Economic Questions (Calculation Based)

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TECON 480 – Class 11

August 21, 2019

Part 3 – Undertaking the analysis

• Instructions available on Canvas for the following:

• Assignment #4 (due tonight at midnight)

• Final report (due Sat, Aug 24 at midnight)

• Includes template to use as starting point

• Final Exam due Sun, Aug 25 at midnight

• No class on Fri, Aug 23

Announcements / Reminders

Today’s Class

• Discuss the concept of shadow prices

• Primary example: value of a statistical life

What is the “Value” of Your Life?

• Do you believe that your life is priceless?

• In other words, do you think that the value of your own life is infinite?

• Do you act like the value of your own life is infinite?

� Did you come to class today?

� Are you wearing a helmet right now? 4

What is the “Value” of Your Life?

• Many are uncomfortable with the idea of equating a person's life with a finite dollar amount

• They often believe that a human life can only be infinitely valued

• To object is immoral and repulsive

The Reality

An Economist’s Response

• An economist perceives that individuals do not place an infinite value on their own lives (let alone the lives of others)

• Why would an individual take even the slightest risk of losing their infinitely-valued life, do something mundane like walking

to the grocery store?

• What some economists do explicitly, virtually every individual does implicitly

� they place a finite value on human life 8

Willing to Make Tradeoffs in Life

• Example of such a tradeoff: value of life vs. the value of time and the probability of fatal accidents at different speeds

Statistical Value of Life

• Economists routinely use a statistical value of life estimate in policy analysis to measure such trade-offs

• This is the value of life in a cost-benefit analysis sense

• The dollar cost of improved safety must be compared to the dollar benefit of improved safety

• If the benefit is measured in lives saved, a dollar value of life is important to determine to make these comparisons

Statistical Value of Life

• Statistical value of life is a different concept than what you may be willing to pay to save your own life

• Compare:

How much are you willing to pay to reduce the number of expected deaths in society by one?

vs.

How much are you willing to pay to save yourself from guaranteed death?

The Ford Pinto

• The Ford Pinto case represents a tragic example of the application of value of life estimates in a CBA framework

• On an Indiana highway in 1978, three girls between the ages of sixteen and eighteen were killed while driving a Ford Pinto

• Apparently, had Ford made an $11 modification in the design of the Pinto, the deaths of the girls may have been avoided

Ford Pinto: Costs

• https://www.youtube.com/watch?v=lgOxWPGsJNY

Ford Pinto: Costs

• Ford had undertaken a cost-benefit analysis

• Ford assigned a dollar value to the potential loss of human life in the event of just such an accident

• It was more cost-effective for Ford to pay damages to the families of accident victims than it was to make the modification

• Note: this was a process that Volkswagen repeated recently in regards to violating emissions standards

• Cost: An $11 modification for the total number of Pintos on the road was approximately $138 million 14

Ford Pinto: Benefits

• Ford determined how many individuals would probably be killed or injured in a rear-end Pinto collision

• Using average liability amounts from wrongful death and injury litigation, they calculated their legal liability of not using the

modification

• Using a liability amount of $200,000 for each person killed, and $67,000 for each person injured, they totaled their overall liability

at approximately $50 million

What was Ford Thinking?

• Thousands of decisions must go into something as complicated as product design for an automobile

• Any single improvement in safety may cost just a few dollars…

• …but if there are hundreds of potential safety modifications to consider, the improvements in safety may cost thousands of

dollars

Sound Business Decision?

• Ford made a sound business decision for its shareholders

• In their analysis, only the shareholders had standing

• Was it a sound decision from society's perspective?

• Proper cost-benefit analysis doesn't only require using a value of life estimate, it requires using the appropriate one

• But what is meant by appropriate? 17

A Social Perspective

• From a social perspective, a value of life includes anything that can be considered valuable to the individual

• The goal of estimating the value of life, then, is to try to place a dollar value on both the pecuniary and nonpecuniary aspects of that value

• Many public programs and projects involve the prevention of loss of life: dams, maintaining roads, traffic signs, provision of health care, employment of firefighters, etc.

• How do economists value a life saved (death averted) in the cost-benefit calculus?

• Value of life = present value of lifetime earnings

• Represents productivity gains from extending life (benefit side)

• Represents productivity losses from early death (cost side)

• For society as a whole, represents a loss in national output due to mortality

Human Capital Approach

• This method often used in court cases

• e.g., court awards the family of a man who dies at 35 in a car accident the amount of his expected PV of lifetime earnings =

$650,000

• Problems with human capital approach:

• People who are not working for pay (e.g., homemakers, students, retirees) are valued at 0!

• Even for the employed, time away from the job is valued at 0

• Implies that people with higher wages have higher social value

• Does not account for labor market imperfections, e.g., discrimination.

Human Capital Approach

• Individuals routinely take actions that suggest they are either willing to pay to avoid, or must be paid to incur, an increased risk of death

• Example: marginal benefit vs. marginal cost of buying a smoke detector in your home

• Advantages:

• Measures total value of life (not just labor market value)

• Includes foregone earnings and non-market value of life

• Based on observable market behavior, i.e. revealed preference approach

• Disadvantages:

• Estimates vary widely

• Price paid may be less than true WTP

� value will be understated

Willingness-to-pay (WTP) Approach

Hedonic Wage Analysis

• Example: How much additional money must a firm offer a worker to take on a risky job, versus one with no risk?

• To answer this question, one could compare the average wages of risky jobs vs. non-risky jobs

• Working as a coal miner is more risky than working as an investment banker, but investment bankers get paid more

� Must examine the tradeoff between wages and risks, holding constant all other factors that influence pay

Hedonic Wage Analysis

• Suppose you are trying to choose between two job offers:

• Both jobs are completely identical to you except in two respects:

• One job has a slightly higher risk of death than the other job

• The wage rates may differ between jobs

Hedonic Wage Analysis

• Dataset with observations on: • Workers

• Their annual earnings

• Worker characteristics

• Job characteristics (including the risk of dying on the job in that worker’s industry)

Ln(Earningsi) =α0 +α1(Educationi) + α1(Experiencei) +

α2(Management Positioni) + α3(Fatality Riskj) + εij

• One can estimate this regression, and the estimate of α3 can be used to derive a VSL 25

Hedonic Wage Analysis

• Data on worker characteristics is available from the Bureau of the Census

• The Department of Labor collects data on fatal occupational injuries by industry

U.S. Occupational fatality rates by industry, 2005

Industry BLS, CES survey

Natural resources and mining 139.0

Mining 28.3

Construction 16.2

Manufacturing 2.8

Trade, Transportation, & Utilities 5.8

Wholesale Trade 3.5

Retail Trade 2.6

Financial Activities 1.2

Educational & Health Services 0.9

Fatality Rates Per 100,000 Workers

Hedonic Wage Analysis

• Suppose the estimated coefficient α3 = 300

• This implies that a worker requires 300 times more earnings for a job with a 100% fatality risk versus a job with a 0% fatality risk, holding all other factors constant

• If average earnings are $32,000 then the VSL = $32,000 * 300 = $9,600,000

Hedonic Wage Analysis

• The riskier job pays a wage premium relative to the less risky job

• It may be possible to identify the exact wage premium that makes you completely indifferent between the two jobs

� This value is called a “compensating differential”

• With that amount, and some idea of the difference in the risk factors of the two jobs, we can estimate a value of life

Hedonic Wage Analysis

• Suppose the riskier job has a one in ten thousand (1/10,000) higher death risk than the less risky job

• The riskier job requires a $500 minimum annual wage premium for an individual to accept this risk

• If 10,000 workers each give an identical answer, we have a total of ($500 X 10,000), or $5 million

• In a statistical sense, then, we can say that one life is valued at $5 million 29

Valuing Human Life

• Labor market data from the U.S. typically finds a VSL of $4m to $9m in year 2000 dollars

• Median U.S. value is $7 million ($2000) or $8.7 million ($2009) based on meta analysis in Viscusi and Aldy (2003)

• Interpretation: require $870 to face risk of death = 1/10,000

Valuing Human Life

• Can also estimate a VSL based on the prices that people pay for safety devices that reduce the risk of death

• Price of smoke detectors vs. reduction in fire fatality risks

• Premium paid for areas with low air pollution vs. reduction in death from clean air

• Price of children’s car seats vs. reduction in auto fatalities when in use 31

Back to the Ford Pinto

• The problem with Ford's CBA was not that they were trading lives for dollars

• Ford correctly determined legal liability to be based on the $200,000 wrongful death damage estimate that the courts used

• If the social value of life estimate falls in the lower end of the $3 million to $7 million range, the dollar cost of not adding the safety modification in

terms of life lost and injury would be close to $1 billion (not $50 million)

• With the larger value of life estimate, the cost-benefit analysis shows that the safety modification would have been cost-effective and should have

been implemented 32

Optimal Level of Safety

• Opportunity costs: every dollar of resources we spend somewhere is one dollar less we can spend elsewhere

• This is why it is important to carefully consider where the dollars are spent, even when considering saving lives

• A 1985 FAA regulation that implemented an aircraft cabin fire protection standard cost $100,000 per life saved

• In this case, pretty much any statistical value of life estimate you use would suggest that the regulation is extremely cost-effective

Optimal Level of Safety

• A 1978 OSHA regulation that implemented an arsenic occupational exposure limit cost $127

million per life saved

• Even if you use the very high end of the value of life estimates, this regulation does not appear to be

justified

Optimal Policy

• Question that must be answered in designing social policy for health and safety issues is:

What is the optimal accident rate in any given risky situation?

� The answer to this question must ultimately involve some

form of cost-benefit analysis that trades lives for dollars,

regardless of how much importance you place on the costs or

benefits being considered

Heterogeneity of VSL

• Workers who choose higher risk levels may have different:

• Perceptions of the risk entailed

• Preferences

• Income, age, etc.

36 To adjust for individual’s age, measure:

Value of Statistical Life-Year (VSLY)

The “Senior Discount” Controversy

• EPA used a senior discount of 37% in analysis of Clear Skies initiative in 2002

• Political firestorm:

Seniors on sale 37% off

• EPA backed off approach � proposed Senate legislation banning all demographic adjustments

2008 “Devaluation of Life” Controversy

• Based on conflicting results of 2 meta analyses:

Viscusi and Aldy vs. Mrozek and Taylor, in 2008

• EPA Air Office lowered the VSL from $8 million to $7 million

• Economic puzzle since income levels have risen. Why did studies differ?

• Political firestorm – Bush conspiracy?

http://www.cc.com/video-clips/e8zxmm/the-colbert-report-the- word---priceless

Policy Implications

• U.S. agencies required to compare the costs of proposed regulations to the benefits, which are often in terms of lives saved

Values of a statistical life used by U.S. Regulatory Agencies, 1985-2000

Agency Regulation Value of a statistical life (millions, 2000 $)

Federal Aviation Administration

Protective Breathing Equipment $1.0

Food & Drug Administration

Regulations Restricting the Sale & Distribution of Cigarettes & Smokeless Tobacco to Protect Children & Adolescents

$2.7

Environmental Protection Agency

National Ambient Air Quality Standards for the Ozone

$6.3 39

Policy Implications

• Should the VSL vary with:

• Age?

• Income?

• Country?

Additional Shadow Prices

• The following tables are from Boardman et al. and provide examples of a wide-range of shadow price estimates

• These estimates come from a variety of revealed and stated preference approaches

• These are common inputs to a various CBAs

Willingness to Pay

• There are three broad categories of benefits for which individuals may be willing to pay:

1. Use value

2. Existence value

3. Option value

Willingness to Pay

https://www.youtube.com/watch?v=q8AZHtF2f50

Active and Passive Use Value

• Social benefits are measured through individuals’ willingness- to-pay (WTP)

• WTP usually derived from observation of peoples’ behaviors

• e.g. such as changes in consumption (demand)

• In some situations, however, people are willing to pay for something they don’t “consume”

� How can we measure this “existence” value?

Active and Passive Use Value

Example: wilderness land

• What is the link between people’s WTP and their use of this land?

Active and Passive Use Value

• We can characterize 3 categories:

1. Active use

• People that make some use of the object in question

• Example: hiking

2. Passive use or Non-use

• People that are willing to pay even though they don’t use it

• Example: thinking about existence of wilderness

3. Option to use

• Amount someone is willing to pay to keep open the option of using the object in the future

• Example: one day I’ll start hiking, I swear…

Active and Passive Use Values

• Following table gives a possible classification of benefit categories:

Active and Passive Use Values

• Non-use value not easy to define

• There are a number of complications:

• Sometime difficult to determine if a good has non-use

• People can derive both use and non-use from an asset

• They are not mutually exclusive

• Difficult to separate the non-use value and use value components from the individual’s total WTP

• Non-use value cannot be directly observed, only discovered through stated preferences

Measuring Total Economic Value

• Surveys can be used to directly elicit the total value an individual places on a good

• Ask people to state their WTP based on all their possible motivations for valuing policy changes

• This approach depends on the analyst’s ability to frame correct questions, and requires the analyst to convey a full description of

the policy in question

� This is an example of the stated preference (or contingent

valuation) approach

Measuring Total Economic Value

• Eliciting altruistic existence values poses special problems

• For an individual’s own consumption, cost and benefits can be estimated separately and then added together to obtain net

benefits

• Altruistic values, however, may depend on the distribution of costs and benefits: who will use the good and who bears the cost

of maintaining it?

• The response may also not be “honest”

• If these problems are addressed and if the sample of individuals interviewed includes all the people with standing, then the

valuations would complete the CBA

• Often, however, only a sample of people are interviewed to supplement direct observation of use value

• As WTP of use and non-use values are sensitive to the order in which they are valued, use values should normally be discovered

before non-use values, or else non-use will be overestimated

• Non-use values are also sensitive to geographic areas

• Usually people give higher existence values for assets in closer proximity

• Therefore, the extrapolation of samples over a large geographic area is controversial

Measuring Total Economic Value

• Many economists would be more comfortable measuring existence value through the observation of behavior

• i.e. the revealed preference approach

• As a pure public good, however, its “behavioral trace” is likely to be so weak that considerable ingenuity is required to find ways of measuring it

• Nevertheless, increasingly sophisticated methods for measuring benefits offers some hope that a way will be found

• These include making inferences from individuals’ contributions to organizations such as the Nature Conservancy and from their allocation of time to complementary market goods

• Even if the methodology is not perfect, it is currently the most appropriate approach

Measuring Total Economic Value

• Should Existence Value be Included in CBA?

• Although existence values for unique and long-lived assets should be estimated whenever possible, costs and benefits

should be presented with and without their inclusion to make

clear how they affect net benefits

• When existence values can’t be measured, the analyst should discuss their possible significance on the sign of net benefits

� Is it likely that it would change the results of the CBA?

Measuring Total Economic Value

Example: Ecosystem Valuation

CBA in Excel

• A useful video illustrating a small-scale CBA in Excel:

https://www.youtube.com/watch?v=uGMHkFKEnz0

• Many additional videos available at the following link:

http://conservation-strategy.org/en/csf-econ-video-lessons

The Major Steps in CBA

1. Specify the set of alternatives.

2. Decide whose benefits and costs count (standing).

3. Identify the impact categories, catalogue them, and select

measurement indicators.

The Major Steps in CBA

4. Predict the impacts quantitatively over the life of the

project.

5. Monetize (attach dollar values to) all impacts.

The Major Steps in CBA

6. Discount benefits and costs to obtain present values.

7. Compute the net present value of each alternative.

The Major Steps in CBA

8. Perform sensitivity analysis.

9. Make a recommendation.

Tips for Being an Informed Policymaker

Consumer’s Guide to Regulatory Impact Analysis: Ten Tips for

Being an Informed Policymaker

• Dudley, S., et al. (2017). “Consumer’s Guide to Regulatory Impact Analysis: Ten Tips for Being an Informed Policymaker.”

Journal of Benefit-Cost Analysis, 1-18.

• Abstract: Regulatory impact analyses (RIAs) weigh the benefits of regulations against the burdens they impose and are

invaluable tools for informing decision makers. We offer 10

tips for nonspecialist policymakers and interested stakeholders

who will be reading RIAs as consumers.

Tips for Being an Informed Policymaker

1. Core problem: Determine whether the RIA identifies the core problem (compelling public need) the regulation is intended to address.

2. Alternatives: Look for an objective, policy-neutral evaluation of the relative merits of reasonable alternatives.

3. Baseline: Check whether the RIA presents a reasonable “counterfactual” against which benefits and costs are measured.

4. Increments: Evaluate whether totals and averages obscure relevant distinctions and trade-offs.

5. Uncertainty: Recognize that all estimates involve uncertainty, and ask what effect key assumptions, data, and models have on those estimates.

Tips for Being an Informed Policymaker

6. Transparency: Look for transparency and objectivity of

analytical inputs.

7. Benefits: Examine how projected benefits relate to stated

objectives.

8. Costs: Understand what costs are included.

9. Distribution: Consider how benefits and costs are

distributed.

10. Symmetrical treatment: Ensure that benefits and costs are

presented symmetrically.

Summary

• CBA is one component of the decision-making process

• Must be cognizant of:

• Omitted/non-quantified costs and benefits

• “Contingency calculations”: i.e. the costs of the omitted cost would have to be > $X / person to make the project not viable

• Distributional concerns

• Can provide different weights to certain impacts

Assignment #4

• Any remaining questions?