Environmental Demand Theory

M Rafiq

Discussion• Demand curve is an information on importance of a

good for individual• Out of limited income, allocation for a good, given

choices- elastic vs. inelastic demand• Demand curves are useful that it is consumer

summaries for analysis, govt. policies impacts• It is also useful for analyzing for environmental goods,

given that there are markets to observe consumption at different prices.

• Yet the idea of demand curve representing underlying preferences is as valid as for any private good.

• Harder to measure

Environmental goods are special??• Inputs into the production function, Waste

repository & amenity values.• Why valuation is linked with consumer theory.• Tradeoff between conventional goods &

environmental protection.• No matter how intangible an environmental

resource is, its protection requires money, so• It is useful to enquire how much people are WTP• Elicitation of true value is though difficult, but it

does not diminishes the validity of Principals of demand for environmental goods and services.

Continue..• For a private good market is available to observe the price

and quantity relationship, but still actually measuring is not an easy task.

• So it is even harder to generate a demand for clean air, as there is no observations on P & Q.

• Yet individual who value them, will have WTP• The higher the price of it, the more people would be

willing to tolerate pollution and vice versa.• Absence of market for environ. goods is a problem but it is

a problem with all public goods-• For example public school schools• Demand for public schooling is difficult, because of lack of

markets.

Continue..• But the difference is the other public goods have a

supply side. • There is cost of production• A point of reference, though should not impact

consumption• It would still make the process of valuation easier.• People may have different points on their demand

curves or are aware of cost of private schooling.Environmental goods are disconnected from supply side. Who produces wilderness area?? Though there is cost of cleaning air, yet is dispersed, different from constructing a school.

Willingness to Pay• For conventional, the demand is a function of prices.• Similarly the welfare analysis is consumer surplus.• For environmental good since there is no market, a

key concept corresponding price & Surplus is WTP.• A. MWTP- Price Each point of the demand curve.• In case of selling or giving up a possession-MWTA.• The MB of one less unit of pollution is the same as

MD of one more unit of pollution.• Further, MWTP for one more unit of Pollution is(-) &

equal to the –ve of the MB of one less unit of pollution.

Graphical picture

WTP VS. MWTP• Important to note between the two concepts• TWTP for an individual citizen can be an amount to

eliminate all air pollution form the city.• The same as damage (monetary) to an individual from all

the city’s pollution.• Payment to eliminate one more unit of pollution can be

MWTP.• For environmental goods, area under the DD curve

between two different quantities of the good gives the WTP for the environmental commodity

• Since no payment is made for pollution(as for gasoline),this is consumer surplus, though negative.

Valuation• • For the past ten weeks, we • have “naively” drawn supply • and demand for • environmental goods.• • Where did “demand” come • from?• • The key feature of • environmental goods is that • they are non-market: there • is no price. • Other than that, we stick to • standard consumer theory • as closely as possible.

Measuring Demand for Environmental Goods

Stated Preference• Contingent valuation• Done through surveys• Not very reliable• Not very fashionable in academic economics

Revealed Preference• Hedonics• Amount of the environmental good affects price of a market good e.g.

House Price = f(Pollution)• Household production• We combine environmental goods with market goods to produce a good

that generates utility.• e.g. U = f(Parks Visited(Park Quality, Travel Time))• e.g. U = f(Clean Air Breathed(Air Quality, Air Masks))

A. Consumer demand for market good• Ordinary versus compensated demand curves• Xq(pz,pq,y) Vs. hq(pz,pq,uo)• Why should we worry about the two different kind

of demand curves?• Price effect in isolation from the income effect• Compensated demand curve shows this, so two

points on compensated DD curve two relative prices, but same level of utility

• Ordinary shows it for two different level of utility since income is held constant, so price effect is bundled with income effect

Further notes• Program evaluation of a government plan is about

the effect of changes in relative prices• But price effect only• Therefore compensated demand curve• However, during application, ordinary demand

curve is measured• We observe different prices and income not

different level of utilities.

The expenditure function• A useful way of rewriting the compensated DD

function is E(pz,pq,U)=pzhz(pz,pq,U)+pqhq(pz,pq,U)• How much income is necessary to achieve U, while

facing pq & Pz –money necessary to make the purchaseAdvantages : 1)units are measurable(money) & different values of the Expenditure function can be compared .(2) parameters of the expenditure function are prices, not quantities-consumer choices are factored in.A simple relationship between the expenditure function & Expenditure function is ∆ E(pz,pq,U)=hz(pz,pq,U) ∆ pz or

hz(pz,pq,U)= ∆ E(pz,pq,U)/ ∆ pz

The expenditure function• Expenditure function not familiar but similar to

consumer surplus• Area under the ordinary demand curve-CS• Area under compensated DD Curve-the amount of

income that must be taken away to keep the utility constant: E(pz1,pq,U) - E(pz*,pq,U)

• So it denotes the changes in the constant utility expenditures.

• Both the areas are welfare measures and conceptually very similar.

Welfare Measures

• Previously consumer & producer surplus measures were identified for valuing cost & benefits under market mechanism.

• However the focus is on consumer surplus

• Theoretically correct measures of welfare; CV & EV

• Income is not bundled up

Compensating Variation (CV)• The amount of income that should be compensated

either way in the wake of new prices to keep her at the original utility level.

• by referring to an income change the welfare change is now equivalent monetary change.

• For a price decrease CV is the amount that a person is WTP in order to consume at the new price level .

• e(Px`,Py,U0)- e(Px´´,Py,U0)

Equivalent Variation (EV)• Equivalent variation, in the same context is income

necessary to reach a new level of utility under old prices.

• Thus the difference between CV & EV lies in the reference prices.

• Another way to define EV is; the minimum amount which must be paid to an individual to forgo buying at new prices.

Continue…• CV & EV therefore represents the area under the

Hicksian demand Curve.• The discussion leads to interpretation of CV & EV as the

measure of WTP & WTA.• So CV in case of price decrease is the lump sum amount

as the wtp to just exhaust the welfare gains from the new prices.

• For the policy maker the choice between them depends on weather the proposed changes are suppose the pass;

• The Kaldor potential compensation test or• The Hicksian version of the potential compensation test

Continue• Kaldor’s criteria is similar to pareto’ improvement• that is it possible for the winners to fully

compensate all the losers from a policy change and still make someone better off.

• CV is the measure to be used in this case• The compensating income changes required to

keep them at the initial utility level• When the total collection from all the gainers

exceeds that of the compensation for the losers,; it passes Kaldor’s test

Continue…• EV will be used for the Hick’s criteria;• That is it is possible for all the losers to bribe the

gainers to forgo the proposed the policy change.• They will only accept if the change in the utility is

large enough as from the proposed measure.• Relating this discussion with Consumer Surplus we

can se is that Marshallian Consumer Surplus has some practical ease it is not theoretical correct measure

• Because it is not an index of utility change but only under special circumstances.

Continue…

• It is also not a measure of gain or loss that can be employed under a potential compensation test.

• However Marshallian surplus lies between CV & EV.• CV ≤ CS ≤ EV

• Although CV & EV are theoretically correct measure of welfare, however, they are related with Hicks demand function which can not be observed.

B. Consumer demand for environmental goods

• Restricted Demand• In the case of environmental or other public good

the quantity is not chosen by the consumer• But still we can talk about demand and expenditure

function, price is not appropriate parameter.• We should deal simply with the quantity q. if z is the

conventional private good.• Ordinary demand function for z—xz(pz,q,y), • Compensated demand function hz(pz,q,U)• Demand for boat rentals(z) f pz, water quality (q)

Continue..• The expenditure function is straightforward• E(pz,q,U)=pz hz(pz,q,U)• Demand function & expenditure function are similar,

except that q is appearing instead of pq.

• This is called as restricted demand & expenditure function.

• There is an interesting relationship between q &E to link the restricted functions to the conventional one.$30 worth of grocery, 5 loafs of bread, no observable price of bread

Continue..• Can we find how much bread is worth to you, only

by observing the demand for other groceries?? • Similar to observing demand for market good when

consuming a nonmarket environmental good• Value of environment???• Suppose you get one more loaf & observe that you

need not to spend quiet as much on other groceries to keep the utility constant.

• For a compensated DD for Z, how much income should be taken away-constant utility

• Suppose 1$- value of one loaf.

Further discussion• If there is a change in q, say ∆q, since q is desirable,

utility will go up- income is reduced accordingly.• The ratio of ∆ in exp. due to ∆q is the value of q at

margin-MWTP for q– ∆ E(pz,q,U) / ∆q = pq

An important assumption over here is the weak complimentarity assumptionIf z become so expensive that there is not demand for it- there will be no demand for q.