Assessing Costs for Environmental Decision Making

Chapter 8

1. Environmental Costs: Conceptual Issues

• ___________________: the change in costs arising from policy-induced improvements in environmental quality

costs after the policy is implemented – existing level of environmental expenditures

2

Modeling Incremental Costs

• Find baseline TSC before policy• Find TSC after policy is implemented• Subtract baseline from new TSC

– TSC can be found as area under MSC

• Recall MSC = MACMKT + MCE

3

MSC and TSC of AbatementM

SC

($m

illi

on

s)

A (abatement %)

MSC = 4 + 0.75AMSC = MACMKT + MCE

0

4

A1

TSC

4

Modeling Incremental CostsM

SC

($m

illi

on

s)

A (abatement %)

MSC = 4 + 0.75AMSC = MACMKT + MCE

0

4

20

19

25

22.75

Incremental costs = $104.375 million

5

• Economic costs include– Explicit (or monetary) costs– Implicit (or nonmonetary) costs

6

Explicit Costs

• Administrative, monitoring, and enforcement expenses incurred by the public sector plus compliance costs incurred by all sectors– Capital (or fixed) costs

• Fixed spending on plant, equipment, construction… for pollution abatement

– Operating (or variable) costs• Variable costs of operating and maintaining

abatement processes

7

Implicit Costs

• Value of nonmonetary effects that negatively affect society’s well-being – Examples: diminished product variety, time costs of

searching for substitutes, reduced convenience…

8

2. Estimating Explicit Costs

• Two methods– Engineering Approach– Survey Approach

• Common to use a combination approach

9

Engineering Approach

• Estimates abatement spending based on least-cost available technology

• Relies on __________ in abatement methods• Drawbacks

—difficult to use for proposed policy due to uncertainty

—likely understates true costs because it assumes all firms are cost-effective

10

Survey Approach

• Derives estimated abatement expenditures from a sample of polluting sources via _________

• A more direct means to obtain abatement cost• Drawbacks

– polluters have an incentive to exaggerate costs to officials to increase the probability that the proposed regulation will be rejected

11

3. Cost Classifications

• By economic sector– Shows cost distribution across public and

private sectors

• By environmental media– Shows how costs vary across air, water, and

solid waste abatement activities

12

Benefit-Cost Analysis in Environmental Decision

Making

Chapter 9

1. Benefit-Cost Analysis in Practice

Making ________ adjustments• Benefits and costs must be adjusted to

account for how their values change over time

14

Time Adjustments• Purpose

– Benefits and costs do not accrue to society at the same time

– Benefits and costs often accrue in the future

• Two types of adjustments

a. Present value determination• accounts for the opportunity cost of money

b. Inflation correction• accounts for changes in the general price level

15

= Discounting

= Adjusting for inflation=Deflating

a. Present Value Determination• Discounts a __________ (FV) into its _______

______ (PV) by accounting for the opportunity cost of money (its highest valued alternative use, which is the rate of return (r) on investment)

• Explains why money loaned in the present must be paid back in the future with interest

O. C. of money = r = rate of return = interest rate

1. People prefer to consume now rather than later.2. $100 could be invested to yield a 10% return. The O.C. of $100 is $10.

16

• General formula PV = FV[1/(1 + r)t] where:• [1/(1 + r)t] is the _______________• t is number of time periods• r, the discount rate, is the only variable

-called the social discount rate in public policy -should reflect the social opportunity cost of

funds

• PV determination is the means by which future environmental benefits and costs are adjusted

17

r = the discount rate = the social discount rate

b. Inflation Correction

• Adjusting for movements in the general price level

– Converting a real variable today to its future nominal value to account for expected inflation

• Nominal valueperiod x+t= Real valueperiod x (1 + p)t,

–where p is the expected inflation rate

– Converting a nominal value to its real value• Real valueperiod x = Nominal valueperiod x + t (1 + p)t

• Known as deflating

18

• Present value of benefits in real terms (PVB) over all t periods = (bt/(1+rs)t)

• bt: real benefits

• Present value of costs in real terms (PVC) over all t periods =(ct/(1+rs)t)

• ct: real costs

19

bt = Bt / (1+p)t

ct = Ct / (1+p)t

Adjust for inflation; then discount

2. Benefit-Cost Analysis in Policy

• Step 1: Determine if an option is feasible• Step 2: Select from among feasible options

20

Step 1:Determining Feasibility

• Use the benefit-cost ratio– If PVB/PVC > ___ option is feasible

OR

• Use the present value of net benefits (PVNB), which equals (PVB – PVC)– If PVNB > ____ option is feasible

21

Step 2:Select Among Feasible Options

• Decision rule: To achieve allocative efficiency – Maximize PVNB = (bt - ct)/(1+rs)t for all t

periods, among all feasible alternatives

• Decision rule: To achieve cost-effectiveness:– Minimize PVC = (ct/(1+rs)t) for all t periods,

among all feasible alternatives that achieve a predetermined benefit level

22

3. Reservations About the Use of Benefit-Cost Analysis

• Measurement Problems– Estimation is particularly problematic due to

intangibles– Implicit costs

• Equity Issues– Distribution of benefits and costs may be

highly skewed

23

4. Federal Government Support

• Reagan’s Executive Order 12291– Explicitly called for maximizing net benefits

(allocative efficiency) and choosing the least-cost alternative (cost-effectiveness)

– Detail of potential benefits and costs to be given in a Regulatory Impact Analysis (RIA)

– Applicable to any “major rule,” i.e., a regulation expected to have an annual impact of at least $100 million

24

• Clinton’s Executive Order 12866– Explicitly refers to adopting/proposing

regulations for which benefits justify costs (allocative efficiency) and designing regulations in most cost-effective manner

– Applicable to any “significant regulatory actions,” including those expected to have an annual impact of at least $100 million

– Detail to be given in an Economic Analysis (EA)

25

• Bush’s Executive Order 13258– Makes only minor amendments to Clinton’s

Executive Order 12866 – Extends the use of economic criteria in

policy design and evaluation through an Economic Analysis

26

5. Regulatory Impact Analysis (RIA):Lead in Gasoline• Estimated incremental benefits included health

effects and nonhealth effects, such as increased fuel economy

• Estimated incremental costs were estimated using an engineering cost model of the refinery industry

• The resulting PVNB over the 1985-1992 period (excluding blood pressure effects) was estimated to be $5.9 billion and supported the proposed new lead standard

27

28

Extra information:Opportunity Cost for Individuals

The money we pay for a good/service is a part of its cost;

The total cost of any choice is everything we must give up.

29

Opportunity Cost—What is given up when taking an action

Arises from the scarcity of time or money

30

Example:

In one hour, Charlie can fix 4 flat tires or type 200 words. His opportunity cost of fixing 4 flat tires is ___________.

31

The opportunity cost of any activity can be measured by the value of the best alternative to that choice.

32

Example:

You are spending a couple of hours reading Chapter 1. Instead of reading, you could be doing many other things: watching TV, go shopping, earning extra money tutoring high school students… Assume that tutoring is your best alternative.

The opportunity cost of reading Chapter 1 is________________________________________.

33

Opportunity cost includes:

(a) Explicit Cost—Dollars actually paid out for a choice

(b) Implicit Cost—Value (forgone income) of something (time) sacrificed when no direct payment is made

34

You are considering attending a concert.

Ticket price: $35Cost of driving and parking: $20

In order to attend the concert, you will have to take time off from your part-time job (5 hours, $6 per hour).

Your opportunity cost of attending the concert= explicit cost + implicit cost = monetary cost + forgone income

35

=________________________ =_____________=______

36

Comments on “opportunity cost”:

• Most accurate and complete concept of cost

• The one we should use when making our decisions

37

TIME VALUE OF MONEYThe idea that money available at the present time is worth

more than the same amount in the future due to its potential earning capacity. This core principle of finance holds that, provided money can earn interest, any amount of money is worth more the sooner it is received. 

Everyone knows that money deposited in a savings account will earn interest. Because of this universal fact, we would prefer to receive money today rather than the same amount in the future.

For example, assuming a 10% interest rate, $100 invested today will be worth $110 in one year ($100 multiplied by 1.10).  Conversely, $110 received one year from now is only worth $100 today ($110 divided by 1.10).

38

Solving for FV:The Formula Method

• After 1 year:FV1 = PV(1 + r) = $100*(1.10) = $110.00

• After 2 years:FV2 = PV(1 + r)2 = $100*(1.10)2 = $121.00

• After 3 years:FV3 = PV(1 + r)3 = $100*(1.10)3 = $133.10

39

Solving for PV:The Formula Method

Solve the general FV equation for PV:

PV = FVt /(1 + r)t

PV = FV3 /(1 + r)3

= $133.10/(1.10)3

= $100