Why do economists use money to measure the value of environmental change?
Ian Bateman, September 2022
The fundamental challenge for the social decision maker is, or at least should be, to develop policies and make decisions which will raise social wellbeing. There is a huge amount of wriggle room within the interpretation of this task, but one of the points of general (if not quite unanimous) agreement is that merely leaving everything to be determined by the actions of the market won’t result in outcomes which maximize, or even necessarily improve, that social wellbeing. One of the main reasons for this is that while the market is highly responsive to the prices it generates, left to its own devices it tends to be blind to any benefit or cost without such a price. This in turn is a major problem because many of the most socially valuable benefits and costs lack market prices. Changes in the cleanliness of the air we breathe, the quality of waters in our rivers and the stability of the global climate can all be of massive value yet are typically accorded zero market price.
The reason for this difference is essentially down to property rights. Where, because of natural limits or laws, the owners of assets (such as land) can exclude others from consuming the goods and services (such as food) those assets produce then markets arise as consumers compete as rivals for those goods. Prices are the natural regulating mechanism through which those ‘private goods’ are allocated from their private owners to private individuals, reflecting the underlying values both groups hold. However, other assets, including many forms of natural capital such as the air, climate and open-access water resources deliver ‘public goods’ whose use by one individual is not rival and does not preclude its use by others (just because I go to the beach that does not stop you going to the beach). Markets do not naturally develop under such circumstances and the value of such goods is not reflected in market prices. Consequently the market frequently fails to provide desired levels or quality of public goods.
It may surprise some readers that it is this distinction between the zero market price of many public goods and their often high social value which, to a considerable degree, defines the difference between finance and economics. While those two terms are often treated as synonymous, finance deals in market prices while true economics focusses upon values irrespective of whether they are reflected in prices or not. The most frequent cause of the common but incorrect equivalence of finance with economics is that both disciplines measure their focal constructs of price or value using the same metric; money. For the financial analyst this choice is straightforward; a focus upon market decisions necessitates a focus on prices. For the economist the choice of a money metric for measuring wellbeing arises from a desire to consider all the benefits and costs of a decision, both as private and public goods. While private goods have prices, non-market public goods are frequently unpriced and are instead most naturally measured in a disparate array of non-commensurate physical metrics. So why do economists eschew such physical measures in favour of monetary assessments of non-market, unpriced public goods such as those provided by the environment?
The systems nature of the environment with its myriad connections and linkages means that, every time we place pressure upon one element of that system, multiple elements respond and change. So, for example, a policy intended to boost production of a certain agricultural crop might result not only in delivering that desired direct effect but also generate numerous unanticipated indirect effects, some beneficial such as enhancing farm incomes and employment, but others costly including water pollution, emissions of greenhouse gases and the loss of wild species habitats and associated biodiversity. Failure to include all these benefits and costs within analyses will at best result in the inefficient use of scarce resources, while at worse such omission can result in decisions which actually lower overall social welfare. As can be seen, these direct and indirect effects comprise a mix of private and public goods, which are in turn typically measured through a non-commensurate mix of market prices and physical metrics. Comparison across these different units in their raw form is challenging to the point of infeasibility; what is the trade-off rate between mg/l of water pollution, tons of carbon emissions and the market price of food? The common outcome is that those measures that are most familiar to decision makers gain primacy; typically market prices.
From the perspective of the welfare economist such outcomes are far from optimal. What is really needed is a way of converting all these benefits and costs, whether public or private goods, into a common metric which itself is related to social wellbeing. Sadly there is no such perfect measure, but the use of money can be defended as the least-worst of the options available. The economic intuition here is that value can be assessed in terms of how much an individual is prepared to give up of one beneficial item to obtain another. Ideally we might measure this trade-off in terms of units of happiness but that is of course an unobservable concept which varies between each and every person. The economic approach is instead to look around for a metric which is both familiar to all and generally accepted as a unit of value; money is the best of a bad bunch of available measures. Given that money can be used to facilitate the exchange of a huge range of beneficial items then the amount of money which a person is prepared to give up to obtain a good is demonstrably related to that individual’s value for that good. This willingness to pay (WTP) concept provides a defensible measure of value which can in principle be applied to any good or service, private or public, irrespective of whether the market has provided a price or not.
WTP is not a perfect measure of the wellbeing provided by either a market or non-market good. For one thing variation in incomes means that some people’s ability to pay for a good is constrained below what they would like to pay. Because of this, welfare economic assessments sometimes adjust measures of WTP to reflect the fact that a WTP of £1 from someone who is poor often implies a higher value than a WTP of £1 from someone who is rich.
The term ‘economic value’ then refers to the wellbeing delivered by some change; a very different concept to the ‘financial value’ of the same change which refers only to its market priced expression. In the case of environmental public goods while the former economic value of a change might be very high, the latter financial value might well be zero. For example, while the economic value of tackling climate change is enormous, its financial value is typically zero – which is the major reason why the climate problem evolved in the first place.
With this money metric of WTP the economist can, in principle, value all the myriad benefits and costs which arise when a change to the environment system, and the intertwined economic system, occurs (Bateman et al., 2013). But the move from principle to practice involves several challenges especially in the valuation of changes to non-market, unpriced, public goods.
How do economists use money to measure the value of environmental change?
The development of methods for the monetary valuation of peoples’ preferences for change in environmental goods has provided one of the most active and longest running foci for research across the entire field of economics. Numerous approaches have been developed but three methods dominate: production function analysis (values reflected in the goods which economies produce), revealed preference techniques (values reflected in what people do) and stated preference methods (values reflected in what people say).
In essence the production function approach involves recognizing the role which natural capital and the ‘ecosystem services’ it provides (Bateman and Mace, 2020) plays in the production of (typically) market priced private goods. For example, the production of nearly all food in the world relies on the growth services provided by fertile soils. It is reasonably straightforward to see how changes in that fertility result in changes to food output. Indeed the common use of fertilizers and their associated costs is in part a reflection of reductions in fertility services as a result of excessively intense farming in the past. Extending this same example, we can work out the value of the climate as an input to food production by examining how changes in temperature and precipitation affect food output (Ritchie et al., 2020).
The revealed preference method starts from the observation that peoples’ values are often revealed in their behaviour. For example, when house buyers pay higher prices for properties in quieter locations their preferences for peace and quiet are revealed in monetary terms. A common variant of this approach is to examine the choices that visitors make regarding which open access recreational sites they visit (and which they don’t) as revealing their value of the different attributes of those sites (Day, 2020). These choices involve costs in terms of travel expenditure and the time visitors devote to reaching sites, costs which can be expressed in money terms (travel time being valued by looking at trade-offs with foregone income (Bockstael et al., 1987) or other travel costs such as faster but more expensive toll roads (Fezzi et al., 2014)). By examining the relationship between the travel costs of different sites, the number of visits made to those sites, and the attributes of those sites (e.g. their water quality) analysts can reveal the values visitors must have placed on those site attributes when making their recreational choice (e.g. the value of visiting a site with higher water quality).
Revealed preference methods are widely applied but a problem arises when we wish to value states of the world which do not currently exist. Behavioural approaches are not an option here and so economists frequently respond to this challenge by presenting survey respondents with hypothetical scenarios of environmental improvement, for example future improvements in water quality (Bateman et al., 2011). Here respondents state their preferences for proffered trade-offs between improved water quality and higher water payments, typically elicited via a series of choices between different levels of improvement and cost. The resulting stated preferences, estimated via the money metric of WTP, should in theory be directly comparable with the other benefits and costs of water improvement schemes.
Such stated preference approaches to the monetary measurement of WTP values are, in principle, extremely versatile being applicable to the valuation of almost any private and public good that can be quantified and comprehended. This includes both those goods and service which deliver wellbeing through their consumption or use and those that are valued just for their continued existence or for passing on to future generations. Such non-use values include public goods such as the continuance of untouched, typically unvisited wilderness areas, or the conservation of wild species and biodiversity (Morse-Jones, et al., 2012). By definition revealed preference methods, which rely upon use behaviour are of no avail here and stated preference methods are the only route for estimating the monetary WTP values necessary to ensure their inclusion within conventional economic benefit-cost comparisons.
Bateman, I.J., Brouwer, R., Ferrini, S., Schaafsma, M., Barton, D.N., Dubgaard, A., Hasler, B., Hime, S., Liekens, I., Navrud, S., De Nocker, L., Ščeponavičiūtė, R., and Semėnienė, D. (2011) Making benefit transfers work: Deriving and testing principles for value transfers for similar and dissimilar sites using a case study of the non-market benefits of water quality improvements across Europe, Environmental and Resource Economics, 50(3): 356-387, DOI 10.1007/s10640-011-9476-8
Bateman, I.J., Harwood, A., Mace, G.M., Watson, R., Abson, D.J., Andrews, B., Binner, A., Crowe, A., Day, B.H., Dugdale, S., Fezzi, C., Foden, J., Haines-Young, R., Hulme, M., Kontoleon, A., Lovett, A.A., Munday, P., Pascual, U., Paterson, J., Perino, G., Sen, A., Siriwardena, G., van Soest D., and Termansen, M. (2013) Bringing ecosystem services into economic decision making: Land use in the UK, Science, Vol 341, No. 6141: 45-50, 5th July 2013. DOI: 10.1126/science.1234379.
Bateman, I.J. and Mace, G.M. (2020) The natural capital framework for sustainably efficient and equitable decision making, Nature Sustainability, https://doi.org/10.1038/s41893-020-0552-3
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Day, B.H. (2020) The Value of Greenspace Under Pandemic Lockdown, Environmental and Resource Economics, 76: 1161–1185, https://doi.org/10.1007/s10640-020-00489-y
Fezzi, C., Bateman, I.J. and Ferrini, S. (2014) Using Revealed Preferences to Estimate the Value of Travel Time to Recreation Sites, Journal of Environmental Economics and Management, 67:58–70, http://dx.doi.org/10.1016/j.jeem.2013.10.003
Morse-Jones, S., Bateman, I.J., Kontoleon, A., Ferrini, S., Burgess, N. and Turner, R.K. (2012) Stated preferences for tropical wildlife conservation amongst distant beneficiaries: Charisma, endemism, scope and substitution effects, Ecological Economics, 78: 9–18, doi:10.1016/j.ecolecon.2011.11.002
Ritchie, P.D., Smith, G., Davis, K.J., Fezzi, C., Halleck-Vega, S., Harper, A., Boulton, C.A., Binner, A.R., Day, B.H., Gallego-Sala, A., Mecking, J.V., Sitch, S., Lenton, T.M. and Bateman, I.J. (2020) Shifts in national land use and food production in Great Britain after a climate tipping point, Nature Food, 1:76–83, doi:10.1038/s43016-019-0011-3