catered for by conventional tools,
such as cost-benefit and cost effectiveness analyses, whereas environmental goods and
services, which tend to be public goods, lack market prices, and pose additional conceptual
and practical challenges.
The importance of integrating economic rationale into environmental decisions at the
decentralized level, along with non-economic criteria, and the need to address capacity and
institutional constraints at the local level and their policy implications are reviewed
5. Date
November 2005
6. Author(s)
Vito Cistulli Agricultural Policy Support Service, Policy Assistance Division, FAO, Rome, Italy
7. Module type
Thematic overview
Conceptual and technical materials
Analytical tools
Applied materials
Complementary resources
8. Topic covered by
the module
Agriculture in the macroeconomic context
Agricultural and sub-sectoral policies
Agro-industry and food chain policies
Environment and sustainability
Institutional and organizational development
Investment planning and policies
Poverty and food security
Regional integration and international trade
Rural Development
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EASYPol Module 017
Conceptual and Technical Material
9. Subtopics
covered by the
module
10. Training path
11. Keywords
Decentralization and agricultural development