Environmental Demand Theory
Environmental Demand Theory
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
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.