ECO335

INTRODUCTORY ENVIRONMENTAL ECONOMICS

Instructor: Ram Ranjan

Email: ram.ranjan@snu.edu.in
Topic 1: Willingness to Pay, Managing Water Demand, Cost-Benefit
Analysis, Discounting, Green Accounting
 You may find the below additional sources
useful for this topic
• Field and Field (7e: Environmental Economics: an introduction)
• Pages 40-48—marginal willingness to pay, demand function, demand for
water
• Pages 111-121—cost benefit analysis, discounting
Key Concepts

• Need for Environmental Economics

• Willingness to Pay (WTP)
• Demand Function
• Demand for Urban Water
• Consumer Surplus
• Cost-Benefit Analysis (CBA)
• Discounting the Future
• Environmental Accounting
 Environmental Economics

• Uses economic concepts, tools and methods to help resolve

environmental challenges
• What are the key environmental challenges society faces today?
 Examples of Environmental Management
Challenges
• Global warming (global scale)
• Lack of property rights in air, lack of markets for emissions
• Emission from vehicles, industrial plants (global as well as local impact)
• Externality correction
• Water security/scarcity (?)
• Prolonged droughts (man made), inefficient water usage, water markets,
environmental water buybacks
• Water pollution
• Extinction of fish species, loss of fisheries
• Over-exploitation, lack of property rights, increasing demand for fish for
consumption
• Invasive species, agricultural pests
• Climate change could exacerbate the problem
• Air quality degradation, health impacts, mortality
 How can environmental economics be
useful?
• Help value the environment, so that expenditures on protecting the same
can be justified

• Help evaluate the tradeoffs

• Who should be allocated scarce water when there are multiple users?
• What are the costs of economic growth on the environment and sustainability?

• Optimize use and allocation of scarce resources across users

• Prevent excessive use/over-exploitation of natural resources through creation

of markets

• Integrate with other disciplines

 Examples

• Managing common property resources such as oceans, lakes, etc.

• Internalizing social costs of pollution emissions

• Water pollution, air pollution, agricultural or urban pollution, industrial
pollution, pollution of ocean and lakes, pollution from power plants, etc.

• Building new infrastructure (such as rails, buildings, etc.) requires

• Energy efficiency considerations
• Due to emissions, energy prices--scarcity
• Growth in urbanization requires evaluation of:
• Future risks from hazards
• Costs to commuters
• Costs to society (infrastructure costs, health costs, energy, carbon footprint,
costs associated with provision of water, food, housing, etc.)
 Concept:
Willingness to Pay (WTP)/Marginal Willingness to Pay (MWTP)

• Context---Valuation of goods consumed by individuals, valuation of

environmental goods and services
• Once we know individual’s or society’s WTP for a particular
environmental service or good, we can use that monetary value to
justify taxation or expenses aimed at preserving the environment.
 Willingness to Pay (WTP)

• Individuals hold preferences over goods and services

• Amount a person is willing to pay for a particular good is their WTP
• For example: we may need to know how much we are (as a society)
willing to pay for preserving rain forests (or polar bears), in order to
allocate scarce resources for their preservation and management
• How to measure a person’s (or society’s) WTP?
What is your WTP to preserve polar bears?

https://www.mnn.com/earth-matters/wilderness-resources/blogs/7-reasons-why-arctic-sea-ice-
matters
WTP for preservation of rainforests

https://www.thoughtco.com/land-biomes-tropical-rain-forests-373496
 WTP Value

• 10 dollars per person per year for each urban resident towards
protecting polar bears.

• Sum this across the entire city and the total value of society’s WTP
would be in millions of dollars
 Derive the WTP using a demand function

• What is a demand function?

Concepts: Demand Function and Consumer Surplus

• How to draw a demand function?

• What does it mean?
• How can we infer consumer surplus and WTP/MWTP from a demand
function?
Demand Function: Example
Price

Price

P1
Draw a demand function for a good of your choice
(example, daily coffee consumption demand)
 Demand Function

• Is negatively sloped=> more of the commodity is desirable only at a

lower price
 Example of a demand function for coffee

Price ($/cup)
mwtp

2 4
Cups of coffees
 Marginal willingness to pay for coffee in the
previous slide
• Marginal willingness to pay (MWTP) measures the amount an
individual is willing to pay for an additional unit of coffee.
• MWTP is higher initially and declines as more cups of coffees are
consumed
Linear Demand Function: MWTP declines by a constant amount as quantity consumed increases.
At some point, MWTP becomes zero.
There is also an upper limit on MWTP.

Price mwtp

Quantity
What does curvi-linear demand imply?

Price
Higher mwtp

Lower mwtp

Quantity Demanded
 Demand Functions: compare two demand
functions
(from Field and Field)
Steeper demand Flatter demand

Environmental demand for individual i Environmental demand for individual j

Demand Functions of Two Separate
Individuals
Elastic and Inelastic demand functions

elastic demand
Price

inelastic demand

Quantity demand
Elastic and Inelastic demand functions

Perfectly inelastic demand

Price

Perfectly elastic demand

Quantity demand
 Elastic and Inelastic demands

• Necessary goods (medicines, salt, etc.) have an inelastic demand

• Goods with many substitutes (e.g., vegetables) have an elastic

demand

• Price elasticity of demand measures how responsive demand for a

good is to a change in its price. If the demand increases (decreases)
sharply as the price falls (increases), the good is said to have an
elastic demand function.
 Properties of Demand Functions

• MWTP could drop off rapidly or slowly as depicted by the slope of the
demand function

• Elasticity of demand refers to the responsiveness in quantity demanded with

respect to a change in price. If quantity demanded is highly responsive to a
price change it is considered as an elastic demand, else inelastic demand.

• The demand for salt—is it elastic or inelastic?—draw its demand function

• Draw a demand function for shoes

 An application of the demand function to
solve an environmental problem
• How to prevent wastage of water by urban residents, given that
water is becoming scarce?

• If the price of water is increased, how will it affect the utility (or
wellbeing) of the urban consumers?
Urban Demand for Water
Urban Water Demand: has two components

• Outdoor demand is more elastic than indoor demand

• Aggregate demand may be kinked

Indoor demand
Price
Outdoor demand
Urban Demand for Water

• Outdoor demand is more elastic than indoor demand

• Aggregate demand may be kinked. Carefully observe the price at
which the kink occurs.

Indoor demand
Price
Outdoor demand

Aggregate demand
(thick line)
Aggregate demand for urban water is kinked

Price of water

Quantity demanded
Exercise

• Vertical summation of demand function—valuation of biodiversity is

done through a vertical summation of individual demand functions.
The amount of biodiversity (forests, rivers, etc.) is fixed and cannot
be increased to meet individual demand, however the same
biodiversity can be enjoyed by all.
• Draw wtp for rainforests for two individuals and find their aggregate
valuation through vertical summation.
• Pick a point on the horizontal axis and find the joint wtp for that unit of
biodiversity…
 Consumer Surplus

• Consumer surplus measures the net benefit to an individual from

consuming any good
• It is equal to their total wtp for a certain quantity of good minus the
total cost of buying the same amount.
• In the following slide we will try to find the consumer surplus when
the individual consumers 5 cups of coffees
 Consumer Surplus

Price per unit

($/cup of
coffee) 10

5 10 quantity
 Calculate Consumer Surplus when price is
$5/unit
• Price =$5/unit, quantity demanded =5 units
• What is the price at which demand becomes zero? Also, at zero price,
what is the quantity demanded?
• Demand =10 units at price=0 and 0 units at price =$10/unit
• Demand is a linear function of the price
• Consumer surplus is the net surplus generated in the process of
consuming a commodity. It measures the sum total of surplus values
that the consumer derives from the consumption of each unit of the
commodity. While calculating the surplus, the cost of purchasing the
commodity must be excluded.
 Consumer Surplus

Total wtp for

5 cups of
Consumer coffees is the
surplus at 5 sum of the
10 cups of yellow and
coffees blue areas
Price per unit
($)

5 Total cost of
buying 5 cups
of coffees

5 10 quantity
Consumer surplus (CS)

• CS= Area above the price line

• Area of a Triangle =1/2 * Base *Height
• Area=1/2*5*5
Consumer Surplus?
 Concepts

• Cost-Benefit Analysis
• Discounting
• Discount Factor
• Discount Rate
Concept: Cost Benefit Analysis (CBA)

• CBA analysis of a project helps with figuring out whether the project
would be financially viable.
• A triple bottom line criteria is relevant while doing CBA
• Financial bottom line, environmental bottom line and social bottom line
• Example:
• An environmental manager needs to decide whether or not to build a
dam to preserve water.
• The costs involve the cost of dam construction
• The benefits involve benefits to the environment, agriculture, etc.
• Another example of a CBA project would be evaluating all the
economic, social and environmental benefits of building automated
trains from Delhi to SNU
 CBA

• If the sum of costs exceeds the sum of benefits: The project is

financially unviable
• Challenges:
1. Uncertainty and Irreversibility
2. Discounting
3. Ecosystem Value Measurement
4. Some costs and benefits may not be quantifiable
• Benefits to the environment
 Discounting the Future

• A dollar in the bank becomes $1.1 next year at 10 percent rate of

interest
• Therefore, if you received $1.1 next year from someone, its present
value (today’s value) would be only $1.
• Similarly, if you kept 10 dollars in the bank today, it would grow to
$11 in year 2, $12.1 in year 3….and if you left the same dollar for 8
years, it would grow to 19.48 dollars
Amount at the beginning of yr
Year 1 1 10
Year 2 2 11
Year 3 3 12.1
Year 4 4 13.31
Year 5 5 14.641
Year 6 6 16.1051
Year 7 7 17.71561
Year 8 8 19.487171
 Discounting concept

• From the previous example, we can conclude that the present value
of 19.48 dollars received 8 years from now is only 10 dollars. This is
so because, I only need to put 10 dollars in the bank to convert it into
19.48 dollars by year 8.

• We will derive a formula to discount any future money received to

convert it into its present value worth. That is, how much should we
multiply 19.48 dollars with so that it is equal to 10 dollars.

• The benefit of this discounting is that while doing CBA, all future
income and cost streams can be treated as if they are occurring now,
instead of at various times in the future.
 Deriving the formula

Time Amount at the Amount at the end of year Formula Alternate Formula
beginning of
year

Year 1 10 10+10*.1=10+1=11 10*(1+r) 10(1+r)

Year 2 11 11+11*.1=12.1 11*(1+r) 10(1+r)*(1+r)=10*(1+r)^2

Year 3 12.1 12.1+12.1*.1=13.31 12.1*(1+r) 10(1+r)*(1+r)*(1+r) =10*(1+r)^3

Year 4 13.31 13.31+13.31*.1=14.64 13.31*(1+r) 10(1+r)*(1+r)*(1+r)*(1+r)=10*(1+r)^4

Year 5 14.64 14.64+14.64*.1=16.1 14.64*(1+r) …10(1+r)^(number of years=5)

Year 6 16.1 16.1+16.1*.1=17.71 16.1*(1+r)  

 Formula for Discount Factor

V= final amount received at the end of t years

A= initial amount
r=rate of interest or discount rate

• where DF is the discount factor, which when multiplied to V, tells us the lower
amount (A) that we need to put in the bank today to get a higher amount V in
the future. Alternatively, if you receive V in the future, it is worth receiving a
lower amount A today.
 Year Benefit Cost Net Benefits
1 10 80 -70

Cost
2 10 0 10
3 10 0 10
4 10 0 10
Benefit 5
6
10
10
0
0
10
10

Analysis 7
8
10
10
0
0
10
10
9 10 0 10
The project gives a benefit of 10
million dollars in each year 10 10 0 10
The sum total of benefits is 110 11 10 0 10
million dollars Total benefit 110 30
The total cost is 80 million dollars Total cost 80
The net benefit from the project is Net Benefit 30
30 million dollars
CBA

• A project that extends over multiple time periods, will yield costs and
benefits in different years. As $10 million received 10 years from
today has a lower value than the same amount received today, all
future costs and benefits of the project must be adjusted so that only
their present value is used.
• By multiplying the future costs and benefits by the DF for that
particular year, one can find their present value.
• Once the present value of all costs and benefits is known, next step is
simply to sum them to find whether the sum total of costs and
benefits is +ve or –ve
• If the sum is +ve, the project is financially viable.
 Another example, this time with discounting
applied
• Next slide
Time Cost Benefit DF Cost*DF Benefit*DF Net discounted
Benefit
1 .1M 1/(1+r)^1 .1M*1/(1+r)^1

2 .1M 1/(1+r)^2 .1*1/(1+r)^2

3 .1M 1/(1+r)^3 .1*1/(1+r)^3

4 .1M 1/(1+r)^4 .1*1/(1+r)^4

5 .1M 1/(1+r)^5 .1*1/(1+r)^5

6 .15M 1/(1+r)^6 .15*1/(1+r)^6

7 .15M 1/(1+r)^7 .15*1/(1+r)^7

8 .15M 1/(1+r)^8 .15*1/(1+r)^8

9 .15M 1/(1+r)^9 .15*1/(1+r)^9

10 .15M 1/(1+r)^10 .15*1/(1+r)^10

Put total column Put total column sum Deduct total column
sum of discounted of discounted benefits sum of discounted
costs here as -ve here as +ve costs from the total
column sum of
discounted benefits
Reading: Critique of CBA

• https://friendsoftheearth.uk/sites/default/files/downloads/policy_ap
praisal.pdf
Green Accounting
 Ongoing Debate over Future Generations’
Welfare
• How far in the future should we care?
• Should future generation’s welfare be discounted?
• What should be the discount rate?
• Is using economic CBA for investing in an environmental project
ethically justified?
Concept: Environmental Accounting

• Attempts to account for use of environmental resources in

production of national output
• Without environmental accounting value of GDP is overestimated
• GDP does not include loss or damage to environmental resources in
measuring output
Problems with using gross domestic product
(GDP) as an indicator of growth
• Book: Blueprint of Green Economy (pp.105-109)
• Monetary national accounts ignore:
• Use of defensive expenses
• Negative impact of any environmental damages on economic welfare of
society
• Degradation or depreciation of natural and environmental resources
Defensive Expenditure

• Costs incurred in protecting oneself from air, water and noise

pollution
• Think of other examples
Negative Impact of Environmental
Degradation
• Damages from pollution
• Health impacts
• Natural hazards
• Flooding resulting from removal of forests
• Pest invasions from trade
• Invasive species being transported through the ballast waters of ships, cargo of planes,
etc.
Capital depreciation

• Ecosystem degradation
• Lake eutrophication
• Groundwater depletion
• More examples?