5.

2 ECONOMIC VALUATION OF NON-

TRADED GOODS

Project Appraisal Techniques contd…

An Overview
The economic valuation of natural resource scarcity such as forest and soil
resources and accounting of environmental damages is important for various
reasons in Nepal. Valuation of natural resources includes:

a) The valuation of biodiversity in protected and outside areas;

b) Accounting the value of these resources and environmental damages into the
system of national accounts by estimating and bringing the attention to the
depreciation of natural assets;
c) Using the values as indicators during environmental assessment; and
d) Estimating the appropriate level of user fees, park entry fees, and pollution
charges and other fees and charges for environmental amenities and services.
Environmental Aspect in Project Analysis
• When a project implemented, people other than its owners, workforce or
customers are benefited or disadvantaged by its operation. The operation of the
project results in a net gain or loss to society but not to those who undertake the
project. This category of the benefit or cost is defined as an external effect or
externality.
• There are two main problems associated with the externalities in the cost benefit
analysis. These include
• (a) identifying the externality, particularly in the advance of the project operation; and
• (b) quantifying the value of externality for incorporation into the cost- benefit analysis.
• The later involved the measuring the impact of the externality on people’s welfare
in monetary term and determining its economic value so that it can be included in
the economic cash flow of the project.
Types of externalities
a. Technical externalities
• True externalities are technological externalities that impact on the actual
production or consumption possibilities of other producers or consumers.
• An example of negative externality is the discharge of waste by factories
along the passing river which kill all the fish in the river and make it
possible for local fisherman to continue to harvest fish from the river.
• A classic example of a positive externality is the case of a fruit grower
and apiarist whose properties are adjoined. The bees from the apiary
pollinate the fruits, which enable them to blossom. On the other hand,
the nectar from the fruit increases the honey production of the apiarist.
b. Pecuniary externality
• Unlike the technological externality, a pecuniary externality does not affect the
consumption or production possibilities of other producers or consumers, just their
costs of production or consumption.
• A negative pecuniary may occur as a result of the project pushing up the price of
specialized input that is inelastic supply, such as skilled labor. This externality will
impact on other users of the factor who are forced to pay more for it as a result of the
project’s increased demand.
• Pecuniary externalities are not true externalities. Any changes in input or output prices
included by a project should be reflected in accurate projections of these prices and
these should be included in the cash flow of the project.
• Any impact of such price changes on the project’s consumers or input producers will
be included in the economic analysis of the project via the measurement of consumer
or producer surplus.
c. Externalities created during the production
process
• Each stage of product’s life can be examined to determine when
externalities will be created.
• The water and air pollution created by an industrial project are
examples of negative externalities created during the production
process and are associated with the use and disposal of project’s inputs.
• The example of the apiarist and the fruit grower is one of the positive
technological externalities being created during the production process.
• The example of positive externality generated by the project during the
production process is the skills created when labor is trained during the
project.
d. Externality created in the distribution of project
outputs

• For example, trucks carrying gravel and sand when

distributed to the construction sites may break up local roads,
causes noise, air pollution and road congestion and increase
the number of road accidents.
• Street entertainers, who while distributing their services,
entertain passers who may not reward the entertainer, may
create the positive externality.
e. Externalities created in the consumption of project outputs

• An example of this is the consumption of soap and cleaning detergents

by one person which produces a positive externality for others,
including a more pleasant, odorless environment and reduced risk of
disease.
• Or the availability of public education will create externalities for the
whole community by improving the range of services and goods
available.
• Respiratory diseases caused by passive smoking are an example of a
negative externality created by the consumption of a product.
INCORPORATING EXTERNALITIES IN THE CASH FLOW

a. Internalizing the externality via project redesign

• In a number of cases, the best solution fro the project designer is trying to internalize the
externality so that it becomes a direct cost or benefit of the project. In case where projects
produce a negative externality like environmental degradation, it will often be optimal to
redesign the project to reduce such negative impacts or prevent them all together.
• Where for example a project generates air or water pollution, the project could be
redesigned to include anti- pollution devices to prevent the release of these pollutants into
the atmosphere or waterways.
• In the case of private property where property rights are unclear, the government intervenes
to force the project to internalize its negative externalities. It may for example impose
emission controls fixing the legal maximum levels of pollutants that may be released by
polluting factories.
b. Internalizing the externality via compensation

• In the industries, the technology to control pollution may not exist or may be so
expensive that it far exceeds the economic cost of the pollution prevented. In this case,
the only possible solution may be either not to produce at all or to compensate those
suffering from the pollution.
• Those receiving the compensation could include local farmers whose crops have been
destroyed or local residents who have lost their environmental amenity, the utility may
they received from living in a clean environment.
• Where the victims of some negative externality have inadequate property rights, it may
not be feasible to internalize externalities. This may make it difficult to device
satisfactory compensation schemes.
• The problem therefore will be how to directly value positive or negative externalities
experienced by such groups so that they can be included in the economic cash flow of
the project.
c. Internalization by taxation and subsidies
• Another example of forced internalization of externalities is the taxing of consumer goods
whose consumption causes large negative externalities.
• For example, high excise taxes on cigarette and alcohol are designed to discourage
consumption and internalize the high public costs of individuals consuming these products.
• On the other hand, government often subsidizes or provides free goods and services such as
primary and secondary school education and mass inoculation programmes whose
consumption creates large positive externalities. This is done to ensure that their production is
at a socially optimal level.
• Sometimes it is not technically possible or socially desirable to internalize an externality
associated with project. In such cases, it will be necessary to value the externality directly for
inclusion in the project’s economic cash flow, even if it will not enter in the financial cash
flow.
• For example, in the case of dam project, the project conceivably charge local farmers to use
the road built as part of the project and add the toll collected to the project’s direct benefits.
• However the project may decide that it is too expensive to set up the toll road. In this case, it
will need to directly value the external benefits created by the road so that these can be
entered into the project’s economic cash flow.
Economic Valuation Methods
Physical Linkage and Behavioural Approaches
• A. Physical Linkage Methods
• This approach to economic valuation is based on the measurement of physical effects of the
changes in environmental quality.
• A rational individual is willing to pay up to as much as the amount of the costs which damage
would impose, to prevent the damage from occurring in the first place or costs equal to the net
value averting damages from pollution.
• Identification of physical linkages or cause- effect relationships includes establishing the links
between:
a) Environmental degradation and productivity;
b) Deforestation and soil erosion;
c) Soil nutrient levels and productivity;
d) Water and air pollution and health effects; and
e) Recycling and energy use, etc.
B. Behavioral Approach
• The behavioral approach directly measures people’s preference and
concerning changing in their economic welfare which is subjective
judgment and affecting education, time, age, sex and cultural
background.
• This unpriced approach involves a process of measuring people’s
preferences for changes in risk of human life and other
environmental changes rather than providing direct value of the
environment or human life or health.
Direct measures of Externality’s Impact

a. Measuring productivity changes (Production function approach)

• The project may create externality that affects the productivity of other
producers and consumers. This productivity change can be measured in term of
value of the net output produced.
• For example, the minimum economic cost of the air or water pollution that
destroys the local crops will be the market value of these crops over the lifetime
of the project that produces them or while the damage continues to occur.
• If some less sensitive or less profitable crop can be grown instead, the
difference between the value of the preferred crop and less valuable substitute
can be calculated and used as measure of the cost of pollution.
b. Change of earning or human capital approach

• The loss or gain of earnings can measure this, or change in the value of human capital of
those affected.
• For example, air pollution from local mining or brick factory or project may cause some
miners to develop lung disease, reducing their working life or even causing premature
death.
• Their lost earnings will be measure of their decreased productivity and minimal estimate
of the cost of pollution.

• The increased earnings of workers who received trainings on a project and then go on to
work for other employees is another use of the human capital approach to measure the
value of externalities.
• In this case, such earnings are a measure of the positive externalities generated by a
project’s training.
c. Opportunity Cost Method
• If the externality is very difficult to measure, one method of handling
this is to measure the Net Present Value (NPV) of the project that
generates the externality and compare it with the NPV of the next best
alternative project, which does not.
• The difference between the two project’s NPVs is the opportunity cost
of the externality.
• The decision- maker can then decide if the cost or benefit of the
externality exceeds the difference in the project’s NPVs.
d. Preventive expenditure approach
• Another readily identifiable cost of negative externality will
be the preventive expenditures that people incur to reduce or
avoid the damage from such an externality.
• Such expenditures are made in order to maintain the
productivity of their economic activities or their level of
environmental amenity.
• The cost sound insulation installed by people living near the
airports is an example of such preventive expenditure.
e. Replacement cost approach
• The replacement cost method measures the cost of
environmental degradation in terms of the resources that
must be used to replace the environmental services lost as a
result of this degradation.
• For example, the benefits of a project to provide clean river
water may be measured in term of the saving in water
treatment costs.
INDIRECT MEASURES OF EXTERNALITY’S IMPACT

• In addition to the use of directly observable prices, the range of other approaches has been
developed to measure externalities related to environmental amenity.
• These measures rely on prices that indirectly measure the externality’s impact on welfare.
a. Hedonic Pricing Method
• The hedonic pricing technique is particularly useful in measuring changes in environmental
amenity such as noise or air pollution.
• It involves comparing the prices for residential or agricultural land or properties in areas close to a
source of pollution, such as an airport, with those for land in similar suburbs away from such
pollution sources.
• Controls are introduced it eliminate differences due to the intrinsic value of the house or land using
large samples and econometric regressions.
• The difference in land prices that cannot be explained by any of these other factors will represent
the present value of the occupant’s expected loss of environmental amenity by living close to the
pollution source.
b. Travel Cost Method
• Measuring changes in travel times and travel costs is another indirect use of market
prices to value a project’s externalities.
• This approach can be used to measure both negative externalities like traffic
congestion and positive externalities from environmental amenities like national
parks or scenic area generally.
• In the case traffic congestion in the vicinity of a project, for example, the additional
travel time costs of road users, valued in economic prices, will provide an estimate
of the welfare loss as a result of the unmarketed externality, congestion.
• The basic rationale of this approach is that people will reveal the utility gain from a
recreational facility by the amount they are willing to pay to visit it each year.
• The travel cost method can be used to provide a minimum valuation of other
unmarketed items like historical and cultural sites.
c. Contingent Valuation Method
• Sometimes, the externalities created by a project cannot be measured either
directly or indirectly in market prices because there is no actual or even
surrogate market for the good or service concerned.
• Sites of cultural, historical or spiritual importance and the continued existence
of species and unspoiled wilderness areas are good examples of items that
could not be readily valued in terms of people’s observed willingness to pay
in market prices.
• Furthermore, people may get utility or pleasure, from mere knowledge of
existence of environmental or cultural amenities even if they have never used
or seen them and do not intend to.
• This utility is called non- use or passive value.
• Contingent valuation methods have therefore been developed to directly ask
people what value they put on environmental and other amenities, including
facilities from which they get only passive value.
 c. Contingent Valuation Method contd…
• This will involve surveys to determine the willing to pay to prevent
the externality or willingness to accept to include them to put up with
this negative externality.
• There are three problems associated with this method.
• The first is the possible existence of hypothetical bias because of the difficulty
of obtaining meaningful responses to hypothetical questions. This can be
remedied by the careful construction of questions and conduct interviews.
• The second problem relates to whether the respondent is asking to pay for an
amenity.
• A third problem is the free rider problem, which may bias responses. People
may undertake the amount they may be pay to retain a positive externality, or
social service or public good, if they believe that they will be required to pay
this amount.
Conclusions
• The most obvious externalities likely to have measurable effect in term of
market prices should be examined and measured first. Other secondary
impacts should then be investigated and if necessary, surrogate prices and
survey technique such as contingent valuation may be used to measure
any other identifiable externalities.
• Once the techniques outlined above have used to estimate the aggregate
value of the externality over the project’s life, this should be added to the
cost and benefit stream of the project.
• Costs incurred and benefits forgone as result of externalities generated
will be economic costs of the projects,
• while benefits generated and costs saved will be economic benefits.
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