Environmental Demand Theory:

Introduction
 One of the cornerstones in economics is the understanding of
consumer preferences for goods.
 The typical way of representation of those preferences is
through demand functions.
 The problem with demand curves for environmental goods is
that there are typically no markets, so we have no
observations on how much of an environmental good is
consumed at different prices.
 In this topic, demand theory of environmental products is
examined.
 Economists have developed the concepts of public bads and
externalities to describe the characteristics of these
environmental commodities that lead to market failure.
What is so special about an
environmental good?
 Environmental problems really involve a trade-off between
using resources (money) for conventional goods and services
and using same resources for environmental protection
 What a demand curve of environmental goods represents:
How much is the consumer willing to pay for particular
levels of environmental goods.
 Distinctions between environmental and ordinary goods is the
existence of a market characteristics. E.g. it is difficult to
generate a demand curve for clean air in an urban area.
 The absence of a market is the major factor that complicates
finding the demand curve for environmental goods.
Measuring Demand
 A conventional demand curve plots quantity demanded as a
function of price. Without a market there is no price.
 Because of the absence of markets for environmental goods,
measuring demand is not straightforward.
 Two Approaches to measure demand: Revealed preference
and Stated preference.
 Within Revealed Preference: hedonics and household production
 Within the Stated preference: the dominant approach is contingent
valuation.
Revealed preference
 In revealed preference, we observe a real choice in some market and infer
information on the trade-offs between money and the environmental good.
 Eg, we may notice that two communities are identical except that one has high
housing prices and clean air and other has lower housing prices and dirty air.
 We may infer that the difference in housing prices reflects the value of people
place on clean air.
 In the hedonic approach, the goal is to see how the price of a conventional good
(e.g. house) varies as the amount of closely related environmental good changes
(e.g. the air quality in the vicinity of the house). This relationship is then used to
infer value.
 The household production approach starts with the assumption that consumers
will combine private goods with environmental goods to ‘produce’ another good,
which is real source of utility.
 For instance, soundproofing may be combined with noise that impinges on the
outside of a house to obtain particular indoor noise levels.
Stated preferences
 Stated preferences, basically involves asking people how much an environmental
good is worth.
 Opinion polls and surveys are used to derive this information.
 In stated preferences, the dominant approach is contingent valuation.
 Contingent valuation relies on direct revelation of demand from consumers. The
name literally means “value contingent on there being a market”—if there
were a market, how much would you pay for the environmental good?
 There values are obtaining by directly questioning a sample of potential
consumers of the environmental good.
 Contingent valuation is a type of constructed market. In a constructed market, a
researcher will take a situation in which no market exists and generate a market.
Constructed markets can be hypothetical or real.
 For instance, laboratory experiments
Analysis of Consumer Demand for market Goods

The starting point for analysis is a utility function for a consumer,

u(z,q) where z and q are two products. This utility function gives
the level of utility for various bundles of z and q.
Ordinary Vs Compensated Demand

 An ordinary demand function gives the amount of a good a consumer chooses as a

function of prices and income: Xq (Pz, Pq, y).
 Figure-1 illustrate the graphic process of generating a demand curve for good q from
indifference curves between goods z and q. as the price of q changes, the slope of the
budget line shifts;
 The utility maximizing choice of q also changes, tracing out the demand curve. This is an
ordinary demand curve because income, rather than utility is kept constant as the
price of q changes.
 An alternate way to generate a demand curve is to keep utility constant as the
price of q changes.
 The only way to keep utility constant as prices change is to adjust income so
that the consumer remains on the same indifference curve.
 The demand curve that traces out quantity demanded as a function of price,
keeping utility constant, is called compensated demand function: Hq (Pz,Pq,
U) where U is a particular level of utility. This is shown in Figure-2.

Analysis
 Two points on a compensated demand curve represent two
relative prices but same level of utility.
 In contrast, two points on an ordinary demand curve
represents two different prices and two different utility levels
(since income is constant).
 We often wish to evaluate the effects of a government policy
that changes relative prices.
 To evaluate such policy, we want to examine the results of
the price changes only, not income effects (since income
effects can be addressed through programmes to redistribute
income). In other words we want to use compensated demand
function.
Relationship Between two demand curves
 We can connect the two demand functions conceptually.
 Figure-3 shows a plot of an ordinary demand curve (Xq) and
two compensated demand curves (Hq), for different utility
levels.
 One point shared by the ordinary and compensated demand
curve is point A.
 At A on the ordinary demand curve, the consumer enjoys the
some level of utility, call it U1. At the level of utility, we can
trace out a compensated demand curve. It must pass through
A.
 A similar logic would apply to point B.
The Expenditure Function
 A useful way of rewriting the compensated demand function
is in terms of the expenditure function:
E (Pz, Pq, U) = PzHz (Pz, Pq, U) + PqHq (Pz, Pq, U) (1)
This indicates how much income is necessary to achieve
utility U, facing price Pz and Pq.
The expenditure function is useful for two reasons:
1. Its units are measurable in money, so we can easily compare
different values of the expenditure function.
2. The parameters of the expenditure function include prices,
not quantity consumed.
 The expenditure function is very similar to the utility function to
achieve a certain level of utility.
 There is a simple relationship between the expenditure function and a
compensated demand function.
 Suppose we have $20 to buy groceries. You go to the store and buy
an optimal basket of goods, including a packet of bread.
 Suppose the price of bread goes up by $1. How much money do you
need to be able to afford the same basket (thus keeping utility
constant)?
 Precisely, the number of packets of bread in your basket times the
price increase of $1.
∆ E (Pz, Pq,U) = Hq (Pz, Pq,U) ∆Pq Or (2)
Hq (Pz, Pq,U) = ∆ E (Pz, Pq,U)/ ∆Pq (3)
 That is, the ratio of the change in the expenditure function to a change
in the price of good is the same as the compensated demand for good.
Consumer demand for Environmental Goods
Restricted Demand
 The quantity environmental goods or public goods in general is not chosen by the
consumer.
 Let q be the environmental good; z be the conventional good. The ordinary demand
function for z can be written as Xz (Pz, q, y) and the compensated demand function as
Hz (Pz, q, U).
 Example: We might observe the demand for boat rentals (z) and see that it depends on
the price of z and water quality (q).
 The expenditure function in this case is straightforward:

E (Pz, q,U) = Pz Hz (Pz,q,U) (4)

 The demand functions and the expenditure functions are very similar except that the
quantity of q appears rather the price of q.
 We call this type of demand and expenditure functions restricted demand and
expenditure functions.
 There is an interesting relationship between q and E.
 Let us start with a grocery basket with a variety of groceries
that you have chosen, including five packets of bread priced
at $1 each. The cost of basket is $35: $5 for bread and $30 for
other items.
 Now suppose we do not observe the price of bread and see
you are spending $30 for non-bread items, when you have
five packets of bread in your baskets. The question is, can we
determine how much the bread is worth to you only by
observing your demand for the other groceries?
 This is akin to observing demand for market goods when
consuming a non-market environmental good; our problem is
finding the value of the environmental good.
 The answer is yes.
 We can determine the value of one more packet of
bread.
 Suppose we give you one more packet of bread and
observe that you do not need to spend quite as much
on other grocery items to keep utility constant.
 We observe from your compensated demand
function for the other grocery items how much
income must be taken away to keep utility constant.
 This is your marginal valuation of a packet of bread.
 Now consider the restricted expenditure function again.
 What happens if we increase q by a little say ∆q?
 Since q is desirable, utility will go up unless we reduce income
accordingly.
 The ratio of the change in the expenditure function to the change in q is
the value of q at the margin. This is marginal willingness to pay for q,
which we denote Pq.
 If q were offered on the market at this price, and income were
supplemented by Pq q, the amount chosen voluntarily would be exactly q.
thus we have a connection between compensated demand and the
restricted demand function:
∆E (Pz,q,U)/ ∆q = -Pq (5)
 Think of Eq.(5) as having four unknowns, Pz, Pq, q and U. If values of
three are known, we can get the value of the fourth, using Eq (5).
 The equation can be rearranged to yield q as a function of
remaining variables:
q = Hq (Pz, Pq,U) (6)
 Which is the compensated demand function for q.
 This can also be seen graphically. We start with a
compensated demand curve for our market good, z: hz
(Pz,q,U). Suppose the price of z happens to be P*z and the
amount of q is qo.
 Now suppose we increase q a bit to qo + ∆q. Since q is
environmental quantity, presumably, it is desirable. Thus to
keep utility constant, we need to takeaway some z when q is
increased. The resulting compensated demand curve for qo +
∆q is shown in the figure, slightly lower than the initial one.
 The shaded area in the figure corresponds to the income
equivalent of the change in q.
 Increasing q a little increases utility so we need to take a bit
of income away to keep the utility constant. That is the
shaded area.
 This can be interpreted as marginal willingness to pay for the
change in q.
 If we measure demand for ordinary goods for different levels
of the environmental goods, we may be able to find a demand
for the environmental good, even though there is no market
for that good!
Measuring the Welfare Effects of
Environmental Improvement
 The welfare effects of changes in environmental
quality can be evaluated using compensating and
equivalent surpluses.
 Suppose an individual consumes q0 and has income
of y available and gets U0.
 We then change the amount of environmental quality
consumed to ql. The individual will now be at a new
level of utility, U1.
 What is the value of the environmental change?
Compensating Surplus and Equivalent surplus

 The amount of money that would keep the individual at the

original level of utility with the change in q is called the
compensating surplus
 While the amount of money that would move the individual
to the new level of utility without the change in q is called
the equivalent surplus.
 Conceptually, these two terms are very analogous to
compensating and equivalent variation in the case of a market
good.
 The reason for using the term "surplus" instead of "variation"
is that the consumer is not free to vary the quantity of q. In all
other respects, the concepts are identical.
 CS(q0,ql) is the compensating surplus of moving from q0 to
q1 and ES(q0, q1) is the analogous equivalent surplus:
 CS (q0,ql) = E(Pz, q0,U0) -E(Pz, ql, U0) (A)
 ES((q0,ql) = E(Pz, q0,U1) -E(Pz, q0,U0) (B)
 If the amount of q that our consumer consumes has been
reduced from q0 to ql (if q1< q0). So we want to compensate
consumers for the change in q by giving them an amount of
money that brings them back to the same utility level.
 This is the CS defined in Eq. as the difference in the income
needed to achieve the old level of utility at the old quantity
[E(Pz, q0,U0)] and the income needed to keep the same level
of utility at the new quantity [E(Pz, q1,U0)].
 Consumer surplus can be either a willingness to pay (WTP)
or a willingness to accept compensation (WTAC) measure.
 An individual's willingness to pay for a change in
environmental quality is based on a theory of rational choice,
and is therefore a consistent estimate of preferences.
 The individual choice of all market goods and services is
constrained by fixed monetary income, and the prices of
these goods and services (maximizing utility s.t. income
constraint).
 Q0 is fixed level of environmental good, the problem is to
define the economic value of an increase in the level of the
environmental good from Q0 to Q1 (remember, differences in
utility are not measurable => consumer surplus).
WTP/WTAC for improved environmental services
X

starting in A:
to increase quality (Q0 => Q1), and to keep
consumption good X fixed, the individual's utility
increases from U0 to U1.
D
two questions:
- what is the maximum she is willing to pay (WTP)
to secure the change from Q0 to Q1?
A B answer: the individual would give up the market
X U1 good (X) to reach the original level of utility (U0) (B
=> C) compensating surplus (CS).
C
- what is the minimum compensation the individual
U0 is willing to accept (WTAC) to forgo the increase in
the environmental good?
answer: the individual would require an increase in
the level of the composite consumption good (X) to
Q0 Q1 Q reach U1, when Q0 would have => Q1 (A => D) (ES)
 The ES is the change in income that would have the
same ("equivalent") effect as the quantity change,
without the quantity change actually occurring.
 We compare the expenditures that yield utility UI at
the original quantity with the expenditure necessary
to yield utility U0 at the original quantity:
 ES(q0, q1) = E(Pz, q0,U1) -E(Pz, q0,U0) (C)
 which is actually the same as Eq. (7b) because E(Pz,
ql,U1) = E(Pz, q0,U0)
 These are subtle definitions, perhaps difficult to understand. So consider a more
concrete example.
 Suppose X lives in a house close to the ocean with only a vacant field between
him and the ocean. He has a nice view of the ocean.
 Now it turns out Y owns the vacant field and wants to build a house that will
block X's view of the ocean.
 There are two ways to view the money equivalent of the damage to X from the
house built by Y.
 One measure would be the maximum amount X would pay Y not to build the
house.
 Clearly, X would be willing to pay an amount such that his income after payment
and with a clear view of the ocean results in the same utility as his income without
the payment and without the view. This is the equivalent surplus—a money
measure that is equivalent to the loss of the view.
 X actually will be indifferent between paying this amount to prevent the loss of
the view and not paying but losing the view.
 Another way of looking at the value would be if the town X
lives in has laws that prohibit construction that blocks
another's view without permission of the viewing party.
 If Y wants to build his house, he has to pay X for that right.
 How much would he have to pay X?
 He would have to pay the amount of money so that X's utility
with the payment but without the view is the same as with no
payment but no blocked view.
 This is the compensating surplus—Y has to compensate X for
the loss of utility from taking away his view.
 We can examine ES and CS graphically. The Figure shows quantities of z
and q that may be consumed.
 As before, assume z is a conventional private good and q is an
environmental good, supplied directly.
 If the price of z is pz, and income is y, the budget constraint is y = pzZ, a
horizontal line. This is because q is an environmental good that is
supplied but for which.payment is not made.
 At the initial level of q, qo, utility is U0.
 Suppose the quantity of the environmental good then increases to ql,
yielding utility U1.
 The compensatory surplus is the monetary value of z that would return to
Uo, at the new quantity of environmental good.
 The equivalent surplus is the monetary value of z that would move to U1,
instead of changing q.