Costs and Benefits

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Costs and Benefits
Andrew Foss (andrew_foss_at_ksg09.harvard.edu) Econo
mics 1661 / API-135 Environmental and Resource
Economics and Policy Harvard University February
20, 2009 Review Section
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Agenda

• Fish Protection at Power Plants
• Overview
• Role of Economics
• Costs
• Concepts
• Components
• Estimation Methods
• Benefits
• Concepts
• Components
• Estimation Methods

Note A good general reference on costs and
benefits is EPA, Guidelines for Preparing
Economic Analyses, September 2000 (link),
Chapters 7 and 8
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Fish Protection at Power PlantsOverview

• Many power plants draw water in from lakes,
  rivers, estuaries, and oceans to cool their
  equipment
• Cooling water intake at power plants kills fish
  and destroys fish eggs
• Impingement Fish and eggs are trapped against
  screens
• Entrainment Fish and eggs are sucked into pipes
• EPA has adopted rules under Section 316(b) of the
  Clean Water Act to minimize the adverse
  environmental impacts of cooling water intake at
  power plants
• EPA has established performance standards for
  impingement and entrainment based on use of
  cooling towers (shown on p. 1), which greatly
  reduce cooling water intake and thus kill few fish

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Fish Protection at Power PlantsRole of Economics

• In the original EPA rules on cooling water
  intake, operators of power plants without cooling
  towers could apply for less stringent performance
  standards if they demonstrated that the costs of
  installing cooling towers or other necessary fish
  protection technologies were disproportionate to
  the benefits
• In a subsequent legal case, a U.S. court of
  appeals ruled against use of benefit-cost
  analysis for individual plants
• the EPA, given a choice between a technology
  that costs 100 to save 99 - 101 fish and one
  that costs 150 to save 100 - 103 fish (with all
  other considerations, like energy production or
  efficiency, being equal), could appropriately
  choose the cheaper technology on
  cost-effectiveness grounds. Cost-benefit
  analysis, however, is not permittedRiverkeeper,
  Inc. et al. v. U.S. EPA, 475 F.3d 83 (2d Cir.
  2007)

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Fish Protection at Power PlantsRole of Economics

• The legal battle continues
• Prof. Stavins and other economists urged the
  courts in July 2008 to allow the use of
  benefit-cost analysis (link)
• The U.S. Supreme Court heard arguments in
  December 2008 and is expected to deliver a ruling
  this spring (link)

Cost-Effectiveness Analysis
Benefit / CostRatios
Benefit- Cost Analysis
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CostsConcepts

• The economic cost of an activity is the value of
  whatever must be given up for the activity
  (opportunity cost)
• Opportunity cost typically exceeds monetary
  outlays

Economic Costs of Activities
Activity Economic Cost
Attending college or graduate school Tuition textbook costs forgone wages from best possible job if working
Building park on vacant public land Forgone net benefit of best alternative use of public land (hospital perhaps)
Cutting down forests Machinery cost labor cost forgone soil services forgone water services forgone CO2 sequestration forgone medicines forgone pollination (see Tietenbergs Example 2.2) existence value
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CostsConcepts

• Transfers between members of society, such as
  taxes paid by firms or individuals to
  governments, should not be counted as costs
• Any social deadweight loss from taxation and any
  labor costs to collect and process taxes,
  however, should be counted

• Suppose power plant operators failing to meet
  fish protection standards have to pay the
  government fines
• The fines should not be counted as costs of the
  regulation, because they are transfers

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CostsComponents
Cost Component Definitions
Cost Component
Real Resource Compliance Costs Purchase, installation, operation, and maintenance costs of control technologies Costs of changes in production inputs and processes Costs of time spent preparing permit applications, reports, etc.
Government Regulatory Costs Costs of administering, monitoring, and enforcing regulation
Social Welfare Costs Losses in consumer and producer surplus due to increase in price or decrease in output of goods and services
Transitional Costs Costs of reallocating resources due to regulation
Indirect Costs Costs of changes in market structure, such as increased market power Costs of changes in product quality Forgone benefits of discouraged investment
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CostsComponents

• Illustration of social welfare costs
• Losses in consumer and producer surplus from
  increased marginal cost across regulated industry

Welfare Effects of Industry-Wide Increase in
Marginal Cost
Price
Price
MC1 S1
D
D
CS1
MC0 S0
MC0 S0
CS0
P1
P0
P0
PS1
PS0
Quantity
Quantity
Q0
Q0
Q1
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CostsComponents
Cost Components of Fish Protection
Cost Component
Real Resource Compliance Costs Purchase, installation, operation, and maintenance costs of fish protection technologies (screens, deterrent systems, cooling towers to reduce water intake) Costs of time spent preparing permit applications and reports for fish protection
Government Regulatory Costs Costs of administering, monitoring, and enforcing regulation for fish protection
Social Welfare Costs Losses in consumer and producer surplus due to increase in price of power during temporary plant outages to install control technologies for fish protection
Transitional Costs N/A Probably not significant in the case of regulation for fish protection
Indirect Costs N/A Probably not significant in the case of regulation for fish protection
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CostsComponents

• Illustration of social welfare costs in power
  market
• Suppose a nuclear power plant must shut down
  temporarily to install fish protection technology
  (cooling towers)
• Supply curve shifts left, raising power price and
  reducing surplus

Welfare Effects of Nuclear Plant Outage to
Install Technology
Price
Price
D
D
CS0
CS1
PS1
MC0 S0
MC1 S1
P1
P0
Gas Plants
Gas Plants
P0
PS0
Coal Plants
Coal Plants
Nuclear Plant
Quantity
Quantity
Q0
Q0
Q1
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CostsEstimation Methods
Cost Estimation Method Definitions
Cost Component
Direct Compliance Cost Method Sum up compliance costs obtained from engineering estimates, and multiply by quantity, then possibly add government administrative costs Assumes no behavioral response Least expensive method of cost analysis May be appropriate when elasticities (behavioral responses) are small or compliance costs (and price increases) are small
Partial Equilibrium Analysis Look at effects on supply and demand in affected market Incorporates behavioral responses But assumes that effects of regulation are confined to one market or a few
General Equilibrium Analysis probably necessary for power sector regs Look at effects on all sectors of economy Complex and expensive, but may be necessary if regulating a key industry Two principal approaches input / output (I/O) models and computable general equilibrium (CGE) models
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BenefitsConcepts

• Benefits in environmental economics reflect
  willingness to pay for improvements in
  environmental quality

Measures for Environmental Goods(e.g., Fish
Protection)
Total Marginal
Total Benefits (TB) Total Willingness to Pay (WTP) Marginal Benefits (MB) Marginal Willingness to Pay (MWTP) Demand
Measures for Environmental Bads(e.g., Fish
Kills)
Total Marginal
Total Damages (TD) Total Willingness to Accept (WTA) Marginal Damages (MD) Marginal Willingness to Accept (MWTA)
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BenefitsConcepts

• MWTP and MWTA may vary across income classes

Marginal Willingness to Accept Increases
inNitrogen Oxide Concentration
Income 15,000
3,000
Income 11,500
2,000
MWTA (/pphm)
Income 8,500
1,000
0
2
4
6
8
10
NOX (pphm)
Note pphm parts per hundred million
1970 Source Adapted from Harrison and
Rubinfeld, Hedonic Housing Prices and the Demand
for Clean Air, Journal of Environmental
Economics and Management, Vol. 5 (1978), pp.
81-102
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BenefitsConcepts

• Suppose MWTP is equal in magnitude to MWTA
• This is not necessarily so (see Tietenbergs
  Debate 3.1)

Environmental Good(e.g., Fish Protection)
Environmental Bad(e.g., Fish Kills)
100
100
MB MWTP Demand
MD MWTA
Q
F
TB Total WTP
TD Total WTA
0
0
Fish Protected
Fish Killed
TD Total WTA
TB Total WTP
MB MWTP
MD MWTA
-100
-100
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BenefitsConcepts

• Suppose the marginal benefit to society of
  protecting Q fish at a power plant is MB(Q) 100
  Q
• Suppose the marginal cost of protecting Q fish at
  the power plant is MC(Q) ?Q
• What is the optimal level of fish protection at
  the power plant?
• If the power plants has the right to kill 100
  fish, what is society willing to pay to achieve
  the optimal level of fish protection?

MB MC 100 Q ?Q Q
75 fish protected Total WTP is area under MWTP
from Q 0 to Q 75 fish
protected Total WTP 2575 ½7575 Total WTP
4,687.50
Optimal Level of Fish Protection
100
MB MWTP Demand
MC
TB Total WTP
0
Fish Protected
Q75
100
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BenefitsConcepts

• Suppose the marginal damage to society from
  killing F fish at a power plant is MD(F) F
• Suppose the marginal savings from killing F fish
  at the power plant is MS(F) 33? ?F
• What is the optimal level of fish kills at the
  power plant?
• If society has the right to the optimal level of
  fish kills, what is society willing to accept in
  compensation for the power plant killing 100 fish?

MD MS F 33? - ?F
F 25 fish killed Total WTA is area
under MWTA from F 25 to F 100
fish killed Total WTA 2575 ½7575 Total WTA
4,687.50
Optimal Level of Fish Kills
100
MD MWTA
MS
TD Total WTA
0
FishKilled
F25
100
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BenefitsConcepts

• Suppose someone suggests evaluating the benefits
  of fish protection by calculating the costs that
  the local fish and wildlife agency would
  otherwise have to pay to stock the waterbody with
  fish from a fish nursery

• This is the avoided cost method of evaluating
  benefits,and it is incorrect because it does not
  measure the value to society of improvements in
  environmental quality
• For an example of what NOT to do, see link, p.
  111

AvoidedCosts
Willingnessto Pay
Willingnessto Accept
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BenefitsComponents
Benefit Component Definitions (Two-Way Taxonomy)
Use Value Non-use Value
Market Use Value The value to society of using an environmental resource as a market product Existence Value The value to society of knowing that an environmental resource exists
Market Use Value The value to society of using an environmental resource as a market product Altruism Value The value to society of knowing other people can use an env. resource
Non-market Use Value The value to society of using an environmental resource not as a market product Bequest Value The value to society of knowing future generations can use an env. resource
Non-market Use Value The value to society of using an environmental resource not as a market product Option Value The value to society of having an option to use an env. resource
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BenefitsComponents
Benefit Components of Fish Protection
Use Value Non-use Value
Market Use Value Larger stock for commercial fisheries Larger stock for bait suppliers Existence Value Stewardship of waterbody Historical or cultural importance
Market Use Value Larger stock for commercial fisheries Larger stock for bait suppliers Altruism Value Interpersonal equity re waterbody
Non-market Use Value Larger stock for recreational fisheries Larger stock for subsistence fisheries Aquatic recreation (boating, diving) Bequest Value Intergenerational equity re waterbody
Non-market Use Value Larger stock for recreational fisheries Larger stock for subsistence fisheries Aquatic recreation (boating, diving) Option Value Potential future use of waterbody
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BenefitsEstimation Methods
Benefit Estimation Methods for Fish Protection
Use Value Non-use Value
Market Use Value Market quantities and prices Existence, Altruism, Bequest, and Option Values Contingent valuation (CV) Contingent ranking Choice experiments
Non-market Use Value Travel cost method,aka Hotelling-Clawson-Knetsch (HCK) Discrete choice models, aka random utility models (RUMs) Hedonic pricing models Existence, Altruism, Bequest, and Option Values Contingent valuation (CV) Contingent ranking Choice experiments
Revealed Preference Methods(maybe stated
preference methods here as well)
Stated Preference Methods
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BenefitsEstimation Methods

• Suppose that without new regulation for fish
  protection at power plants, 1 million pounds of
  cod would be caught by commercial fisheries each
  year and the wholesale price of cod would be 1
  per pound
• Suppose the new regulation would increase the
  annual cod catch by 0.03 million pounds
• Suppose the price elasticity of demand for cod is
  -1.5

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BenefitsEstimation Methods

• What is the change in cod price from the new
  regulation? What is the change in gross revenue
  to commercial cod fisheries?

Use the price elasticity of demand to estimate
the change in cod price e (?Q / Q) / (?P / P)
-1.5 ?Q / Q 0.03 million / 1 million 3 ?P /
P (?Q / Q) / e 3 / -1.5 -2 P1 P0
(100 2) 1 per pound 98 0.98 per
pound Calculate gross revenue before and after
regulation P0 Q0 1 per pound 1 million
pounds 1 million P1 Q1 0.98 per pound
1.03 million pounds 1.0094 million Change in
gross revenue 1.0094 million - 1 million
9,400
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BenefitsEstimation Methods

• Suppose the change in social welfare (consumer
  surplus producer surplus) is half of the change
  in gross revenue to commercial cod fisheries
• What is the change in social welfare?

Change in gross revenue 9,400 Change in
social welfare ½ Change in gross revenue ½
9,400 4,700
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BenefitsEstimation Methods

• Suppose the new regulation would begin next year
  and its impacts would persist for all time
• What is the net present value of the change in
  social welfare from a larger stock for commercial
  cod fisheries, assuming a social discount rate of
  7 percent?

NPV S 4,700 / (1 r)t for t from 1 to 8 Use
the perpetuity formula S A / (1 r)t for t
from 1 to 8 A / r NPV 4,700 / r 4,700 /
7 67,143 Proof of perpetuity formula (or
see link) NPV S A / (1 r)t for t from 1 to 8
A / (1 r) A / (1 r)2 A / (1 r)3
Factor out 1 / (1 r) from right side NPV 1
/ (1 r) A A / (1 r) A / (1 r)2
NPV 1 / (1 r) A NPV r / (1 r)
NPV 1 / (1 r) A NPV A / r
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To Be Continued

• Next time More on benefit estimation methods