Lecture 8 - Valuation of Natural Resources PDF

LECTURE 8 VALUATION OF NATURAL RESOURCES  Learning outcomes At the end of this lecture students will: understand the basic concepts of economic value. appreciate that a good’s market price does not always measure its economic value. be able to demonstrate an understandi...

LECTURE 8 VALUATION OF NATURAL RESOURCES  Learning outcomes At the end of this lecture students will: understand the basic concepts of economic value. appreciate that a good’s market price does not always measure its economic value. be able to demonstrate an understanding of the types of values/benefits of natural resources. analyze the Total Willingness to Pay (TWP) for or the Total Economic Value (TEV) of a resource. understand and be able to apply the various methods for valuing non-market natural resource services and outputs 2  Basic Concepts of Economic Value Measures of economic value are based on what people want – their preferences. The theory of economic valuation is based on individual preferences and choices. People express their preferences through the choices and tradeoffs that they make, given certain constraints, such as those on income or available time. 3 Basic concepts of economic value... The economic value of a particular item, or good, for example a loaf of bread, is measured by the maximum amount of other things that a person is willing to give up to have that loaf of bread. If the person has only two goods to choose from- bread and pasta - the value of a loaf of bread would be measured by the most pasta that the person is willing to give up to have one more loaf of bread. Thus, economic value is measured by the most someone is willing to give up in other goods and services in order to obtain a good, service, or state of the world. 4 Basic concepts of economic value... In a market economy, money (e.g. dollars or cedis) is a universally accepted measure of economic value. This is because the number of dollars/cedis that a person is willing to pay for something tells how much of all other goods and services they are willing to give up to get that item. This is often referred to as “willingness to pay.” 5 Basic concepts of economic value... It is often incorrectly assumed that a good’s market price measures its economic value. However, the market price only tells us the minimum amount that people who buy the good are willing to pay for it. When people purchase a marketed good, they compare the amount they would be willing to pay for that good with its market price. They will only purchase the good if their willingness to pay is equal to or greater than the price. Many people are actually willing to pay more than the market price for a good, and thus their values exceed the market price. 6 Basic concepts of economic value... In order to make resource allocation decisions based on economic values, what we really want to measure is the net economic benefit from a good or service. For individuals, this is measured by the amount that people are willing to pay, beyond what they actually pay. The economic benefit to individuals is often measured by consumer surplus. This is graphically represented by the area under the demand curve for a good, above its price. 7  The Demand Curve Price Consumer Surplus Market Price Quantity 8 Basic concepts of economic value... Producers of goods also receive economic benefits, based on the profits they make when selling the good. Economic benefits to producers are measured by producer surplus – the area above the supply curve and below the market price. 9 Basic concepts of economic value... If producers receive a higher price than the minimum price they would sell their output for, they receive a benefit from the sale – the producer surplus. Thus, benefits to producers are similar to benefits to consumers - – because they measure the gains to the producer from receiving a price higher than the price they would have been willing to sell the good for. 10 11 Basic concepts of economic value... The net economic benefit from a good or service is the consumer surplus plus the producer surplus. When measuring economic benefits of a policy or initiative that affects an ecosystem, economists measure the total net economic benefit. This is the sum of consumer surplus and producer surplus. 12  Types of values/benefits of natural resources Economists usually classify Natural resource benefits or values into three main components: – Use Values (Active natural resource values), – Option Value, and – Non-use Values (Passive natural resource values). Use values Reflect the direct use of the environmental resource. They arise from using the resource in some way. 13 Types of values of natural resources... Examples – fish harvested from the sea, – timber harvested from the forest, – water extracted from a stream for irrigation, – the scenic beauty conferred by a natural vista (view). Use values can be divided into consumptive and non-consumptive values. 14 Types of values of natural resources... Consumptive values: – Arise from extractive resources: Examples are timber, minerals, recreational and commercial hunting and fishing, and agriculture. – Extractive resources are those subject to some process of physical removal from their natural surrounding and perhaps physical transformation during their use. Non-consumptive values: – Arise from non-extractive resources i.e. resources that are utilised but not removed or diminished in quantity or quality. – Examples are ecotourism, animal watching, boating, rock climbing, etc. 15  Types of values of natural resources... Option value Reflects the value people place on a future ability to use a resource. It reflects the willingness to preserve an option to use a resource in the future even if one is not currently using it. Whereas use value reflects the value derived from current use, option value reflects the desire to preserve a potential for possible future use. 16 Types of values of natural resources... Non-use values Reflect the value that people place on a resource independent of their actual use of the resource. They are values or benefits that do not derive from the use of the resource. Non-use values reflect the common observation that people are more than willing to pay for improving or preserving resources that they will never use. Non-use values are comprised of existence and bequest values. 17  Types of values of natural resources... Existence value: The value placed on the continued existence of a resource, independent of its use values. It refers to the willingness to pay to maintain the existence of a resource even though no future utilization is likely. It relates to valuation of the resource as a unique asset in itself, with no connection to its use values. Example: Culture, heritage, biodiversity, etc. 18 Types of values of natural resources... Bequest value: This represents the value (to current users) of being able to pass on a resource in its present condition as an inheritance to future generations. It is the willingness to pay to preserve the resource for future generations. Example: Willingness to protect open space so one’s grandchildren will live in a world with ample amounts of this resource. 19 Types of values of natural resources... Total Willingness to Pay (TWP) for or the Total Economic Value (TEV) of a resource is the sum of these categories of values TWP (TEV) = Use Value + Option Value + Non-use value. 20  Valuation Methods When markets are involved, interactions among buyers and sellers establish prices and quantities of transactions, which can often be analysed to determine the willingness to pay of demanders and the marginal costs of suppliers. Thus, Market Valuation Methods rely on our ability to measure demand and supply curves with data generated by transactions in markets. 21 Valuation Methods... Valuing non-market resources, however, presents a problem since they are not traded on the market and, therefore, it is difficult to estimate the demand curves of such resources. We therefore must rely on alternative techniques to obtain data and to estimate demand curves (marginal benefits). Economists have developed a number of techniques to measure these non-market values. These include the Contingent valuation method, the Travel cost method, Hedonic methods, etc. 22  The Contingent Valuation Method (CVM) It is a direct non-market valuation method because it attempts to determine economic preferences by asking individuals directly. It is a stated preference method. It can be used to estimate use values, non-use values and option values. The CVM utilizes surveys to determine how much individuals are willing to pay to achieve improvements in environmental quality. 23  The CVM... The method is based on the idea that people’s WTP for environmental quality or a resource or a resource service can be determined by asking them directly. The technique is called “Contingent Valuation” because it attempts to elicit people’s valuations of contingent, or hypothetical, situations. In the absence of markets, people are essentially asked to choose as if there were a market for the output or resource in question. 24 The CVM... Values provided by this method are hypothetical in that the respondent is assumed to behave as if there were a real market. Hence, the valuation is contingent upon the creation of this hypothetical market. 25 Steps in a CV analysis Identification and description of the environmental quality characteristics to be evaluated. Identification of respondents to be approached Design and application of a survey questionnaire through personal, phone or mail interviews (recently, focus groups have sometimes been used) – Avoid leading questions or questions that will prejudice the respondents. Estimation of willingness to pay function 26 Steps in a CV analysis... The estimation of willingness to pay function involves: – Analysis of the results; and – Aggregation of individual responses to estimate values for the group affected by the environmental change. Economists use statistical techniques to relate the willingness to pay that people reveal to a demand function for environmental quality. 27 Steps in a CV analysis... The Survey Questionnaire The central purpose of the questionnaire is to elicit from respondents their estimate of what the natural resource is worth to them. A number of techniques have been used to get this response. – Asking people outright to provide the amount with no prompting or probing on the part of the interviewer. – Using a bidding game. E.g. double-bounded dichotomous choice (DBDC) elicitation method – Giving the respondents printed response cards with a range of values, and then asking the respondents to check off their maximum willingness to pay. 28  Examples of questions in CV studies 1.There are less than 1,000 American Crocodiles left. Habitat necessary for the American Crocodile is rapidly being bought for development. The Nature Conservancy is considering buying land in an effort to save this species. What would you be willing to pay in the form of an annual donation in order to buy enough habitat to save 100 crocodiles? $_______________ If you said $0, please tell me why? 2. What is your annual income? 3. What is your age? 4. Male Female (circle one) 5. Do you belong to a conservation organization? Yes No Which one? __________ How much do you donate annually? 29 Suppose the Government of Ghana commissions an environmental NGO with excellent track record of protecting forest reserves to supervise the conversion of the Atewa Forest Reserve to a national park with a buffer zone, and manage the park to ensure that it provides improved benefits such as clean water and air, No regulation of microclimate, preservation of some star species, and preservation of culture to the local communities. Would you be willing to make a monthly donation for a year to support the proposal? Reason why? Yes Would you be willing to pay Bi to support the project? Yes No What about BH? What about BL? Yes No Yes No Bidding game - Double-bounded What is the maximum amount you are willing to pay? dichotomous choice (DBDC) 30 elicitation method  Advantages of the CVM The CVM is very flexible in that it can be used to estimate the economic value of virtually anything. CVM is the most widely accepted method for estimating total economic value, including use values, option values, existence values, and bequest values. The nature of CV studies and the results of CV studies are not difficult to analyse and describe, even though the method requires competent survey analysts to achieve defensible estimates. – The monetary value obtained can be presented as mean or median value per capita or per household or as an aggregate value for the population of the study. 31 Advantages of the CVM... CVM circumvents the absence of markets for non-marketed goods and services by presenting consumers with hypothetical markets in which they have the opportunity to pay for the good or service in question. 32 Problems/biases associated with the CVM Hypothetical bias: This is the tendency for hypothetical payments to differ from actual payments due to a difficulty in correctly picturing the situation. Stated preferences may not always match actual preferences because people are not bound by a real income constraint. Since the respondent does not actually have to pay the estimated value, he or she may treat the survey casually, providing ill-considered answers. 33 Problems/biases associated with the CVM... Information bias: This occurs when respondents are forced to evaluate goods/attributes for which they have little or no experience. Contingent value markets are purely hypothetical, and the individuals surveyed may or may not know anything about the resource problem before the survey. This can lead to bias responses 34 Problems/biases associated with the CVM... Compliance Bias: When the cultural practices of respondents cause them to feel it is inappropriate to respond to questions in some particular way, their WTP may be quite different from their “true” WTP. This is referred to as compliance bias and can cause substantial differences between reported and true WTP values. 35  Problems/biases associated with the CVM... Compliance bias can be caused by the respondents being influenced by their knowledge of the sponsor of the survey or the interviewer. – Sponsor bias - occurs when a respondent gives a WTP amount that differs from his/her true WTP amount in an attempt to comply with the presumed expectations of the sponsor. – Interviewer bias - occurs when a respondent gives a WTP value that differs from his/her true WTP value in an attempt to please or gain status in the eyes of a particular interviewer. 36 Problems/biases associated with the CVM... Starting Point bias: This is the tendency for reference points for bidding games and payment card mechanisms to induce higher or lower responses. Starting point bias may arise in those survey instruments in which a respondent is asked to check off his or her answers from a predefined range of possibilities. How that range is defined by the designer of the survey may affect the resulting answers. A range of ¢0 to ¢100 may produce a different valuation by respondents, for example, from a range of ¢10 to ¢100. 37 Problems/biases associated with the CVM... Strategic bias: This is the tendency for respondents to overstate or understate WTP in order to affect policy or influence a particular outcome. Some responses may be irrational from an economic perspective. Individuals may bid too high or too low because they are unduly biased one way or the other. Therefore, the study will fail to capture their true willingness to pay. 38 Problems/biases associated with the CVM... Embedding problems/effects: This occurs when respondents are willing to pay almost the same for the inclusive good and/or for different quantities of the same good – one part of the lake as well as for the entire lake – hundred birds and a million of birds Past surveys have been shown to be unresponsive to scale. Individuals asked about saving 20 ducks, 2000 ducks, and 20,000 ducks, for instance, stated the same price for saving all quantities of ducks. Economic theory posits that individuals should have different values for saving different numbers of ducks. 39 Problems/biases associated with the CVM... Warm Glow effects: Individuals may just like the idea of giving rather than providing true willingness to pay for the particular resource or problem in question. The values in surveys may represent general charity rather than the value for the specific good considered. 40 Problems/biases associated with the CVM... Payment vehicle used: Payment vehicle represents the way in which the payment will be likely made. Willingness to pay can be ‘in reality’ paid through increased taxes, contributions to special public funds, etc. The format of the payment vehicle (for instance an increase in taxes) can encourage the respondent to pay less or even nothing for a contingent product even if he/she would be willing to pay a certain positive amount if a no-tax vehicle were considered. 41 The Travel Cost Method (TCM) An indirect method of estimating non-market values A revealed preference method Since revealed preference methods require observations of human behaviour, they can only measure Use Values. The TCM is widely used to estimate the value of recreational sites including public parks and wildlife reserves in developed countries. The method provides a common way to derive demand curves for recreation requiring travel from different distances. 42 The TCM... The Travel Cost Method takes advantage of the fact that people have to incur travel costs to visit natural resource sites. Because many of these recreational sites, (e.g. public beaches, forests, and parks) are usually free, there is no obvious price information available to determine the value of the site. Economists have therefore adopted the use of indirect measures, such as the cost of travelling to the site, as a proxy for (or in place of) the price of obtaining a visit to the site. 43  The TCM... The TCM suggests that there is a relationship between the number of trips that each person will take to a recreational site and the distance they have to travel to get there (or the cost incurred to get there): i.e. Trips = F(Distance or travel cost) Individuals who live close have a low price of visiting the resource for each trip, and therefore are more likely to demand more trips. Individuals living farther away have a higher price and will take fewer trips to a site. The relationship between number of trips and distance (or travel costs) defines a demand curve for trips, with travel costs as the measure of price. 44 Marginal Willingness to Pay or Travel Cost or Price Consumer Surplus for each visitor WTP Individuals Travel costs WTP function T Number of Trips 45  The TCM... Marginal Willingness to Pay or The demand function Travel Cost or Price Consumer Surplus for each visitor for trips (willingness to pay or marginal benefit function) to the recreation site is shown as a downward WTP Travel Individuals WTP sloping line. costs function As with other goods, the higher the price, T Number of the fewer trips you will take. Trips 46  The TCM... Marginal Willingness to When the number of Pay or Travel Cost or Price Consumer Surplus for each visitor trips taken is T, the travel costs for each trip are WTP. Thus, at T the marginal cost of a trip is WTP. WTP Individuals Considering all T Travel costs WTP function together, the total travel cost would be T * WTP, or the area T Number of noted as travel costs. Trips 47  The TCM... Marginal Willingness to Pay or Travel Cost Consumer Surplus for each The average cost per trip or Price visitor would then be calculated as (T* WTP)/T. For this same number of T trips, the total value of the WTP recreation site to a visitor who travels there T times Travel Individuals WTP per year is the area costs function underneath the WTP function between the origin and T T Number of Trips i.e. the area (consumer surplus + travel cost). 48  Procedure of the TCM The procedure of the TCM involves: Surveying visitors to recreation sites to obtain data on – the number of visits (which could be zero), – various components of travel costs, and – relevant economic and demographic information (such as income levels, age, and educational attainment). These data are then analysed to yield a demand curve for recreational visits. Once the demand curve is identified, the non-market benefits of the site are estimated by calculating the area under the demand curve. 49 Factors that Influence Site Visitation Environmental quality: Environmental quality can encompass many different aspects of a site, ranging from scenic beauty to infrastructural development like parking lots, or even bathrooms. These different factors can influence the demand function for sites. A more precise way to define the travel cost demand function would account for differences in environmental quality across sites: Trips = F (travel cost, environmental quality). 50  Factors that Influence Site Visitation... Unique features: These are a more specific form of environmental quality. The “hanging walkway” at Kakum National Park is a unique feature that attracts individuals from very long distances to visit this park. Unique features may alter the shape of the demand function, making parks with the feature more valuable than other similar parks without the feature. The figure below shows separate travel cost functions for a unique park and local parks. 51 Factors that Influence Site Visitation... Marginal Willingness to Pay = Travel Cost Unique Park (e.g. Kakum National Park) Local Park (e.g. Amakom children’s park Number of Trips 52  Factors that Influence Site Visitation... Other activities: With many sites, the analyst must be careful to assess only the value directly attributable to the use of the site itself. For example, individuals visiting the Mole National Park in Damango may be on a family vacation, and they may have other things that they plan to do in Damango, like visiting family friends. Therefore, economists cannot assign the entire cost of the trip to the value of Mole National Park alone. This can affect trips to unique or local sites equally, and must be considered carefully in travel costs studies in order to avoid overvaluing sites. 53  Factors that Influence Site Visitation... The travel costs themselves: What costs should be include in the travel cost model? Should only the direct costs of transportation to the site be included in the analysis? The opportunity cost of time away from work, or from some other recreational activity, may be substantial and should be considered in travel cost models. Economists have typically included the following in travel costs (or the price of accessing a site): – Direct monetary costs such as fuel and lodging costs. – Time Costs: The opportunity costs of not working while travelling to visit the site. 54  Advantages of the TCM It is analogous to the more conventional empirical techniques used by economists to estimate economic values based on market prices. It is based on actual behaviour rather than stated willingness to pay i.e. it is based on what people actually do but not what they say they would do in a hypothetical situation. It is relatively inexpensive to apply because on-site surveys provide opportunities for large samples who tend to be interested in participating. Results from travel cost method are relatively easy to interpret and explain. 55 Limitations of the TCM The method assumes that people perceive and respond to changes in travel costs in the same way that they would respond to changes in admission price, and that they would not have incurred travel expenses if the commodity were priced. The method assumes that individuals take a trip for a single purpose. – However, some trips may be multi-purposed. – It can be difficult to apportion the travel costs among the various purposes and this may cause the value of the facility to be overestimated 56 Limitations of the TCM... Defining and measuring the opportunity cost of time, or the value of time spent travelling, can be problematic. – There is no consensus on the appropriate measure of the value of time – Further, if people enjoy the travel itself, then the travel time becomes a benefit, rather than a cost, and the value of the site may thus be overestimated. 57 Limitations of the TCM... Availability of substitute sites will affect the estimated values. – E.g. if two people travel the same distance, they are assumed to have the same value. – However, if one person has several substitutes available but travels to a particular site because it is preferred, this person’s value is actually higher and this should be recognised. 58 Limitations of the TCM... People who value certain sites may choose to live nearby. If this is the case, they will have low travel costs, but high values for the facility that are not captured by the travel cost method. Standard travel cost method provides information about current conditions but not about gains or losses from anticipated changes in the conditions of the site. 59 Limitations of the TCM... In order to estimate the demand function, there is the need for enough difference between distances travelled to affect travel costs and for differences in travel costs to affect the number of trips made to the site. – Thus, the travel cost method is not suited for facilities near major population centres where many visitations may be from “origin zones” that are quite close to one another. 60  Limitations of the TCM The travel cost method is limited in its scope of application because it requires user participation. – It cannot be used to assign values to on-site environmental features and functions that users of the site do not find valuable. – It cannot be used to value off-site values supported by the site. – It cannot be used to measure non-use values. – Thus, sites that have unique qualities that are valued by non- users will be undervalued. It sometimes ignores users who travel on foot or bicycle. Interviewing visitors on the site can introduce sampling biases to the analysis. 61  Hedonic Pricing Method (HPM) An indirect method, a revealed preference method A valuation technique that is used to estimate economic values for ecosystem or environmental services that directly affect prices of marketed goods. It is most commonly applied to variations in housing prices that reflect the value of local environmental attributes. It can be used to estimate economic benefits or costs associated with: – environmental quality, including air pollution, water pollution, or noise – environmental amenities, such as aesthetic views or proximity to recreational sites 62  The HPM... The basic premise of the hedonic pricing method is that the price of a marketed good is related to its characteristics, or the services it provides. For example, the price of a car reflects the characteristics of that car—comfort, style, luxury, fuel economy, etc. Therefore, we can value the individual characteristics of a car or other good by looking at how the price people are willing to pay for it changes when the characteristics change. 63 The HPM... The HPM is most often used to value environmental amenities (or environmental quality) that affect the price of residential properties (Houses). In general, the price of a house is related to – the characteristics of the house and property itself, – the characteristics of the neighbourhood and community, and – environmental characteristics. Thus, if non-environmental factors are controlled for, then any remaining differences in price can be attributed to differences in environmental quality. 64 The HPM... For example, if all characteristics of houses and neighbourhoods throughout an area were the same, except for the level of air pollution, then houses with better air quality would cost more. This higher price reflects the value of cleaner air to people who purchase houses in the area. 65 Applying the HPM using housing prices To apply the hedonic pricing method, the following information must be collected: – A measure or index of the environmental amenity of interest. – Cross-section and/or time-series data on property values and property and household characteristics for a well-defined market area that includes homes with different levels of environmental quality, or different distances to an environmental amenity, such as open space or the coastline. 66 Applying the HPM using housing prices The data are analyzed using regression analysis , which relates the price of the property to its characteristics and the environmental characteristic(s) of interest. Thus, the effects of different characteristics on price can be estimated. The regression results indicate how much property values will change for a small change in each characteristic, holding all other characteristics constant. 67  Procedure of the HPM: An Illustration Assume that an agency wants to measure the benefits of an open space preservation programme in a region where open land is rapidly being developed. The procedure is as follows: 68 Step 1: Collect data on residential property sales in the region for a specific time period (usually one year). The required data include: – selling prices and locations of residential properties. – property characteristics that affect selling prices, such as number and size of rooms, and number of bathrooms. – neighbourhood characteristics that affect selling prices, such as property taxes, crime rates, and quality of schools. – accessibility characteristics that affect prices, such as distances to work and shopping centres, and availability of public transportation. – environmental characteristics that affect prices. 69  In this case, the environmental characteristic of concern is the proximity to open space. The researcher might collect data on – the amount and type of open space within a given radius of each property, – whether a property is directly adjacent to open space. 70 Step 2: Once the data are collected and compiled, the next step is to statistically estimate a function (regression analysis) that relates property values to the property characteristics, including the distance to open space. The resulting function measures the portion of the property price that is attributable to each characteristic. Thus, the researcher can estimate the value of preserving open space by looking at how the value of the average home changes when the amount of open space nearby changes. 71  Hedonic Wage Studies Some economists have used hedonic methods to estimate the value of human life by comparing wages in fields with different risks. For instance, firemen and policemen have relatively riskier jobs than many of us. By comparing their wages to those from other fields, – along with information about the relative risks of the different fields, we can infer the wage differential associated with risk. 72  Over the years, many hedonic wage analyses have been done by economists. They have developed a range of different estimates for the value of human life. However, this is quite controversial. 73 Advantages of the HPM The method’s main strength is that it uses observed data based on actual choices not hypothetical choices. – This makes it relatively straightforward and uncontroversial to apply. Data on property sales and characteristics are usually readily available through many sources and can be related to other secondary data sources to obtain descriptive variables for analysis. – This makes the method relatively inexpensive to apply. 74  The method is versatile, and can be adapted to consider several possible interactions between market goods and environmental quality Estimated values obtained from one study can be used in other policy areas if the sites have similar demand and supply characteristics. 75  Limitations of the HPM The scope of environmental benefits that can be measured is limited to things that are related to housing prices. The method only captures people’s willingness to pay for perceived differences in environmental attributes, and their direct consequences. Thus, if people aren’t aware of the linkages between the environmental attribute and benefits to them or their property, the value will not be reflected in home prices. The method assumes that people have the opportunity to select the combination of features they prefer, given their income, which is rarely the case in real life. 76  Full hedonic studies require a considerable amount of data, which may be difficult and expensive to collect. – In addition, the studies tend to be time- consuming. The method is relatively complex to implement and interpret, requiring a high degree of statistical expertise. 77  The Productivity Method The productivity method is also referred to as the net factor income or derived value method. It is used to estimate the economic value of ecosystem products or services that contribute to the production of commercially marketed goods. It is applied in cases where the products or services of an ecosystem are used, along with other inputs, to produce a marketed good. For example: – water quality affects the productivity of irrigated agricultural crops, or the costs of purifying municipal drinking water. – thus, the economic benefits of improved water quality can be measured by the increased revenues from greater agricultural productivity, or the decreased costs of providing clean drinking water. 78  Productivity Method... If a natural resource is a factor of production, then changes in the quantity or quality of the resource will result in changes in production costs, and/or productivity of other inputs. This in turn may affect the price and/or quantity supplied of the final good. It may also affect the economic returns to other inputs. Two types of benefits (or costs) may be important. – First, if the quality or price to consumers of the final good changes, there will be changes in consumer surplus. – Second, if productivity or production cost changes, there will be changes in producer surplus. Thus, the economic benefits from improvements in the resource can be estimated using changes in observable market data. 79 Applying the Productivity Method To apply the productivity method, data must be collected regarding how changes in the quantity or quality of the natural resource affect: – costs of production for the final good – supply and demand for the final good – supply and demand for other factors of production This information is used to link the effects of changes in the quantity or quality of the resource to changes in consumer surplus and/or producer surplus, and thus to estimate the economic benefits. 80 The method is most easily applied in two specific cases: Cases where the resource in question is a perfect substitute for other inputs. – For example, increased water quality in a reservoir means that less chlorine is needed for treating the water. – In this case, an increase in quantity or quality of the resource will result in decreased costs for the other inputs. – Thus, in this example, the benefits of increased water quality can be directly measured by the decreased chlorination costs. Cases where only producers of the final good benefit from changes in quantity or quality of the resource. Consumers are not affected. – For example, improved quality of irrigation water may lead to greater agricultural productivity—more crops are produced on the same amount of land. – If the market price of the crops to consumers does not change, benefits can be estimated from changes in producer surplus resulting from increased income from the other inputs. – Thus, in this example, the profits per acre will increase, and this increase can be used to estimate the benefits of improved irrigation water quality. 81 Hypothetical Example of PM Problem: A reservoir that provides water for Kumasi’s drinking water system is being polluted by agricultural runoff. Ghana Water Company staff want to determine the economic benefits of measures to eliminate the runoff. 82 Step 1: The first step is to specify the production function for purified drinking water. This is the functional relationship between the inputs—water of a particular quality from the reservoir, chemicals, and filtration, and the output—pure drinking water. 83 Step 2: The second step is to estimate how the cost of purification changes when reservoir water quality changes, using the production function estimated in the first step. The researcher would calculate the quantities of purification chemicals and filters needed for different levels of reservoir water quality, by plugging different levels of water quality into the production function. These quantities would then be multiplied by their costs. 84  Step 3: The final step is to estimate the economic benefits of protecting the reservoir from runoff, in terms of reduced purification costs. For example, if all runoff is eliminated, the reservoir water will need very little treatment and the purification costs for drinking water will be minimal. This can be compared to the cost of purifying water where runoff is not controlled. The difference in purification costs is an estimate of the benefits of eliminating runoff. Similarly, the benefits for different levels of runoff reduction can be estimated. This step requires information about the projected success of actions to reduce runoff, in terms of the decrease in runoff and the resulting changes in reservoir water quality. 85 Advantages of the Productivity Method In general, the methodology is straightforward. Data requirements are limited, and the relevant data may be readily available, so the method can be relatively inexpensive to apply. 86  Limitations of the Productivity Method The method is limited to valuing those resources that can be used as inputs in production of marketed goods. When valuing an ecosystem, not all services will be related to the production of marketed goods. Thus, the inferred value of that ecosystem may understate its true value to society. Information is needed on the scientific relationships between actions to improve quality or quantity of the resource and the actual outcomes of those actions. In some cases, these relationships may not be well known or understood. If the changes in the natural resource affect the market price of the final good, or the prices of any other production inputs, the method becomes much more complicated and difficult to apply. 87