Week 1: Week 1: Intro. (anyone remember markets?) Intro. (anyone remember markets?)

& & valuation issuesvaluation issues

the economy

Firms

(production)

Households

(consumption)

Inputs OutputsTHE ECONOMY

the environment as an asset (environomy)the environment as an asset (environomy)

Firms

(production)

Households

(consumption)

Inputs OutputsTHE ECONOMY

Amenity valuesResource inputs

Wastes

Global life-support

Impacts on biodiversity

NATURE

criteria for decision makingcriteria for decision making

is a proposed plan desirable?is a proposed plan desirable?

benefit cost analysis can helpbenefit cost analysis can help

if B > C, supportif B > C, support

if B < C, opposeif B < C, oppose

but how to measure the B and C?but how to measure the B and C?

anthropocentric focusanthropocentric focus

system of measurement is human-system of measurement is human-centeredcentered

all B and C valued in terms of their effects all B and C valued in terms of their effects on humanityon humanity

controversial, but a good starting point. controversial, but a good starting point. what is the alternative?what is the alternative?

but before we start measuring but before we start measuring benefits and costs…benefits and costs…

a review of markets…a review of markets…

demanddemand

relationship between the quantity relationship between the quantity demanded and the price of a good when demanded and the price of a good when all other influences all other influences (tastes and (tastes and preferences, prices of substitutes and preferences, prices of substitutes and complements, income, numbers of complements, income, numbers of consumers and consumer expectations)consumers and consumer expectations) on on buying plans remain the samebuying plans remain the same

demanddemand

law of demandlaw of demand – – ceteris parabis ceteris parabis (With all (With all other factors remaining the sameother factors remaining the same)) – –

if p if p ↑, QD ↓↑, QD ↓

if p ↓, QD ↑if p ↓, QD ↑

demand curve downward slopingdemand curve downward sloping

$

Quantity

demanddemand

demand = MBdemand = MB

demand curve for pizza tells us dollar’s demand curve for pizza tells us dollar’s worth of other goods give up to get 1 more worth of other goods give up to get 1 more pizzapizza

consumer surplus: MB – price paidconsumer surplus: MB – price paid

consumer surplusconsumer surplus

benefits derived from demandbenefits derived from demand

demand measures amount particular good people demand measures amount particular good people willing to purchase at different priceswilling to purchase at different prices

demand and willingness to paydemand and willingness to pay

total WTP (total benefits) is sum of WTP for each unittotal WTP (total benefits) is sum of WTP for each unit sum is the total area under demand curvesum is the total area under demand curve what are total benefits in this case?what are total benefits in this case?

supplysupply

The relationship between the quantity The relationship between the quantity supplied and the price of a good when all supplied and the price of a good when all other influences on selling plans other influences on selling plans (production costs such as labor, energy, (production costs such as labor, energy, capital, and materials)capital, and materials) remain the same remain the same

supplysupply

law of supplylaw of supply – – ceteris parabisceteris parabis – –

if p if p ↑, QS ↑↑, QS ↑

if p ↓, QS ↓if p ↓, QS ↓

supply curve upward slopingsupply curve upward sloping

$

Quantity

supplysupply

supply = MCsupply = MC

supply curve for pizza tells us dollar’s supply curve for pizza tells us dollar’s worth of other goods give up to produce 1 worth of other goods give up to produce 1 more pizza.more pizza.

producer surplus: Price producer surplus: Price –– MC MC

producer surplusproducer surplus

marginal cost and total costmarginal cost and total cost

all env. goods / services have costs (opportunity costs)all env. goods / services have costs (opportunity costs) marginal cost: cost of producing last unitmarginal cost: cost of producing last unit total costs sum of marginal costs; area under mc curvetotal costs sum of marginal costs; area under mc curve what is total cost in this case?what is total cost in this case?

how much to preserve? how much to preserve? environmental economic to the rescueenvironmental economic to the rescue

3 step analysis 3 step analysis – identify optimal allocationidentify optimal allocation– does it exist?does it exist?– how to implement it (policy)how to implement it (policy)

examplesexamples– natural resources: fisherynatural resources: fishery– environmental econ: solid waste / environmental econ: solid waste /

landfilllandfill

optimal allocation: MB = MCoptimal allocation: MB = MC

At q*, MB = MC, net benefits maximized. Cannot At q*, MB = MC, net benefits maximized. Cannot increase benefits by changing qincrease benefits by changing q

MB = MC MB = MC → Efficiency – cannot make one person → Efficiency – cannot make one person better off without hurting anotherbetter off without hurting another

Why?Why?

$

Quantity

MB = MCMB = MC

q*MB > MC MC > MB

S = MC

D = MB

MB = MCMB = MC

If MB > MC, can If MB > MC, can increase quantityincrease quantity → increases → increases benefits more than increases costs benefits more than increases costs

→ → total net benefits increasetotal net benefits increase

If If MC > MB, can MC > MB, can decrease quantitydecrease quantity → decreases → decreases cost by more than decreases benefits → total net cost by more than decreases benefits → total net benefits increasebenefits increase

Only at q* impossible to increase net benefits by Only at q* impossible to increase net benefits by changing quantitychanging quantity

maximize net benefit!maximize net benefit!

net benefit: excess of benefits over costsnet benefit: excess of benefits over costs area under demand curve / above supply curvearea under demand curve / above supply curve

static efficiencystatic efficiency

net benefit from using the resource is net benefit from using the resource is maximizedmaximized

back to fig 2.5back to fig 2.5

is action that preserves 4 miles of river is action that preserves 4 miles of river worth doing? (not if preserving 5 is better)worth doing? (not if preserving 5 is better)

what is efficient level of preservation?what is efficient level of preservation?

what is we preserve 5 instead of 4?what is we preserve 5 instead of 4?

net benefit increases by area MNRnet benefit increases by area MNR

therefore 4 miles of preservation is not efficienttherefore 4 miles of preservation is not efficient

are 5? are 5?

if preserve 6, C > B (triangle RTU is reduction of if preserve 6, C > B (triangle RTU is reduction of net benefit)net benefit)

cannot be better off preserving more or less than cannot be better off preserving more or less than 55

dynamic efficiencydynamic efficiency

above was static analysis (one time period)

maximizes present value of net benefits that could be received from all of the possible ways of allocating those resources over the n periods

discountingdiscounting

most environmental/nat resource issues most environmental/nat resource issues depend on timedepend on time

present value: allows comparison of net present value: allows comparison of net benefit received in one time period to benefit received in one time period to anotheranother

discount rate is the rate at which society discount rate is the rate at which society as a whole is willing to trade off present as a whole is willing to trade off present for future benefits for future benefits

why are discount rates needed?why are discount rates needed?

a dollar received today is considered more valuable than one received in the future

4 primary reasons for applying a discount rate:

1. positive rates of inflation diminish the purchasing power of dollars over time

2. dollars can be invested today, earning a positive rate of return. discount rates reflect the opportunity cost of capital (expected financial return forgone by investing in a project rather than in comparable financial securities)

3. uncertainty surrounding the ability to obtain promised future income. That is, there is the risk that a future benefit (e.g., enhanced fish catches) will never be realized

4. humans are generally impatient and prefer instant gratification to waiting for long-term benefits

pvpv

)1(][

rB

BPV nn

n

n

ii

in

rBBBPV

00

)1(],...,[

B PV r n B PV r n$1,000,000.00 $820,348.299875 0.02 10 $1,000,000.00 $744,093.914897 0.03 10$1,000,000.00 $371,527.882127 0.02 50 $1,000,000.00 $228,107.079790 0.03 50$1,000,000.00 $138,032.967198 0.02 100 $1,000,000.00 $52,032.839850 0.03 100$1,000,000.00 $19,053.100033 0.02 200 $1,000,000.00 $2,707.416423 0.03 200$1,000,000.00 $50.108813 0.02 500 $1,000,000.00 $0.381406 0.03 500$1,000,000.00 $0.002511 0.02 1000 $1,000,000.00 $0.000000 0.03 1000$1,000,000.00 $0.000000 0.02 2000 $1,000,000.00 $0.000000 0.03 2000

total benefit over all 200 years

one time benefit (in yr. 200)

how to choose a discount rate?how to choose a discount rate?

at one extreme, an infinitely high discount rate would render all future actions meaningless

other extreme, using no discount rate means that benefits today are no more valuable than benefits experienced 100 years from now

neither of these extreme views is correct

real question is, “what discount rate best reflects the time preference, productivity, and risk of this project?"

common proxiescommon proxies

federal opportunity cost of capital federal opportunity cost of capital – the absence of the project, the federal the absence of the project, the federal

government could put the funds to productive government could put the funds to productive use reducing the national debt use reducing the national debt

– Federal bonds, ~3-6% averageFederal bonds, ~3-6% average the rate of productivity growththe rate of productivity growth

– ~3%~3% NOAA has adopted a 3% discount rateNOAA has adopted a 3% discount rate OMB uses 7% (ror in private sector) OMB uses 7% (ror in private sector)

example:example:should govt establish a should govt establish a

national marine sanctuary?national marine sanctuary? assume that a marine ecosystem is threatened by

polluted runoff from development; waste from sewage, detergents, and fertilizers; destructive fishing methods; and offshore oil drilling

threatens the viability of reefs and seagrass beds, and threatens the long-term sustainability of the fish and other seafood harvests

in response, the federal government is considering establishing a NMS to provide comprehensive protection of the marine environment

list the benefitslist the benefits

Direct economic benefits:Direct economic benefits:– more ecotourismmore ecotourism– enhanced seafood harvestsenhanced seafood harvests– better bird watchingbetter bird watching– a fishing catch that is sustainable in the long-a fishing catch that is sustainable in the long-

term term

Indirect economic benefitsIndirect economic benefits– preservation of cultural and historic sites (e.g., preservation of cultural and historic sites (e.g.,

lighthouses and ship wrecks) lighthouses and ship wrecks)

list the costslist the costs

productivity losses incurred by industry as productivity losses incurred by industry as a result of the prohibition on off-shore a result of the prohibition on off-shore drilling, waste dumping, and net fishingdrilling, waste dumping, and net fishing

private industry could be required to private industry could be required to purchase costly equipment to comply with purchase costly equipment to comply with new regulations related to the treatment new regulations related to the treatment of industrial waste products (abatement of industrial waste products (abatement cost)cost)

max net benefit, not b-c ratio

PlanBenefits Costs Net Benefits

Benefit-CostRatio

A 1,200.0 1,100.0 100.0 1.091

B 1,350.0 1,200.0 150.0 1.125

C 1,475.0 1,300.0 175.0 1.135

D 1,580.0 1,400.0 180.0 1.129

E 1,682.0 1,500.0 182.0 1.121

F 1,778.0 1,600.0 178.0 1.111

simple benefit-cost excel examplesimple benefit-cost excel example

r 0.07t benefits PV benefits costs PV costs

0 0 0 5 51 0 0 5 4.6728972 0 0 5 4.3671943 0 0 0 04 3 2.288685636 0 05 3 2.138958538 0 06 3 1.999026671 0 07 3 1.868249226 0 08 3 1.746027314 0 09 3 1.631801228 0 0

11.67274861 14.04009

bc ratio 0.831387

0.03 1.020.07 0.83