Handbook of Environmental Economics

Chapter 12

WELFARE THEORY AND VALUATION

NANCY E. BOCKSTAEL

University of Maryland, College Park, MD, USA

A. MYRICK FREEMAN III

Bowdoin College, Brunswick, ME, USA

Contents

Abstract 518

Keywords 518

1. Introduction 519

2. The nature of economic value 520

3. Overview of the environmental valuation problem 522

4. Defining a measure of welfare change 525

4.1. Price changes 528

4.1.1. Toward measurement 530

4.2. Changes in environmental quality 532

4.3. Uncertainty and risk 534

5. Aggregation and social welfare 535

6. Methods of valuation – overview 538

6.1. Revealed preference methods 538

6.2. Stated preference methods 539

7. Revealed preference methods for estimating values 540

7.1. A taxonomy of models 541

7.2. Substitution restrictions 542

7.2.1. Perfect substitution 542

7.2.2. Imperfect substitution 544

7.2.3. Defensive expenditures 545

7.2.4. Applications to human health effects 546

7.3. Complementary relationships 549

7.3.1. Why the weak complementarity restriction is so useful 550

7.3.2. Weak complementarity in a household model 553

7.4. Exploiting other relationships, including weak neutrality 555

7.5. Welfare in a discrete choice context 556

Handbook of Environmental Economics, Volume 2. Edited by K.-G. Mäler and J.R. Vincent

© 2005 Elsevier B.V. All rights reserved

DOI: 10.1016/S1574-0099(05)02012-7

518 N.E. Bockstael and A.M. Freeman

7.6. Hedonic models

558

7.6.1. Hedonic property value models 559

7.6.2. Hedonic wage models 561

8. Use and nonuse values 563

9. Conclusions 566

Acknowledgements 566

References 566

Abstract

Public policies that lead to a reduction in the emissions of air and water pollutants or the

protection of sensitive ecosystems presumably increase the well-being of many mem-

bers of society. Applied welfare economists are accustomed to measuring the welfare

effects of policies that invoke price changes. If it is granted that the public good at-

tributes of most dimensions of environmental quality preclude the development of well

functioning markets for these service flows, how are the monetary values of changes

in environmental quality to be measured? The past twenty to thirty years have seen

the rapid development of the economic theory and techniques for measuring the de-

mands for nonmarketed goods, and in this chapter we attempt to sketch out the major

results. We review the basic concept of economic welfare and derive measures of wel-

fare change for both changes in prices of market goods and changes in quantities and

qualities of nonmarket goods. We then describe the principal economic techniques

for estimating the benefits of environmental quality improvements when these im-

provements either directly affect individuals’ well-being or indirectly affect individuals

through constraints they face. Perhaps the major class of measurement methods is based

on the observation that changes in environmental quality may cause individuals to alter

purchases of goods and services that are complements or substitutes for environmen-

tal quality in their preference orderings. These revealed preference methods are the

primary focus of this chapter. A second major approach to obtaining estimates of the

benefits and costs of environmental changes, stated preference methods, are addressed

in detail in later chapters. Our treatment of welfare effects places special emphasis on

the connection between the underlying economic theory and practical empirical models.

Keywords

welfare economics, nonmarket valuation, environmental valuation, revealed preference

methods

JEL classification: Q51, I12, H43