CHAPTER SIX

6. Valuation and Cost-Benefit Analysis of Environmental Resources

6.1. The Concept of Economic Value
Economic value is one of many possible ways to define and measure value. Although other types
of value are often important, economic values are useful to consider when making economic
choices – choices that involve tradeoffs in allocating resources.

Measures of economic value are based on what people want – their preferences. Economists
generally assume that individuals, not the government, are the best judges of what they want.
Thus, 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.

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
we simplify our example “economy” so that the person only has 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. In a market economy, dollars (or
birr) are a universally accepted measure of economic value, because the number of dollars 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” In general,
when the price of a good increases, people will purchase less of that good. This is referred to as
the law of demand—people demand less of something when it is more expensive (assuming
prices of other goods and peoples’ incomes have not changed). By relating the quantity
demanded and the price of a good, we can estimate the demand function for that good. From this,
we can draw the demand curve, the graphical representation of the demand function.

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

1
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.

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.

The economic benefit to individuals, or consumer surplus, received from a good will change if
its price or quality changes. For example, if the price of good increases, but people’s willingness
to pay remains the same, the benefit received (maximum willingness to pay minus price) will be
less than before. If the quality of a good increases, but price remains the same, people’s
willingness to pay may increase and thus the benefit received will also increase.

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. The supply function tells how many units of good
producers are willing to produce and sell at a given price. The supply curve is the graphical
representation of the supply function. Because producers would like to sell more at higher prices,
the supply curve slopes upward.

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

2
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.

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 plus
producer surplus, less any costs associated with the policy or initiative.

Why environmental valuation and analysis?

@ The need to obtain values of environmental resources to identify (or at least
approximate) a socially optimal decision (optimal pollution tax rate, project appraisal)
A greater part of environmental resources have no markets and, therefore, no market prices at
which they are available to the consumers.
@ Environmental resources often have the characteristics of public goods and externalities
are common; market prices cannot be relied on.
@ The need to demonstrate the importance of environmental policy (many of the net gains
from environmental policy do not show up as immediate monetary gains)
@ Inclusion of environmental impacts in cost benefit analysis of projects/policies
@ Determination of targets for environmental quality standards
@ Accounting for environmental degradation and depletion of resources in measuring
national economic performance
@ The need to make polluters liable and pay compensation for environmental damage

3
 6.2. Dimensions (Components) of Value of natural resources

Many economists have studied about different types of values; however, the starting point is the aggregate
(total economic value). The concept of total economic value is now a well- established and useful for
indicating the values associated with public and quasi- public goods .It can be divided total as human and
non- human values. According to this classification human values further divided in to use and non-use
values andthe non-human values includes values of the resource in its own right and intrinsic values.
Here, the definitions of use and non-use value are detailed and the concepts of sub-value are indicated.

The use values are values related to some forms of activity or expenditure (money or time). It is a value
to the individual arising from the consumption of, or access to a good. The use values can be classified as
direct use value, indirect use values, and option values.

 Direct use values of public goods are values derived from the direct use of the good or service
for activities such as recreation, tourism, natural resource harvesting, hunting, education, and
research.These are associated with tangible uses of environmental resources, such as use in
manufacturing processes or when environmental quality affects human health.
 Indirect use values of goods or services are values derived from the indirect use of the goods or
services under consideration. It largely comprises of the ecological functions such as watershed
protection, breeding habitat for migratory species, climate stabilization and so on.
 Option values are values derived from the option of using environmental goods or services
sometimes in the future. It can be direct or indirect. If a recreation area, for example, exists,
people maintain the option to visit it at some point in the future. Thus, knowing there is a
guaranteed opportunity for future access to the resource has some values.Quasi-option values are
related to future benefits of environmental resources that would result from future use due to
future discoveries on new use of the resource but do not belong to current development activities.
People attach some value to future use of environmental resources, which would be made
impossible by today’s development decision. Thus, quasi - option values refer to future benefits
of environmental resources derived from their future use under new future discoveries on new use
of the resource that are intact by current development decision.
On the other hand, the non-use values are values that are not associated with any economic behavior or
values unrelated to the value of current or planned use of the environmental good. Economists suggest
that there are three main forms of non-use value: bequest value and existence value andaltruistic value.
Some economists refer to existence value as intrinsic value. What is more, sometimes bequest value and
quasi-optional value are included into existence value.

4
  The existence value, a representative sub-value of non-use, is a more complex and unclear form
of value in that it can be considered as unrelated to demand. This is satisfactions that resource is
there. People may have preference for and therefore place value on the continued existence of
resources, with no intention of ever using them. Therefore, the preservation of both natural and
manmade resources may be advocated because it is recognized that they have intrinsic value.
Individuals may be willing to pay simply to know that an area or building would be conserved
even though they expect never to visit it.
 Bequest values are values placed by individuals on environmental resources, which might be
passed on to future generations. They capture the willingness to pay (WTP) in terms of people's
desire to bequeath certain environmental goods and services to one's heirs or future generation.
 Altruistic value: Value of knowing that other individuals in this generation benefit from the
environmental good.
Components of economic value of natural resource

The “Total Economic Value” is the sum of all benefits obtained from a resource.
 TEV = Direct Use Value + Indirect Use Value + Option Value + Bequest value +
Existence Value
6.3. Valuation Methods
 To measure total economic value, economists focus on willingness to pay. For a market
good, TWP is the area under the demand curve up to the quantity consumed.
o Willingness to pay includes actual expenditures and consumer surplus.

5
 Thus, simply using a direct measure of expenditures ignores the consumer surplus, and
underestimates the value.
 The net value is the sum of consumer surplus and producer surplus.
 Since policy analysis should focus on marginal analysis, we want to ask how these change as
we have an incremental change in pollution.
However, for non-market goods and services, estimation of TWP requires either;
- examining behavior
- drawing inferences from the demand for related goods
- through responses to surveys
Many environmental goods and services are not priced correctly in normal markets
Why nonmarket valuation of resources?What valuation techniques are available to value the
services that the environment provides?
Investigations of non-market value aim to capture three things: intrinsic values, instrumental values,
and institutional values(which are the processes and techniques that an institution can use to create
public value). Environmental resources supply a flow of direct and indirect services to the public. While
these resources provide limitless set of valuable attributes, many of their services remains unproved by
the market and the market failed to indicate their true values. Following these facts, economists raised
different suggestions about how to measure the non-marketed goods and services for better economic
analysis.

In the environmental economics literature, there are different non-market valuation methods, which were
invented in the early 1970's and have been developed through time. Such non-market valuation methods
were classified by various standards. Mostly, these valuation methods are usually divided into two: Direct
(stated preference) and indirect (reveled preference) methods.

 Direct methods seek to infer individuals' preferences for environmental quality directly, by
asking them to state their preferences for the environment resources (survey method). Additionally,
direct techniques involve descriptions of situations to individuals and assessment of their valuations
through direct questions. It considers environmental gains and seeks directly to measure the money
value of those gains. This may be done by looking for a surrogate market or by experimental
techniques. These approaches demanded hypothetical set of data to estimate the ex ante(expected)
willingness to pay for various commodities. The hypothetical market is created by someone else
intended to create hypothetical demand and supply interaction for goods and services that are
difficult to set their market behavior in normal market interaction. The hypothetical markets have to

6
 comprise a statement of the proposed change andan institutional mechanism through which the
proposed change is to be provided/avoided and financed. In other words, the economic value is
revealed through a hypothetical or constructed market based on questionnaires. For example,
Contingent valuation method and Choice modeling
 Indirect preference approaches identify the ways in which a non-marketed good influences
actual market for some other related goods, i.e. value is revealed through a complementary or
proxy market. Indirect methods seek to recover estimates of individuals' WTP for environmental
quality by observing their behavior in related markets.For example, Travel cost method
Note that: -Direct valuation methods, can elicit both use and non-use values. However, indirect methods
can only estimate use values, owing to the assumption of weak complementarities. Let us say something
for some of valuation methods and detail notes will be presented below for the two commonly used
approaches.

Economic Methods for Measuring Environmental and Resource Values

Revealed preference (indirect) methods Stated preference

(direct)methods

Market price method Contingent valuation method

Productivity method Choice experiments

Cost of illness approach

Replacement cost approach

Hedonic pricing method

Travel cost method

Market price method
This method estimates economic values for environmental goods or services that are bought and
sold in commercial markets.
 It estimates consumer’s surplus and producer’s surplus using market price and quantity
data regarding the environmental goods/services (e.g. fish, timber) traded in the market.
 The total net economic benefit, or economic surplus, is the sum of consumer surplus and
producer surplus.

7
Environmental goods and services that generate larger economic surplus are more valuable.
Limitations
o Limited coverage.
Only a few environmental goods/services are bought and sold in the markets
o Market imperfections distort prices and the efficacy of such prices in measuring the net
benefits
o Estimation of net economic benefits is model dependent.
Productivity Method
This method estimates economic values for environmental goods or services that contribute to
the production of marketed goods. This method requires that data must be collected regarding
how changes in the quantity or quality of the environmental resource affect;
(i) costs of production of the final good
(ii) demand for and supply of the final good, and
(iii) demand for and supply of other factors of production.
This information is used to link effects of changes in the quantity or quality of the resource to
changes in consumer’s surplus and/or producer’s surplus, and thus to estimate the economic
benefits.
Limitations
o Limited coverage
Not all environmental goods/services are related to the production of marketed goods.
o It is not an easy task to specify and estimate a suitable production function
o It is difficult to apply if changes in the quantity and/or quality of environmental
goods/services affect the market price of the final good, or the prices of any other inputs.
Cost of illness approach
Values health costs of water or air pollution based on cost of illness (including cost of medicine,
doctors visits, hospital stays, other incidental expenses, loss of earnings due to illness).
 Dose-response function identifies the relationship between level of pollutant and degree
of health effect.
Replacement cost approach

8
Estimates the costs required to replace damaged resource or to restore damaged resource to
original state. It is applicable when remedial action must be taken to meet a standard (air or water
quality).
Hedonic pricing method (HPM)
HPM is used to estimate the economic values of an environmental good that directly affect prices
of marketed goods.It is most commonly applied to variations in property prices to estimate the
value of local environmental goods.It can be used to estimate economic benefits or costs
associated with:
o environmental quality, including air pollution, water pollution, noise, soil quality,
water quality, erosion, drainage, proximity to waste sites
o environmental amenities, such as aesthetic views (sea, lake, forest) or proximity
to recreational sites (e.g. coast, open space)
HPM is based on Lancaster’s characteristics theory of value (Lancaster, 1966). That is people
value the characteristics of a good, or the services it provides, rather than the good itself. Thus,
property prices will reflect the value of a set of characteristics, including environmental
characteristics that people consider important when purchasing a property.The price of a
property is related to its characteristics, 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. For
example, if all characteristics of properties 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. To apply the hedonic pricing method, the following information must be collected:
– A measure or index of the environmental amenity of interest (e.g. for air pollution
measurements of SO2, SO3, H2S, H2SO4 etc. or for distance to hazardous waste
sites distance in km)
– Cross-section and/or time-series data on property prices 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.
Advantages of HPM

9
 • HPM is relatively straightforward and uncontroversial to apply, because it is based on
actual market prices and fairly easily measured data.
• Property markets are relatively efficient in responding to information, so can be good
indications of value.
• Property records are typically very reliable.
• Data on property sales and characteristics are generally readily available through many
sources.
• If data are readily available, it can be relatively inexpensive to apply.
Limitations of HPM
• The scope of environmental benefits that can be measured is limited to environmental
goods and services that are related to property markets.
• The method will only capture people’s willingness to pay for perceived differences in
environmental attributes, and their direct consequences. 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 property prices.
• The method assumes that people have the opportunity to select the combination of
features they prefer, given their income. However, the housing market may be affected
by outside influences, like taxes, interest rates, or other factors.
• Transaction costs in the property market are varied and not inconsiderable consisting of
items such as the time spent searching for properties, expenses on lawyers and surveyors,
taxes and the costs of moving possessions from one property to another. Given the
prevailing market prices, a household may want to live in a property with a different set
of characteristics than their current residence. However, if the transaction costs are
sufficiently high, they may negate the benefits of moving. The household will stay where
it is and the housing market will remain out of equilibrium.
• One of the fundamental assumptions of the HPM is that households have perfect
information. If households are not aware of the prices and characteristics of all the
properties in the market then it is likely that the prices that they pay for properties, and by
definition the implicit price they pay for different characteristics, will vary from sale to
sale.

10
 • The method is relatively complex to implement and interpret, requiring a high degree of
statistical expertise.
• The results depend heavily on model specification.
• Large amounts of data must be gathered and manipulated.
• The time and expense to carry out an application depends on the availability and
accessibility of data. If data must be gathered and compiled, the cost of an application can
increase substantially.

Travel Cost Method

It estimates economic values of sites used for recreation. It infers the value of recreational sites
(recreational areas, parks, historic/cultural sites) by using information on how much the visitors
spent (direct costs: travel costs, price of admission and indirect costs: the opportunity cost of
travel time) in getting to the sites. We can infer the value of a change in quality by looking at
demand during different days (e.g. in different types of weather).
Potential problems with the travel cost method
1. What is the opportunity cost of time?
2. Only measures value of those that use the amenity. We need to account for substitutes.
3. Quality is not always measured.
4. Sampling bias in surveys.
Contingent Valuation Method(CVM)
CVM is a method of estimating the value that a person places on a good. The approach asks people to
report their willingness to pay directly to obtain a specified good, or willingness to accept to give up a
good, rather than inferring them from observed behaviors in regular market places. Because it creates a
hypothetical marketplace in which no actual transactions are made, CVM has been successfully used for
commodities that are not exchanged in regular markets, or when it is difficult to observe market
transactions under the desired conditions. The term “contingent valuation” is derived from the nature of
the method: responses are sought from individuals as to their actions contingent on the occurrence of a
particular hypothetical situation.

For example, individuals might be asked their maximum willingness-to-pay (WTP) to enter a national
museum of Ethiopia contingent upon a charge being introduced or a museum being created. Alternatively,
they may be asked to state the minimum amount of compensation required to maintain their original
utility level, if the museum was closed to the public.

11
CVM is a tool that can also estimate non-use values, since there is, by definition, no related market good
for the mere existence, as distinct from use, of the site. Thus, for example, contingent valuation is
required to value the non-use values of public goods such as wilderness and landscape preservation;
biodiversity; the value of preserving historical artifacts, monuments, and the character of old towns and
villages.

CVM has becomes widely used implies it has some advantages as a method.

It is a generalized method in that it can be applied in an extremely wide range of

situations.
It is capable of measuring both use and non-use values. Non-use values have been found
to be very important in many cases. CVM questionnaires can also be designed so that the
researcher gains some insight into why people value a given environmental good, and
how this valuation changes when, for example, uncertainty surrounding the supply of the
good changes.
Underlying the use of CVM is the question of property rights. If the individual does not own the right to a
good, then the relevant measure of utility of the good to the individual is the maximum he or she would
be willing to pay (WTP) to acquire it. Conversely, if the individual owns the good, then the minimum the
individual would be willing to accept (WTA) as compensation for its loss, is the relevant utility measure,
since the individual would restore to his utility level before being deprived of the good by this amount.

WTP and WTA should be similar in magnitude for most goods which are close substitutes and for which
the income effect is small. However, several experiments have revealed that WTP is typically 2 to 5 times
the magnitude of WTA values for the same good.

Steps involved in applying the CVM

(1) Creating a survey instrument for the elicitation of individuals' WTP/WTA.
(a) Designing the hypothetical scenario,
(b) Deciding whether to ask about WTP or WTA,
(c) Creating scenario about the means of payment or compensation.
(2) Using the survey instrument with a sample of the population of interest.
(3) Analysing the responses to the survey.
(a) using the sample data on WTP/WTA to estimate average WTP/WTA for the population,
(b) Assessing the survey results so as to judge the accuracy of this estimate.

12
(4) Computing total WTP/WTA for the population of interest for use in an environmental
cost-benefit analysis.
Given average WTP, total WTP average times the size of the relevant population.
(5) Evaluating the success of the CV exercise.
Example: The protection of cultural monuments in Armenia: The Contingent Valuation Method
WTP to preserve cultural heritage monuments and its surrounding environment
– n=1,000
– In-person interviews (household survey)
– mean WTP= 8 US$
Do surveys lead to true values? (Content validity)
Choice experiments
Respondents are presented with a number of discrete alternatives -in terms of a set of attributes -
and asked to state which they prefer.
 Each alternatives is described in terms of a common set of attributes
 Alternatives are differentiated by levels of the attributes.
It can measure both use and non-use values.
It estimates implicit value without asking WTP question.
Example: It is proposed that a forested area currently subject to some timber harvesting and
uncontrolled recreational access becomes a bird sanctuary with no logging and restricted
recreational access.
6.4. Benefit-Cost Analysis
 Public officials often use cost-benefit analysis to decide whether a project is worthwhile.
 Cost-benefit analysis can be used to guide several decisions:
Is a project worth doing?
Do the benefits outweigh the costs?
Given alternative projects that could achieve the same goal, which project should
be undertaken?
What is the appropriate scale of the projects to be undertaken?
 Logic of CBA analysis:
Calculate the economic benefits and economic costs of each alternative.
These costs and benefits are discounted over time to reflect opportunity values.

13
 Choose projects with the highest net benefit.
o Note: works for a discrete set of choices, not a continuum.
o For continuous choices, use marginal analysis.
 The ultimate goal of CBA is to ensure that society’s resources are put to their most highly
valued uses. That is, scarcity is a concern even for government officials. We want to
make the best use of the resources available to us.
 CBA is often criticized as being the “final word” and for putting too much emphasis on
monetary values. However, it does have a role to play in guiding policy decisions.
 If thought of as a guide to the final decision, rather than a means of providing definitive
answers, CBA can be a useful policy analysis tool.
Steps to Cost-Benefit Analysis
1. Define the Situation
To begin, a community has a set of “resources”, such as money, property, labor,
environmental amenities, and government services. After a program is complete, the set
of resources will change. CBA looks at how these resources change.Thus, we need to
consider what community’s resources are at stake. The jurisdiction doing the analysis matters.
2. Estimate the Costs
 Next, we need to consider the cost of the project, in terms of the resources the community
will use to carry out the project.
 Types of costs:
a. Resources purchased for the project
b. The opportunity cost of resources already owned by the government
 We need to know the value of these assets in their next most valuable use.
c. Resources owned or purchased by local residents
d. External costs
 These costs can be harder to measure, but their values are
important. Later we will talk about ways to value some of these costs.
 It is best to include monetary values for such costs, so that comparisons
are possible.
 However, if monetary values are not possible, the costs should still be
listed, so that they can still be considered in political debate.

14
  To measure costs, we want to find the shadow price of the input used.
o The shadow price of an input or output is its value to the economy as a whole.
o For inputs, the shadow price is the marginal opportunity cost – the value of the
best alternative use of the input.
o Shadow prices are related to the market price, but not exactly the same because of
market imperfections.
 Consider, for example, inputs produced by a monopolist. In that case, P >
MC.
 If the government’s purchase affects the amount available for
private consumption, it is the market price, which measures the
value to consumers, that matters.
 However, the opportunity of using the goods is simply the MC.
Thus, if the government is producing more of the good, it is the
opportunity cost (MC) that matters.
 Resources from the community are being taken from other
uses. MC represents that opportunity cost.
o When taxes are used to raise revenue for a project, we should consider the
marginal excess tax burden.
 This accounts for the costs of raising money through taxation, including:
1. inefficiency (deadweight loss)
2. administrative costs
It is important to distinguish between costs and transfers.
o When resources are not used up nor created, but just shifted from one set of
individuals to another, we say the resources are transferred.
o A transfer does not change the total amount of resources in a community. It just
changes the distribution of the resources.
o Transfers do have equity implications, but we will consider them later.
3. Estimate the Benefits
 Benefits are new resources made available to the community.
 Economists typically measure benefits by a community’s willingness to pay.

15
 o Willingness to pay – the amount that individuals are willing to pay to receive the
benefits (or the costs they are willing to pay to avoid negative effects).
o The demand curve tells us the marginal willingness to pay for consumers.
o Total benefits are the area under the demand curve.
 This is equal to consumer surplus + total expenditures on the good.
o Note that it includes CS plus a bit more because we are only measuring benefits,
not costs. It is the total benefit, not just the benefit above and Note that, if there is
market power, the price paid by consumers tells us the value of the good to
consumers. Therefore, the shadow price of benefits is the price paid by
consumers.
 Types of benefits:
1. Resources measurable in monetary terms
 For goods & services sold in the marketplace, their benefit is the market price of the
good.
2. Resources measurable in physical units, but not in monetary terms.
 We may be able to infer dollar values for these benefits.
 However, even if we can’t place a dollar value on a benefit, information on the
amount of benefit is useful. We can ask whether the estimated costs are worth this
level of benefit.
 Note that this requires personal judgments.
3. Resources valued by the community, but not measurable by any means.
 You should generally be suspicious of these claims.

Often, benefits or costs to be included in CBA are not traded in the marketplace. How
can these be valued?
o Use information on demand from neighboring communities.
o Surveys
 Ask people how much they are willing to pay for services.
 Problem: what people say (stated preference) and what people do (revealed
preference) is not always the same
o Use information on related markets

16
  For example, we can compare property values in neighborhoods with and without
the service.
 Consider two houses with the same features. One is in a neighborhood with
clean air, and the other is in a polluted neighborhood.
 The house in the cleaner neighborhood will sell for a higher price. The
difference in prices is the value of the cleaner air.
 Note use of economic theory here. It allows us to infer values from actual behavior.
 Example: the value of time
 Consider labor/leisure theory:
 At the optimal point, MULeisure/MUIncome = wage
 Therefore, wage equals value placed on leisure time.
o It is important not to double count benefits.
 For example, the benefits of a new park are the willingness to pay for the new
recreational opportunities. In addition, suppose that the new park increases property
values in the neighborhood by $95,000.
 The increased property values occur because of the additional recreational
opportunities. Listing them as an additional benefit would double-count the benefits
of increased recreation.
 However, since there isn’t a clear market for recreational opportunities, the
$95,000 increase in property values could be used to put a dollar value on
those opportunities.
 beyond the cost of producing the good, that we want here.
4. Discounting
The costs and benefits will occur at different times. To compare them fairly, it is important to
discount costs and benefits that occur in the future.
 The idea is to compare a flow of benefits and costs into a single value.
Thepresent value of a future amount of money is the maximum amount you would be willing to
pay today for the right to receive that money in the future.
 Present value accounts for the opportunity cost of not investing the money elsewhere.
 Example:
o You have $100 now

17
 o If you put it in the bank, you will get 5% interest
o Next year, that money is worth (1 + 0.05)x100 = $105
o After two years, it is worth (1.05)(1.05)(100) = (1.05)2(100) = $110.25
 General rule:
o PV = present value (the principal that you invest) r = interest rate
o Future Value = FV = PV(1 + r)t
 As a result, you wouldn’t give up $100 now for $100 next year, because you could invest
the money and get $105 next year.
o The present value of $100 next year is the most you would give up today to get
$100 next year
o FV = $100 = PV(1.05) = $100
o PV = 100/1.05 = $95.24
 General rule
o PV = FV/(1 + r)
 For a stream of payments:
o PV = FV + FV/(1+r) + FV/(1+r)2 + … + FV/(1+r)t
 For payments forever:
o PV = FV/r
 What about inflation?
 When we are discounting costs & benefits, we must remember that inflation affects the
interpretation.
 The key is to be consistent.
o If all the dollar values are real dollars – already adjusted for inflation – use a real
rate of interest.
o If all the dollar values are nominal dollars – we need to adjust for inflation. We
use a nominal rate of interest.
 Recall our example from before. Suppose inflation is 3%. Then, $105 next year is only
worth 105/1.03 = $101.94 today.
o The present value now is 100(1 + r) = $101.94
o This implies a rate of return of approximately 2%.
o Inflation lowers the real return on our investment.

18
  For those interested in the derivation of the real rate of return, define the following terms:
o r = real rate of interest
o g = rate of inflation
o m = nominal rate of interest
o the nominal return (1 + m) = (1 + r)(1 + g) = 1 + r + rg + g
 => m = r + rg + g
 or r = (m - g)/(1 + g)
o In practice, rg is very small, so a useful approximation is:
 m = r + g or
 r=m-g
 E.g. nominal rate = 5%, inflation = 3% => real rate = 2%
o Key point: if nominal prices are used, discount using a nominal rate of interest, so
that inflation is accounted for. If real prices are used, inflation has already
considered. A nominal rate would double count inflation. Therefore, use a real
rate of interest.
 In general, the real rate of interest will be around 3-5%. In the next lecture
we will discuss more carefully how to select the discount rate and the time
period studied.
 What about capital?
 Since we are discounting, the cost of capital should be included in the year the capital is
purchased.
 Depreciation is not necessary. The full cost is already considered when the cost of
purchasing the capital is recorded. Adding depreciation would lead to double counting.
o However, if the capital is not completely used, the salvage value should be added
as a benefit at the end of the program.
Which Discount Rate to Use?

 The discount rate reflects the relative value a person places on future consumption
compared to current consumption.
o Lower values show a greater preference for future consumption.
 If your discount rate is greater than the interest rate, you will be willing to
borrow money.

19
  A high discount rate says that current consumption is important to you.
 If your discount rate is lower than the interest rate, you will be willing to
loan money.
 A low discount rate says that future consumption is important to you.
o Since the market interest rate reflects an equilibrium of lenders and borrowers, we
can use the market interest rate as a measure of the discount rate.
 Why the discount rate matters
o Discounting affects the value placed on future benefits and costs.
o Higher discount rates place less importance on future returns.
o In particular, discounting can affect the desirability of long-term projects
 As a practical matter, this is not a big issue for short-term projects (e.g.
20-30 years). However, for projects with benefits over several
generations, such as climate change, discounting will place very little
weight on future benefits.

5. Interpreting the Results

 Once our calculations are complete, how do we interpret the final results? There are several
alternative criteria.
1. Net present value (NPV) – the present value of benefits minus the present value of costs
 If NPV is positive, the project is worth doing.
 If several projects are under consideration, choose the one with the highest NPV.
 Advantage: not sensitive to whether something is recorded as a cost or a benefit.
2. Benefit –cost ratio – the ratio of the present value of a stream of benefits to the present
value of the stream of costs.
 A project is acceptable if BC ratio > 1.
 Problems
 Sensitive to whether items are recorded as costs or benefits.
 Does not take the scale of the project into account.
3. Internal Rate of Return – the discount rate that would make a project’s net present value
equal zero.
 A project is worthwhile if the IRR is greater than the opportunity cost of funds
for the community (that is, the appropriate discount rate).
 Problem: Doesn’t account for the size of the project

20
  As a result of all of this, NPV is the best method to use.
 The interpretation of net present value (NPV) depends on the situation. Key questions (we'll
cover this next week):
1. Are there several projects being considered?
 If not, the project is acceptable if the NPV is positive.
 If there are several alternative projects, choose the one with the highest NPV.
2. Does the community budget limit the size of the project?
 If so, choose the combination of projects that maximize net benefits, given the
community's budget constraints.
Can the scale of the project be varied? If so, choose the size where marginal benefits = marginal
costs.

21