CHAPTER VI

ENVIRONMENTAL ECONOMICS

Economics plays a major role in all environmental issues. One of the driving forces of
economics is profit. The profit motive often dictates short cuts in production, failing to account for the
cost of environmental protection. For example, a company may choose to invest a little in pollution
control because it makes for higher profit. Such shortcuts have negative effects on the environment
and may directly or indirectly affect humans and biodiversity.

Our own personal economic decisions are important determinants in the destruction of the
environment and the loss of biodiversity. Example, by choosing a cheaper product that may easily fall
apart after a few uses and require constant replacement, we end up consuming more. Can you give
examples of such products? By making decisions based solely on affordability, ignoring their
cumulative impacts on the environment, we help fuel a growth-based economic system that is
destroying the environment at a rapid rate.

A clear understanding of how the economic system works in the environment is necessary to
formulate alternatives that could remove roadblocks to environmental quality.

A. THE COST OF POLLUTION

- refers to the monetary and non-monetary values of damage to both health and the
environment

- the “science” of computing environmental damage is a very inexact one because much of
the damage are done on intangible environmental benefits that have non-monetary values
such as loss of cultural services, damaged regulative services, reduced support services

- the monetary value of damage, on the other hand, refers to the costs incurred from loss of
resources, health problems, pollution abatement, and pollution control.

- one of the most frustrating things about all these damages is that it can be avoided. 95% of
current air and water pollution can be eliminated by known and available technology.
Nothing very exotic is needed.

▪ Auto-emission controls
▪ Smokestack cleaners
▪ Improved sewage and waste treatment facilities
▪ Cooling towers for electric plants
▪ Municipal ang commercial wastes represent salvageable and recyclable materials

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B. EXTERNALITIES

- Defined as COSTS or BENEFITS of an activity borne by a third party.

Positive Externalities (External Benefits)

- BENEFITS that are directly or indirectly received, but not paid for, by third parties
as a result of others’ activities
- have positive effects
Examples:
o A private utility seeking to produce electricity may dam a river that can also
minimize flood damage
o As a homeowner, you benefit if your neighbors plant trees and flowers
o People who are vaccinated do not get sick, thus do not infect those who are
not inoculated

Give other examples and their positive effects on third parties.

Negative Externalities (External Costs)

- COSTS that are directly or indirectly imposed, and uncompensated, on third parties
as a result of others’ activities
- have negative effects
Examples: piggeries, toxic wastes, car exhaust, tall buildings

What are the negative effects of the given examples on third parties?

- An external cost is also defined as the difference between the SOCIAL and
PRIVATE costs of an economic activity

➢ Private Cost (Internal Cost)

- resource costs allocated solely for production or consumption
- does not include the external cost incurred due to production or
consumption
Examples:
o In production, the computation for a capital is based solely on the
costs of raw materials and manpower (private cost). The costs for
pollution abatement (external cost) is not included in the computation
of their required capital.
o In consumption, consumers spend (private costs) a lot on various
products and generate a lot of wastes, but they do not invest
(external costs) on different garbage bins for proper waste
segregation.

➢ Social Cost
- the entire cost for production and consumption, including external costs
- it “removes” the external cost or negative externality, thus social costs
are beneficial
Examples:
o In production, the computation for a capital includes both the costs of
raw materials, manpower, and pollution abatement.

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o In consumption, consumers spend on both their required products as

well as various bins for the different wastes generated

SOCIAL COST = PRIVATE COST + EXTERNAL COST

EXTERNAL COST = SOCIAL COST – PRIVATE COST

C. COST-BENEFIT ANALYSIS (CBA)

- guidelines in pursuing a project, or investment, business, or new equipment

- used to determine if a project is viable from the society’s perspective

1. Basic Techniques of CBA

a. Project selection
- Choose a project that is viable in terms of benefits
Example:
o The NBI proposed to buy a DNA analysis machine to reduce the time
required to process DNA samples collected from a crime scene

b. Estimate the cost of the project

- The estimated cost refers to the total of anything that would require “spending” for
the project
Example:
o cost of the DNA machine, payment for the technician that would run the
machine, etc…

c. Estimate the direct and indirect benefits of the project

- Includes all monetary benefits stemming from the project
Example:
o Reduce crime rates translating to saving thousands of pesos in medical
expenses for victims, reducing the amount spent on transporting DNA
samples to other laboratories for analysis, etc…

d. Determine the discount rate to be used

- The discount rate is the interest rate used to determine the present value of a
project based on future cash flows
- It is used to help figure out the value of a project done at the present, based on the
projections of how much money it will generate in the future
- It expresses the time value of money / discounted value of benefits (DVB)
Example:
o If the money to be used by the NBI to buy a DNA analysis machine would
instead be deposited in the bank, how much will the money earn in terms of
interest? Let’s say, in the bank, the money will earn an interest of 2% yearly.
So, if that money will be used to buy a DNA machine (instead of letting it sit

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it in the bank), the discount rate that would be used to determine if the
investment is worth it would be 2%. This means, the benefits from the DNA
machine should at least be more than 2% yearly, so that it would be
considered a viable investment.

2. Net Present Value

- method used to determine the value of a project, business, investment, or anything that
involves cash flow
- it is important because it tells us if a project is worth it or not
- it considers all the costs, all the benefits, the discount rate, and the time required for a
project
- if NPV is greater than 0, then the project is viable

❖ Formula for Net Present Value

NPV = DVB – CT
DVB = Σ _BT_
(1 + r) t
Where: NPV = net present value
DVB = discounted value of benefits
BT = total benefits
CT = total costs
r = discount rate
t = time

SAMPLE NPV PROBLEM SOLVING

Problem #1A
The NBI is considering buying a DNA analysis machine reduce the time required to process
DNA samples collected from a crime scene. The machine costs Php 800,000 and is expected to
pay back benefits in terms of reduced crime of Php 550,000 at the end of one year, and Php
605,000 at the end of two years. If the discount rate is 10%, is the proposal worth it?

GIVEN

Cost of the DNA machine: Php 800,000

Benefit after one year: Php 550,000
Benefit after two years: Php 605,000
Discount rate: 10% = 0.1

REQUIRED
Determine if the proposal is worth it by computing for the DVB and NPV

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SOLUTION

a. Solve for DVB

DVB = Σ _BT_
(1 + r) t

= 550,000 + 605,000
(1 + 0.1) (1 + 0.1)2

= 550,000 + 605,000
1.1 1.21

= 500,000 + 500,000

= Php 1,000,000 or 1M
b. Solve for NPV

NPV = DVB – CT

= 1,000,000 – 800,000

= Php 200,000

ANSWER

Since the NPV > 0, the proposal is worth it

Problem #1B
Suppose the DNA machine was imported from the US and costs $ 21,000 with a discounted
rate of 20%. If the foreign exchange rate (forex rate) is 1:51, is the proposal still worth it?

GIVEN

Cost of the DNA machine: $ 21,000

Benefit after one year: Php 550,000
Benefit after two years: Php 605,000
Discount rate: 20% = 0.2
Forex rate: 1:51 (1 dollar: 51 pesos)

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REQUIRED
Determine if the proposal is worth it by computing for the DVB and NPV

SOLUTION

a. Convert $ to Php using the forex rate 1:51

$ 21,000 X 51 = Php 1,071,000

b. Solve for DVB

DVB = Σ _BT_
(1 + r) t

= 550,000 + 605,000
(1 + 0.2) (1 + 0.2)2

= 550,000 + 605,000
1.2 1.44

= 458,333 + 420,139

= Php 878,472

c. Solve for NPV

NPV = DVB – CT

= 878,472 – 1,071,000

= – Php192,528

ANSWER

Since the NPV < 0, the proposal in not worth it

Problem #2A
Baguio City considers building a composting plant at the former Irisan dumpsite. The plant
would cost $105,000 and will be operational after one year of construction. The project is expected
to help the city save funds in terms of reduced health expenses of Php 9.5M, Php 11.3M, Php
16.6M, and Php 27.2M for the first four years of operation. In addition, after two years of operation,
a clean Baguio will generate income from tourists amounting to Php 120,000 and Php 180,000.

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However, the project would displace 50 families at a cost of Php 15,000 per family. If the forex
rate is 1:51 and the discount rate is 4.5%, should the project be approved?

GIVEN

Cost of the composting plant: $105,000

Cost of displaced families: Php 15,000 per family (50 families)
Health benefits:
First year: Php 9.5 M
Second Year: Php 11.3M
Third year: Php 16.6M
Fourth year: Php 27.2 M
Tourist Benefits:
Third year: Php 120,000
Fourth year: Php 180,000
Discount rate: 4.5% = 0.045
Forex rate: 1:51

REQUIRED
Determine if the project should be approved by computing for DVB and NPV

SOLUTION

a. Convert $ to Php using the forex rate 1:51

$ 105,000 X 51 = Php 5,355,000

b. Determine the TOTAL benefits per year (you may construct a table to help you visualize)

BENEFITS First year Second year Third year Fourth year

Health Php 9,500,000 Php 11,300,000 Php 16,600,000 Php 27,200,000
Tourist Php 120,000 Php 180,000
Total
Benefits Php 9,500,000 Php 11,300,000 Php 16,720,000 Php 27,380,000
per year

c. Solve for DVB

DVB = Σ _BT_
(1 + r) t

= 9,500,000 + 11,300,000 + 16,720,000 + 27,380,000

(1 + 0.045) (1 + 0.045)2 (1 + 0.045)3 (1 + 0.045)4

= 9,500,000 + 11,300,000 + 16,720,000 + 27,380,000

1.045 1.092 1.141 1.193
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= 9,090,909.091 + 10,347,985.35 + 14,653,812.45 + 22,950,544.84

= Php 57,043,251.73
d. Determine Total Costs

Cost of displaced families: Php 15,000 X 50 families = Php 750,000

Cost of the composting plant: Php 5,355,000
TOTAL Cost (CT): Php 6,105,000

e. Solve for NPV

NPV = DVB – CT

= 57,043,251.73 – 6,105,000

= 50,938,251.73
ANSWER

Since the NPV > 0, the project should be approved

Problem #2B
Supposing environmentalists disagree with the discount rate and insists on 7%. Should the
project push through?

This will serve as your practice problem. Try to solve it, following the steps
previously presented.

Another set of problems will soon be provided to you and will serve as your QUIZ
for the finals.

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GENVI SCI 2019 -2020