Valuation Philosophy3.2
3.3 Money as a Metric in BCA
A BCA requires the ability to add up different kinds of benefits and subtract off different kinds of costs. For instance, a benefit of reducing air pollution might be increased visibility and improved human health, while the cost might be an increase in the price of electricity due to higher pollution control expenses at the electrical utility. To assess the overall net benefits of reducing air pollution, analysts must be able to add up visibility and human health and subtract off pollution control costs in a way that makes sense. One way–the method underlying BCA – is to determine the
value per unit associated with each benefit or cost, and multiply each unit of the good by that value. For instance, if improving visibility from 1 to 5 miles has an average value to each affected person of $10 per year, and there are 1 million affected people, then the visibility benefit would be $10 million. When a similar calculation is done for all benefits and costs, the benefits can be added up, and the cost subtracted, to find the net benefit associated with improved air quality.
Monetizing environmental quality, such as air and water quality, is often considered controversial, for reasons ranging from the fact that we're unfamiliar with thinking of these goods in market terms, to the objection that placing price tags on these goods demeans them in the same way that assigning price tags to human emotions is considered absurd. At the same time, not including them in a BCA will lead to a distorted answer in the analysis. Additionally, while people may be reluctant (for a range of reasons) to price environmental goods, it is probably fair to say that, for many people and for most environmental goods, there is a finite amount they would be willing to pay for very high levels of environmental protection. When economists seek to estimate these values (as will be discussed further below), the intention is to summarize, to the best of their abilities, the tradeoffs that people face in protecting the environment. The primary role of the dollar metric is to provide a means of comparing apples and oranges (or visibility and pollution control technology) in a way that enhances decision-makers'understanding of the tradeoffs.
3.3.1 From Utility to Income
By graphing a consumer's utility using what are called indifference curves, it can be shown that a change in income can be used to measure a change in utility. Thus one measure of how much an individual benefits from an improvement in air quality is the maximum amount of income s/he would be willing and able to pay for the improvement rather than go without. This is the sum of money where the individual is indifferent between paying that sum of money and having a given increment in air quality (e.g., 5 more miles of visibility) versus keeping the money and foregoing the gain.
3.3.2 Income as a Proxy for Sacrifice of Other Goods
We will illustrate this concept of willingness to pay more concretely later in this chapter. At this point we wish to stress that willingness to pay (WTP) in the form of income is simply a proxy for willingness to give up other goods and services to have the policy or project under study, and it
therefore serves as a measure of the benefit of a good. In essence, maximum willingness to pay is often driven as much by a willingness to substitute the new good for the old good as it is by level of income. For example, a person that really likes whale watching might be willing to give up three trips to the open-air concert at the downtown park to have one additional whale watching trip. In this sense, income influences willingness to pay only because we use dollars as the measuring units, not because the individual is directly foregoing income. Rather, the individual is foregoing three concerts to gain one whale watching trip. But if we wish to have a dollar measure of the three open-air concerts foregone to gain one whale watching trip, we must convert the concerts in the park foregone into their income equivalent in dollars. In this way we can compare the value of the whale watching trip gained to the cost society must incur to provide the whale watching opportunities (perhaps reduced off-shore oil drilling or commercial navigation).
3.3.3 From Individual Benefits to Social Benefits
Now that we have an initial means of measuring benefits from an individual's point of view, we need to see how this information would be used to determine if some policy or management action is desirable. To do this, we assume that what is best for society is what is best for the aggregation of individuals in society. That is, society's benefits are the simple sum of the benefits individuals derive. For example, assume society is made up of just two people, Mr. Loomis and Ms. Helfand. There are two possible bundles of goods that cost the same to produce. Society is attempting to decide whether the highest valued use of resources is to produce Alternative B rather than the current Alternative A. Table 7-1 shows the benefits to each of them with Alternative A and Alternative B.
Review of Table 7-1 shows that Alternative B is preferred since Ms.
Helfand receives a bundle of goods she values more highly (i.e, is willing to pay more for) than in Alternative A. At the same time, Mr. Loomis is neither better off nor worse off. Thus, moving from Alternative A to B results in an actual Pareto Improvement in society's welfare: Ms. Helfand gains ($25) and Mr. Loomis stays the same. There is an actual clear gainer and no losers. Thus the'economic pie'gets larger, with Ms. Helfand's slice growing and no change in Mr. Loomis's slice.
Once we have adopted alternative B, we have obtained a Pareto Optimum, or optimum economic efficiency. That is, there are no other alternative allocations of resources that make one of them better off without making the other worse off. Clearly alternative C cannot do it, as Mr.
Loomis gains $50 but at the expense of Ms. Helfand losing $85 as compared to Alternative B. At alternative B the economic pie is at its maximum size, given the current technology and tastes and preferences of Mr. Loomis and Ms. Helfand.
3.3.4 Potential Pareto Improvements
Unfortunately, many policies or management actions, such as raising a gasoline tax or permitting a subdivision in what is currently open space, will result in some groups in society losing and others gaining. For example, is Alternative D in Table 7-2 better than Alternative B?
Alternative D does not represent an actual Pareto Improvement as Mr.
Loomis (current homeowner adjacent to the empty field) is made $25 worse off (compared to B), while Ms. Helfand (the developer) is made $75 better off (compared to B). What can we say about an alternative policy that makes one person better off but another worse off? If we can add individual valuations of Ms. Helfand and Mr. Loomis together we can determine if the sum or total of the valuations are the highest with Alternative D. Using the criterion of total net benefits, Alternative D is preferred since it yields the greatest value of total output. In other words, the economic pie is larger than with any other alternative.
Alternative D represents a Potential Pareto Improvement: the gainer (Ms. Helfand) could potentially compensate the loser (Mr. Loomis) and still have a gain remaining. With Alternative D in Table 7-2, Ms. Helfand could afford to give Mr. Loomis (or the City Parks Department to preserve some other nearby open-space) $25 to get him back to his original level of
benefits ($150 in Alternative B), and Ms. Helfand would still be better off by $50. On this basis, Alternative D is the most economically efficient alternative. In no other alternative could the beneficiaries compensate the losers and still have any gain left over. This is sometimes referred to as a compensation test. Such tests can be quite elaborate, including not only whether the gainers can fully compensate the losers and still have a gain left over, but whether the losers are unable to bribe the gainers into foregoing the program. (See Mishan, 1981).
For the total or sum of benefits to reflect a meaningful measure of social well being involves at least two key assumptions: (1) that we can meaningfully compare different people's valuation of goods or services; (2) that a dollar's worth of benefits provides the same change in individual utility or well being to every person.