Environmental Economics Canadian

4th Edition Field Solutions Manual

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Field & Olewiler Environmental Economics 4Ce – Instructor’s Manual Chapter 8

Chapter 8

BENEFIT–COST ANALYSIS: COSTS

Objectives

The goal is to acquaint students with some basic ideas about the cost side of
benefit-cost analysis. With all the attention that benefit measurement gets, there may be a
tendency to neglect the other side of the analysis.

Main Points

The concept of opportunity cost is the first topic covered; since this underlies
most of the subsequent points of discussion in the chapter, it is obviously important to get
this idea across at the beginning. Additional examples would no doubt be useful, e.g., the
costs of paying workers who would otherwise be unemployed, unpaid family labour, etc.
There are short sections also on environmental costs of environmental programs,
primarily through media switches; no-cost policy changes that result from rectifying price
distortions; and enforcement costs.

The rest of the chapter is organized to go from the particular to the general -- from
costs of a single facility, to costs for a single community, to costs for an industry, and
finally to costs to a nation as a whole. Each of these corresponds to an important policy
perspective, so this progression seems more relevant than any other. In each section we
have tried to give examples that will convey some of the main problems of cost
estimation at that level.

The chapter also contains discussions of the important with/without principle, and
the question of minimum vs. actual (i.e., greater than minimum) costs. Most of the
pollution control efforts in Canada have not been cost-minimizing ones, for a number of
reasons. In retrospect, the chapter may not give adequate attention to the procedures that
must be followed to achieve minimum costs. This would include a restatement of the
equimarginal principle, as well as an intuitive application to the choice of cost-
minimizing input combinations for individual projects and programs.

The chapter contains also a discussion of output adjustments and their relation to
the slope of the demand curve (again, we have avoided bringing in the concept of
elasticity explicitly). In doing this we have used flat marginal cost curves, so that there is
no need to get into the intricacies of industry expansions and contraction. Finally, the
chapter includes a short discussion on long-run structural changes and technological
change, and the difficulties these create for long-run cost estimation.

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Field & Olewiler Environmental Economics 4Ce – Instructor’s Manual Chapter 8

Teaching Ideas

A topic that may need more emphasis is the distribution of costs, of a project or
environmental control program. Much of the political fighting over environmental policy
is, after all, centred on who will bear the cost of cleanup programs. Good illustrations are
hazardous-waste site cleanup programs being contemplated by federal and provincial
governments, the regional distribution of costs under a possible carbon tax. It would be
valuable to discuss various cost allocation principles, such as that costs be allocated in
proportion to benefits received, or in proportion to current wealth levels.

A possible assignment for students at the close of Chapters 6 to 8 is to explain

how they would do a benefit-cost analysis for a personal environmentally friendly life
style change. It is best to keep the scope of the project small. For example they may wish
to evaluate replacing plastic wrappers with re-usable plastic containers for lunches, to
forgo dry-cleaning their clothing or to choose not to bleach their hair. This assignment
also gets students thinking about their own contribution to the pollution problem.

Answers to Analytical Questions

1. Suppose that site A and B both give the same benefits in terms of use as a water
treatment plant (and all other uses). Using site A has an opportunity cost of
$200,000 (what it would sell for) while site B has an opportunity cost of $150,000
(the purchase price). Hence, site B should be used. There may be other factors to
consider. If the life of the plant has a limited time span and a completely new plant
can be built in 10 years, then in ten years if the land on site A is expected to increase
in value relative to site B (more than $50,000), then site A would be the best choice.
Other factors include the current use of site A. Suppose site A is a park that gives
value to the city (estimated to be more than $50,000), then use of site A would
involve a opportunity cost of more than $50,000 making site B the preferred choice.

2. The inverse demand curve is P=90-1.5Q. The original supply curve is MC0= 0.5Q
with a supply curve after the regulation of MC1=10+0.5Q. Before the regulation the
price is $22.5 and the equilibrium quantity is 45 units. After the regulation MC
increases to MC1= 10+0.5Q so that the price increases to $30 and equilibrium
quantity falls to 40. Initially the producer surplus is $506.25, the consumer surplus is
$1518.75 and the total private surplus is $2025. After the regulation, producer
surplus falls to $400 as the quantity falls proportionately by more than the price
increase. The rise in price and fall in quantity demanded results in a new consumer
surplus of $1200. Loss in CS is $318.75 (area a+b+c). Loss in PS is 106.25 (area
(d+e+f)-(d+a)). Total private surplus loss is area (a+b+c) + (d+e+f)-(d+a)=
area(b+c+e+f).

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Field & Olewiler Environmental Economics 4Ce – Instructor’s Manual Chapter 8

$ 90

MC(after regulation)

P1=30 MC (before regulation)

P0=22.5 a b c
d f
e

0 40 45 60 Quantity

3. In the simplest case, the regulated firms are local and so the price of apples is not
affected. The social costs are represented by the loss in producer surplus (area a+b)
due to the increase in marginal costs and the fall in quantity.

$ MC( IPM)
MC (no IPM)

Price
b
a

Quantity of apples

If for example, apples are sold locally, prices may rise resulting in an additional loss
in consumer surplus due to lower quantities demanded at higher prices. For graphical
representation see graph for question 2 above. If the firm is operating at minimum
efficient scale (MEC) with U shaped average costs, and is competing with non-
regulated firms, then the market price is lower than the minimum average costs and
the firm may go out of business. If production simply shifts to non-regulated firms
and workers move, then the costs due to the policy are zero in the long run although
short term relocation costs should be counted. In this case, damages are not reduced
and the policy is ineffective. If the firm offsets the increase in MC by paying workers
or owners a lower wage, then if these decreases in MC exactly offset the increase in
MC due to the regulation, then there should be no change in social opportunity costs.
If the orchard closes down, the extent of loss depends upon whether workers and

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Field & Olewiler Environmental Economics 4Ce – Instructor’s Manual Chapter 8

factors find employment elsewhere. There may also be a consumer surplus loss if
consumers cannot find close substitutes.

Answers to Discussion Questions

1. The lower land price is a monetary effect, but this does not reflect any change in the
underlying productivity of the land, so there is no real opportunity cost associated
with this impact. A way to illustrate this is that average cost curves shift down due to
lower land rental prices. Competition drives prices down to reflect new minimum
average costs.

2. The analysts private costs are the wages forgone ($40). However, if attending the
meeting has no effect on her productivity, then the firm simply saves the $40 and on
net there is no opportunity cost. However, she may learn something at the meeting
that increases her productivity, so that the marginal cost to the firm for future units of
output is lower. This may cancel out or even dominate the hours lost, so that the firm
may reduce costs by more or at least some of her private costs. If the firm paid her
for the two hours and her productivity did not improve, then there is an opportunity
cost to the firm of two hours of work. If on the other hand she learned something so
that her productivity in the future is higher, then the opportunity cost to the firm of
the two hours work lost may be more then compensated for by the increased
productivity.

3. In this case, the environmental regulation has the effect of substantially reducing the
level of competition in the target industry. We usually associate lower competition
with higher prices, so part of the long-run impact might be consumer prices that
increase more than they would if looking only at production costs. Increased
concentration might also lead to higher production costs and to altered rates of
technological change in the industry, both of which have implications for future
pollution-control costs.

4. The economic definition of profits requires valuation of all inputs and outputs at their
opportunity costs. Accounting costs often fail to account for all opportunity costs as
they typically use historical costs, what a factor was purchased for initially instead of
what the factor would be worth if purchased now (with or without principle). In
assessing the impact of a policy on farming profits, economists compare future rental
value of farmland with or without the policy. Economic opportunity costs are
inclusive to society taking into account factors such as employment losses or gains,
changes in consumer surplus due to price changes and external costs such as pollution
created by the policy.

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