DEMAND FOR ENVIRONMENTAL GOODS

One of the cornerstones in economics is understanding consumer preferences for goods. Preferences
are represented through demand functions- relationships that indicate the amount of a good an
individual at a given income level will desire, when facing a particular set of prices. A demand curve is a
way of summarizing how important a particular good is to an individual. Since every individual has a
limited income, the demand curve tells us how much money the individual devotes to a specific good.
Additional information is provided through an indication of how much of the good the individual
chooses to forgo if the price increases. If the good is absolutely indispensable with no clear substitutes,
demand will probably be insensitive to price (inelastic). If on the other hand, the good is important but
there are ample substitutes, an increase in price will drive the consumer to substitutes, with a sharp
decrease in consumption of the good whose price rose.

In much the same way the demand curves are useful summaries of consumer preferences for private
goods, a demand curve can also be useful in summarizing preferences for environmental goods. 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. Yet the
idea of a demand curve as a representation of underlying preferences is just as valid for environmental
goods as for tomatoes, bread, or gasoline. It is just harder to measure.

TYPES OF ENVIRONMENTAL GOODS:

The environment is a very complex place. In understanding the value of environment, we need to
classify them. We can classify goods based on the nature of pollution: air quality is one good , water
quality is another. Or we may classify goods based on the nature of the injured party: health effects of
pollution, damage to agriculture, and damage to buildings and materials. Or we may categorize goods
based on how people perceive the damages. Whether we use the environment or not, they affect
people utility or welfare.

USE VALUE:

Use value is the conventional notion of value associated with consumption of a good. In the case of an
environmental good, this could include current use( I am currently visiting the park), expected use ( I
plan to visit the park later this year ) and possible use ( I might visit the park within the next 10 years).
There are several primary avenues whereby environmental goods impact humans. One is through direct
impact. This would include direct health effects of breathing polluted air (both mortality-death-and
morbidity –sickness )as well as non health effects such as bothersome odors, noise, or visual impacts.

A second avenue for environmental goods to impact humans is through damage to ecosystems.
Agriculture, forests, and forests are ecosystem from which humans directly derive economic benefit.
Clearly pollution that degrades the performance of these ecosystems is undesirable.
NON USE VALUE:

Non use value is a controversial aspect of value. Non use value is a gain in a person’s utility without the
person actually using the good. I may value a blue whale being able to swim freely in the open sea
despite the fact that I have no intention of ever seeing a blue whale swim in the open sea.

Three basic types of non use value are existence value, altruistic value and bequest value. Existence
value is the value a consumer attaches to knowing something exists (e.g.; One may find pleasure simply
knowing that African elephants exist). Altruistic value derives not from my own consumption but from
the fact that I derive benefit when someone else gains utility. So when my neighbor benefits from my
cleaning my front yard, if I am altruistic, I obtain utility from the fact that my neighbor is better off.
Bequest value is similar, though associated with the well-being of descendants or next generation.

The purpose of dissecting value and placing it into these various categories is to understand the
complexity whereby environmental values confer on consumers. Simply looking at the use value of
environmental assets may obscure much of the value.

So we can give the taxonomy of environmental value as below:

Value

Use value Non use value

Existence Value Altruistic Value Bequest Value

Measuring Demand:

Because of the absence of markets for environmental goods, measuring demand is not straight forward.

There are two basic approaches to measuring demand: Revealed Preference and Stated Preference. In
revealed preference, we observe a real choice in some market and infer information on the trade- off
between money and the environmental good. For instance, 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 people place on clean air.

The second approach, stated preference, basically involves asking people how they would trade off
money if they had the opportunity to do so.[* We will discuss on each type later]:

WTP versus WTA:

An issue that has arisen for environmental goods and services is the distinction between what a person
would pay for more of a particular environmental good versus what a person would accept as
compensation for a little less of an environmental good. Both could be used in making decisions on
environmental programs, and if the answers are very different, we should understand why.

Willingness to pay is limited by the income or wealth of an individual whereas willingness to accept is
not. For this reason alone, it is easy to see that WTA and WTP may not be the same for many
environmental goods.

The reason this is an important question is that in generating demand curves for environmental goods
and services we need to know whether we should be dealing with WTA or WTP. Which is correct?

To understand the problem more clearly, we can simplify to a problem with two goods – an
environmental good ( q ) and a numeraire good representing all other consumption of market goods (
x ).We adjust the units of the numeraire good so its price is (as is usual)1. Our starting point involves

consumption of (
x 0 ,q0 ) yielding utility u( x 0 , q 0 )=U 0 . Consider an alternative with increased

consumption of the environmental good: consumption of ( ( x 0 ,q1 ), yielding utility U 1 (>U 0 ) . We

are interested in two numbers:

(1) Starting at
q 0 , the WTP to move to q1 ;
q
(2) The WTA to move to 0 from 1 .
q
 x D

WTA (in lieu of moving from

q1 to q 0

x0 A C

B
U1 WTP (to move from
q 0 to q1 )

U0

q0 q1 q

Fig-1

This situation is illustrated in above Figure. There are two indifference curves
U 0 and U 1 between

environmental good q and the numeraire good x q

. WTP is the distance BC, since going from 0

to
q1 increases utility to U 1 , our individual would be willing to give up as much x as will keep

him at the original level of utility ,

U 0 . WTA, on the other hand is the amount the individual is willing

to take in lieu of moving from

q1 to q 0 . Since q1 yields utility U 1 , our individual would require

enough x to keep utility at

U 1 , which is the distance AD.

Evidence has accumulated over the decades suggesting that there is a significant divergence between
the WTP and WTA measures of value. Since these value measures are used to guide public policy
decisions, the divergence raises questions about which measure to use in actual practice.

The question therefore is whether or not this divergence in value measures really implies irrational
behavior by individuals. The answer is that it does not – we should only expect convergence of WTA and
WTP measures of value when the environmental good or service has a very close or perfect substitute.
The WTP-WTA divergence can range from zero to infinity depending on the degree of substitution
between environmental goods and other market goods. The fewer available substitutes the greater the
divergence.
We have already drawn in Fig-1 two convex indifference curves and have shown that WTA >WTP. The
convexity of indifference curves implies the two goods are imperfect substitutes. On the other hand if
the environmental good or services and marketed goods are prefect substitutes, we will get linear
indifference curve. In that case the two concepts will converge perfectly.

x D

x0 A C

B
U1

U0

q0 q1 q
FIG-2

In Fig-2 , the WTP for increased environmental quality from 0 toq q

1 is equal to the distance BC ,

the amount of marketed goods that the consumer will be willing to forgo. This sacrifice of marketed

good just leaves him on his original utility level

U 0 . On the other hand, the WTA to forgo

environmental amenity from

q1 to q 0 is equal to the distance AD. Thus we can see that AD=BC.

Exercise: Suppose housing ( H ) and air quality ( A ) are the only two things entering into John’s
utility and Jon’s utility function is U ( H , A )= AH . Suppose his income is $10 and the price of housing
is $2.

a. If air quality is A=2 , how much housing will John purchase ? Plot John’s indifference curve
and budget constraint and show how much housing is consumed.
b. Suppose air quality rises to A=4 , plot John’s new indifference curve and new consumption
point.
c. How much John will be willing to pay (WTP) to increase air quality from 2 to 4?
Reference: Kolstad: Intermediate Environmental Economics