28 These criticisms include Fisher et al. ( 1989) and Viscusi ( 1992). Exhibit 7 3 Value of Statistcal Life Estimates ( mean values in 1997 dollars) No clear consensus establishes one of these three methods or any particular study as exhibiting superior features for use in regulatory analyses. However, the relative abundance of available VSL estimates from wage risk studies provides a range of broadly applicable values for reduced mortality risk. As in other benefit transfer exercises, a range or distribution of values serves as a starting point when seeking to identify values appropriated for a particular policy context.

<IP_ADDRESS> Existing Reviews of Value of Statistical Life Estimates Literature surveys found in Viscusi ( 1993) and Fisher ( 1989) represent the best starting points for VSL estimates. In both cases, the authors' goals included presenting a broadly applicable range of values rather than a point estimate Viscusi ( 1993) is more recent and includes some studies not considered by Fisher. 29 Drawing from these reviews, EPA identified 26 policy relevant risk VSL studies as part of an extensive assessment titled The Benefits and Costs of the Clean Air Act, 1970 to 1990 ( EPA, 1997a). 30 These are summarized in Exhibit 7 3 ( IEc 1992, 1993a, 1993b). Five of the 26 studies are contingent valuation studies, the rest are wage risk studies. To allow for probabilistic modeling of mortality risk reduction benefits, the analysts reviewed a number of common distributions to determine which best fit the distribution of mean values from the studies. A Weibull distribution was selected with a central tendency ( or mean) of $ 5.8 million ( 1997$).

Although these studies are generally of high quality, the $ 5.8 million measure of central tendency does not account for variation in study specific factors underlying these VSL estimates. Further research on synthesizing the results of these and other studies, including the use of meta analysis may provide estimates better suited for benefit transfer to environmental policies.

<IP_ADDRESS> Benefit Transfer Considerations for Using Existing VSL Estimates Exhibit 7 3 contains the best range of estimates available at this time. For use in benefits analyses, EPA recommends a central estimate of $ 4.8 million ( 1990$), updated to the base year of the analysis. For example, updating this figure for inflation produces an estimate of $ 6.1 million in 1999 dollars. 31 However, as with any benefit transfer exercise, it is important to consider differences in the nature of the base and policy cases. As noted earlier, for fatal risks these differences fall into two major categories:

differences in the characteristics of the population; and differences in the characteristics of the risks being valued.

Particular differences in these categories are detailed below. Following this presentation is a summary assessment of how analysts might assess the impact of these population and risk dimensions. Generally, policy analysts considering mortality related benefits should include at least a qualitative discussion of the potential impact of these factors on the overall results. It is important to recognize that the ultimate objective of the benefit transfer exercise is to adjust or correct for all of the factors that significantly affect the value of mortality risk reduction in the context of the policy. Analysts should carefully consider the implications of making adjustments for some relevant factors, but not for others.

90 Chapter 7: Benefits 29 A third literature survey, Miller ( 1990), reviews a broad range of value of life studies, including estimates from averting behavior studies that others forcefully argue are not appropriate for environmental policy purposes. In addition, Miller's results are dependent on adjustments he makes to wage risk data. These adjustments are the subject of debate among economists and may be difficult to defend in environmental contexts.

30 This approach for valuing mortality risks was subject to extensive external peer review during the development process of this report. Since the report's release, this approach has been adopted in other EPA benefit analyses. Peer reviewers have recently confirmed the approach for use in a prospective analysis of the Clean Air Act ( EPA, 1999a).

31 This was estimated using the Consumer Price Index ( CPI) for all goods and services. Many economists prefer to use the Gross Domestic Product ( GDP) Deflator inflation index in some applications. The key issue for EPA analysts is that the chosen index be used consistently throughout the analysis. Factors Associated with Demographic Characteristics Age ( longevity): Several authors have attempted to address potential differences in the value of statistical life due to differences in the average age of the affected population or the average age at which an effect is experienced. 32 In the case of reductions in mortality risks, a young person is assumed to experience a greater expected benefit in total lifetime utility than an older person. This hypothesis may be confounded by the finding that older persons reveal a greater demand for reducing mortality risks and hence have a greater implicit value of a life year ( Ehrlich and Chuma, 1990). Though few in number, empirical studies and theoretic models suggest that the value of a life follows a consistent " inverted U" life cycle, peaking in the region of mean age. 33 Two alternative adjustment techniques have been derived from this literature. The first, valuation of statistical life years, is based on the concept of statistical life years introduced in Section 7.4.1. The most common application of this approach is illustrated in Moore and Viscusi ( 1988) and presumes that 1) the value of statistical life equals the sum of discounted values for each life year and 2) each life year has the same value. This method was applied as an alternative case in an effort to evaluate the sensitivity of the benefits estimates prepared for EPA's retrospective study of the costs and benefits of the Clean Air Act ( EPA 1997). A second technique is to apply a distinct value or suite of values for mortality risk reduction depending on the age of incidence. However, there is relatively little available literature upon which to base such adjustments. 34 Health status: Individual health status also appears to affect WTP for mortality risk reduction. This is a relevant factor for valuation of environmental risks because individuals with impaired health are often the most vulnerable to mortality risks from environmental causes ( for example, particulate air pollution appears to disproportionately affect individuals in an already impaired state of health). Health status is distinct from age ( a " quality versus quantity" distinction) but the two factors are clearly correlated and therefore must be addressed jointly when considering the need for an adjustment. At least one pilot study has found that WTP for increased longevity decreases with a declining baseline health state ( Desvousges et al., 1996). 35 Factors Associated with Characteristics of Risk and Other Considerations Risk characteristics appear to affect the value that people place on risk reduction. A large body of work identifies eight dimensions of risk that affect human risk perception: 36   voluntary/ involuntary;

  ordinary/ catastrophic;

  delayed/ immediate;

  natural/ man made;

  old/ new;

  controllable/ uncontrollable;

  necessary/ unnecessary; and   occasional/ continuous.

91 Chapter 7: Benefits 32 See, for example, Cropper and Sussman ( 1990) and Moore and Viscusi ( 1988).

33 Jones Lee et al. ( 1985) reach this conclusion empirically, considering both remaining years of life and the value of a life year. This conclusion supports theoretical predictions by Shepard and Zeckhauser ( 1982).

34 This second approach was illustrated in one EPA study ( EPA, 1995) for valuation of air pollution mortality risks, drawing upon adjustments measured in Jones Lee et al. ( 1985).

35 The fields of health economics and public health often account for health status through the use of quality adjusted life years ( QALYs) or disability adjusted life years ( DALYs). These measures have their place in evaluating the cost effectiveness of medical interventions and other policy contexts, but have not been fully integrated into the welfare economic literature on risk valuation. More information on QALYs can be found in Gold et al. ( 1996) and additional information on DALYs can be found in Murray ( 1994).

36 A review of issues in risk perception is found in Slovic ( 1987). Other informative sources include Rowe ( 1977), Otway ( 1977), and Fischhoff et al. ( 1978). Transferring VSL estimates between these categories may introduce bias. 37 There have been some recent efforts attempting to quantitatively assess these sources of bias. These studies generally conclude that voluntariness, control, and responsibility affect individual values for safety, although the direction and magnitude of these effects are somewhat uncertain.

Environmental risks may differ from those that form the basis of VSL estimates in many of these dimensions Occupational risks, for example, are generally considered to be more voluntary in nature than are environmental risks, and may be more controllable.

Latency periods: Many environmental policies are targeted at reducing the risk of effects such as cancer, where there may be an extended period of latency between the time of exposure and eventual death from the disease. 38 While the benefit of a reduction in exposure is an immediate reduction in the risk of the associated health endpoint, latency periods between exposure and manifestation may affect the value of that risk reduction. Existing VSL estimates are based upon risks of relatively immediate fatalities, making them an imperfect fit for a benefits analysis of many policies. Economic theory suggests that reducing the risk of a delayed health effect will be valued less than reducing the risk of a more immediate one, when controlling for other factors.

A simple ad hoc approach to adjusting existing VSL estimates is to apply a financial discount rate over the expected latency period. However, defining latency periods with existing risk assessment methods may be difficult and empirical estimates may be highly uncertain. Further, the underlying assumptions supporting this procedure may oversimplify how individuals appear to consider delayed health effects. 39 Cropper and Sussman ( 1990) develop an alternative procedure to account for the influence of time on fatal risk reduction values, but their demonstration is data intensive, requiring detailed life tables and agespecific VSL estimates.

Altruism: The existing VSL literature focuses on individual risk tradeoffs, but there is evidence that people are willing to pay to reduce risks incurred by others. Although the literature on altruism is limited, several studies suggest that these values may be significant 40 Other analysts advocate caution in attempting to inflate value of life estimates to reflect altruism, primarily because of concerns over the potential for double counting. 41 <IP_ADDRESS> Summary of Advice from the Economics Literature It is important to recognize the limitations of a single VSL point estimate and to consider whether any of the factors discussed above may have a significant impact on the benefits estimated for mortality risk reductions from environmental policies. In any given policy context, there may be several components that are both relevant and important and that could act to increase or decrease the appropriate risk reduction value used to estimate benefits. Adjustments for each these factors may offset one another to some extent. 42 Analysts should exercise caution in accounting for some important risk and population characteristics when unable to account for others.

92 Chapter 7: Benefits 37 Examples include Mendeloff and Kaplan ( 1990), McDaniels et al. ( 1992), Savage ( 1993), Jones Lee and Loomes ( 1994, 1995, 1996), and Covey et al. ( 1995).

38 Although latency is defined here as the time between exposure and fatality from illness, alternative definitions may be used in other contexts For example, " latency" may refer to the time between exposure and the onset of symptoms. These symptoms may be experienced for an extended period of time before ultimately resulting in fatality.

39 See, for example, the choice of discount rate discussion in Horowitz et al. ( 1990) and Rowlatt et al. ( 1998).

40 In a study that included willingness to pay to reduce others' risk of illness from insecticides, Viscusi et al. ( 1988) found evidence of significant altruistic values. Jones Lee et al. ( 1985) suggests an adjustment to value of statistical life estimates of about one third to account for people's concern for the safety of others.

41 Examples include Bergstrom ( 1982) and Viscusi ( 1992).

42 Sometimes this might mean that very different risks will be valued similarly. There are relatively few studies that assess responses to different types of risk in an individual choice framework. A notable exception is Magat et al. ( 1996), which finds individuals indifferent between mortality risks from an automobile accident and those from fatal lymph cancer. Because of the inherent uncertainty in any analysis, however analysts should consider qualitative evaluations of these factors and explore where sensitivity analysis can satisfactorily address some of these concerns. The importance and relevance of each of the risk and demographic characteristics need to be considered. Depending upon specific policy context, there may be multiple alternatives for supplemental analysis.

For example, when policies do not affect the entire population equally, a sensitivity analysis may show the cost per life saved. In some contexts these values may provide useful information to decision makers on the relative merits of alternative policy options. However, cost per life saved measures implicitly assume that all costs are associated with mortality reduction. For policies that provide other types of benefits, cost per life saved measures may be misleading unless the value of those benefits are first deducted from cost estimates, but it is impossible to make these deductions when some benefits are either non quantified or non monetized. Because of these shortcomings, analysts will need to assess the usefulness of cost per lifesaved measures on a case by case basis.

In general, the decision to perform sensitivity analysis will also depend upon the relative importance of mortality values in the overall benefits estimates and upon having sound theoretical and empirical economic literature upon which to structure the analysis. Parameter values used to formulate the sensitivity analyses must also be supported by the underlying risk assessment data.

What support does the economics literature currently offer for making these potential adjustments? Existing, feasible methods for age ( or longevity) adjustments have significant limitations. Age adjustments may be desirable from a theoretical standpoint, but the relationship between the value of risk reductions and expected remaining life span is complex. Application of existing valuation of statistical life years approaches implicitly assumes a linear relationship in which each discounted life year is valued equally. As OMB ( 1996) notes, although " there are theoretical advantages to using a value of statistical life year extended ( VSLY) approach, current research does not provide a definitive way of developing estimates of VSLY that are sensitive to such factors as current age, latency of effect, life years remaining, and social valuation of different risk reductions." The second alternative, applying a suite of values for these risks, lacks broad empirical support in the economics literature. However, the potential importance of this benefit transfer factor suggests that analysts consider sensitivity analysis when risk data   essentially risk estimates for specific age groups   are available. Emerging literature on the value of life expectancy extensions, based primarily on stated preference techniques, is beginning to help establish a basis for valuation in cases where the mortality risk reduction involves relatively short extensions of life. 43 A small body of literature on the quantitative impact of risk characteristics on risk valuation exists. Although there is some qualitative consistency in the results of these studies, the risk valuation literature is not sufficiently robust to support quantitative adjustments for these factors at this time. Considerations associated with risk characteristics may deserve qualitative discussion in some policy contexts.

Both of the procedures available for accounting for latency have potentially serious shortcomings. For example, neither procedure addresses the dread of death or the morbidity that occurs prior to fatality from protracted diseases, such as that experienced with many cancers. As noted earlier, the simple " discounted VSL" approach may also oversimplify how individuals consider latency in their expressed WTP for reduced mortality risks. This literature does, however, suggest one alternative for conducting sensitivity analysis on this benefit transfer component.

<IP_ADDRESS> Conclusion In summary, these guidelines recognize the theoretically ideal measure of mortality risk reduction benefits and this section has discussed the many variables affecting such a measure. Due to current limitations in the existing economic literature, these guidelines conclude that an appropriate default approach for valuing these benefits is 93 Chapter 7: Benefits 43 It should be noted that many observers have expressed reservations over adjusting the value of mortality risk reduction on the basis of population characteristics such as age. One of the ethical bases for these reservations is a concern that adjustments for population characteristics may imply support for variation in protection from environmental risks. Another consideration is that existing economic methods may not capture social willingness to pay to reduce health risks. Chapter 9 details how some these considerations may be informed by a separate assessment of equity. Chapter 10 describes the potential for efficiency and equity considerations to be considered together in a social welfare function. provided by the central VSL estimate described earlier. However, analysts should carefully present the limitations of this estimate. Economic analyses should also fully characterize the nature of the risk and populations affected by the policy action and should confirm that these parameters are within the scope of the situations considered in these guidelines. While a qualitative discussion of these issues is generally warranted in EPA economic analyses, analysts should also consider a variety of quantitative sensitivity analyses on a case by case basis as data allow. The analytical goal is to characterize the impact of key attributes that differ between the policy and study cases. These attributes, and the degree to which they affect the value of risk reduction, may vary with each benefit transfer exercise, but analysts should consider the characteristics described above ( e. g., age, health status, voluntariness of risk, latency) and values arising from altruism.

As the economic literature in this area evolves, WTP estimates for mortality risk reductions that more closely resemble those from environmental hazards may support more precise benefit transfers. Literature on the specific methods available to account for individual benefit transfer considerations will also continue to develop. EPA will continue to conduct annual reviews of the risk valuation literature and will reconsider and revise the recommendations in these guidelines accordingly. EPA will seek advice from the Science Advisory Board as guidance recommendations are revised. 44 Despite the limitations described in this section, analysts should remember that mortality risk valuation remains one of the most studied benefit categories for environmental policies. Wage risk studies, while not without limitations nonetheless provide revealed preference estimates based on a well tested method. Estimating mortality related benefits will often be relatively straightforward to implement while other benefit categories will require more time and attention. 7.6.2 Human Health: Morbidity Risks Morbidity valuation, or the valuation of non fatal health effects, often requires addressing a more diverse set of issues than mortality valuation. First, there is a tremendous variety in the health endpoints considered for valuation These endpoints vary with respect to their severity, including the degree to which other activities can be pursued and the degree of discomfort or pain associated with the ailment. The duration of the effect also varies considerably from short term effects to those that may be permanently debilitating. Non fatal health effects differ considerably with respect to the availability of existing value estimates. Some of these health effects have been valued multiple times with different methods, while others have not been the subject of any valuation studies.

Willingness to pay to reduce the risk of experiencing an illness is the preferred measure of value for morbidity effects. This measure includes several components. Illness imposes direct costs, such as expenses for medical care and medication, and indirect costs, such as lost time from paid work, maintaining a home, and pursuing leisure activities. Illness also imposes less easily measured, but equally real costs of discomfort, anxiety, pain, and suffering Methods used to estimate WTP vary in the extent to which they capture these components.

A commonly used alternative to WTP is the avoided costs of illness ( COI). For a given health effect, the COI approach will generally understate true WTP. By focusing on market measures of the value of health effects, it leaves out important components such as the value of avoiding pain and suffering. By focusing on ex post costs, it also does not capture the risk attitudes associated with ex ante WTP measures. However, for many effects, estimates of WTP are not currently available or are highly uncertain. Where estimates of WTP are not available, the potential 94 Chapter 7: Benefits 44 A second review on this subject was recently completed by the Science Advisory Board ( SAB), the results of which can be found in " An SAB Report on EPA's White Paper Valuing the Benefits of Fatal Cancer Risk Reductions," EPA SAB EEAC 00 013, July 27, 2000 ( website address http:// www. epa. gov/ sab/ eeacf013. pdf, accessed 8/ 28/ 00). The SAB review elaborates further on using the wage risk literature for valuing mortality risk reductions, concluding that among the demographic and risk factors that might affect VSL estimates, the current literature can only support empirical adjustments related to the timing of the risk. First, the review supports adjusting willingness to pay estimates to account for higher future income levels, though not for cross sectional differences in income. The second time related adjustment recommended is to discount for risk reductions that are brought about in the future by current policy initiatives ( that is, after a latency period), using the same rates used to discount other future benefits and costs. More information on the SAB review and its implications for the Guidelines will be released in a forthcoming supplement to this document. bias inherent in relying on cost of illness estimates should, at minimum, be discussed qualitatively.

Time and resources will often not allow for original morbidity valuation research to support specific benefit analyses As with other types of benefits, analysts will then need to look for estimates available from existing sources, and apply these values to the policy case using benefit transfer techniques. The discussion here is presented with this benefit transfer exercise in mind. The remaining parts of this section present a summary of methods commonly used to value reductions in morbidity, useful references for obtaining existing values, and issues that arise in transferring existing values to the analysis of EPA policies.

<IP_ADDRESS> Available Methods for Estimating Morbidity Values Researchers use a wide range of methods to value changes in morbidity risks. Some available methods measure the theoretically preferred value of individual WTP to avoid a health effect, while others provide useful data but are less well grounded in economic theory. Methods also differ in the perspective from which valuation is measured ( e. g., before or after the incidence of morbidity) and the degree to which they account for all of the components of total WTP.

The three primary research methods used most often to value environmental morbidity are cost of illness, contingent valuation, and averting behavior, as described earlier. Several other primary valuation methods have been used less frequently to value morbidity from environmental causes: hedonic methods, risk risk tradeoffs, health state indexes, and studies of jury awards. However, these methods often do not provide monetary estimates of WTP or suffer from other methodological flaws, and are generally less useful for policy analysis.

Cost of illness: The cost of illness method is straightforward to implement and explain to policy makers and has a number of other advantages. It has been applied for many years, is well developed, and measures of direct and indirect costs are easily explained without reference to complex economic theory. Collection of additional data is often less expensive than for other methods, perhaps making it feasible to develop original cost of illness estimates in support of a specific policy or set of policies. Estimates for many illnesses are available from existing studies and span a wide range of health effects. EPA's Cost of Illness Handbook ( EPA, forthcoming) contains an extensive collection of cost of illness estimates As noted earlier, however, the cost of illness method has several shortcomings and its theoretical basis is quite limited. Generally, cost of illness estimates should be considered lower bounds on WTP.

Averting behavior: In the case of morbidity valuation the averting behavior method can provide WTP estimates based on actual behavior. These measures can account for all of the effects of health on individual well being, including altruism toward other household members if averting actions are taken jointly ( e. g., if everyone in the household drinks bottled water). However, the method has several weaknesses as described in Section 7.5. Existing studies vary in their analytical approach. Some existing studies have attempted to estimate WTP for particular sets of illnesses ( Gerking and Stanley, 1986; Dickie and Gerking, 1991; Bresnahan and Dickie, 1995). Others do not attempt to estimate ex ante WTP, but focus instead on actual household expenditures in response to a particular contamination episode or event ( Harrington et al., 1989; Abdallah, 1990). In practice most averting behavior estimates should be interpreted cautiously as a lower bound estimate on WTP. Also, because behaviors generally avert a range of symptoms ( e. g., a water filter removes contaminants with several potential health effects), it is difficult to isolate the value of avoiding those individual health effects that may be attributable to a particular EPA policy. Indiscriminate use of this method may raise significant problems with double counting or overestimation.

Stated preference methods: Contingent valuation and other stated preference methods can be used to account for all the effects of illness on individual wellbeing including pain and suffering. These methods appear to be the only ones capable of eliciting dollar values for altruism toward persons outside the household Unlike the averting behavior or cost of illness methods, these can be applied to value the risks of illness lacking any connection to market transactions. Stated preference methods have been used to value a 95 Chapter 7: Benefits number of different health outcomes including accidental poisoning ( Viscusi and Magat, 1987; Viscusi et al., 1988); coughing, congestion, and other minor symptoms ( Berger et al., 1987); chronic bronchitis ( Viscusi et al., 1991; Krupnick and Cropper, 1992); and nonfatal nerve disease ( Magat et al., 1996). Some economists, however, express concerns about the hypothetical nature of the transaction and the difficulties inherent in ensuring that respondents understand the change in health status they are being asked to value. 45 <IP_ADDRESS> Existing References for Morbidity Values Analysts have a number of resources available for obtaining information on morbidity values. While these references provide valuable information, they are not substitutes for careful evaluation of original studies when considering a benefit transfer. Useful general references for valuing non fatal health effects include Tolley et al. ( 1994 ) and Johanneson ( 1995). Both of these books provide references to many existing health valuation studies and discuss issues associated with using these estimates for policy valuation. Desvousges et al. ( 1998) assess a number of existing studies in the context of performing a benefit transfer for a benefits analysis of improved air quality. Another good starting point for reviewing available estimates is EPA's Handbook for Non Cancer Valuation ( EPA, 1999c). This report will provide available, published estimates for many illnesses and reproductive and developmental effects.

Because estimates of WTP will not always be available for particular health effects, another useful resource is EPA's Cost of Illness Handbook ( EPA, forthcoming). This handbook includes cost of illness estimates for many cancers, developmental illnesses and disabilities, and other illnesses Work on the handbook is ongoing and new estimates will be included as they become available. 46 Existing EPA economic analyses may also provide useful insights. For example, the Benefits and Costs of the Clean Air Act ( EPA, 1997a) draws upon a number of existing studies to obtain values for reductions of a variety of health effects. The report describes the central estimates used in the analysis, how these estimates were derived, and attempts to quantify the uncertainty associated with using the estimates.

<IP_ADDRESS> Benefit Transfer Using Existing Morbidity Value Estimates Benefit transfer was detailed earlier in this chapter; however there are issues associated with benefit transfer particular to morbidity valuation. As with any benefit transfer, analysts should:

carefully describe the policy case;

assess the quality of the studies and their applicability to the policy case;

evaluate the plausibility of the findings;

consider possible adjustments for differences between the subject of the study and the policy case; and explicitly address uncertainty.

EPA's Handbook for Non Cancer Valuation ( EPA, 1999c) contains additional information on this subject.

Matching the Study Case to the Policy Case Assessing applicability: A key element in evaluating the applicability of a study is the correspondence between the health effect valued in the study and the health effect influenced by the policy. An assessment of this correspondence must consider the set of symptoms covered in the study. The analyst should consider whether the study case consists of a larger or smaller set of symptoms than the policy case. The severity of the symptoms should also be commensurate including the degree to which the illness limits activities and the extent of any discomfort, pain and suffering. Analysts should also assess whether the duration of the base and policy cases are similar.

A second key factor is the similarity between the population examined in the study and the population affected by the policy. Key considerations include the 96 Chapter 7: Benefits 45 See, for example, Mitchell and Carson, 1989; Cummings et al., 1986; NOAA, 1993; Bjornstad and Kahn, 1996; NRDA, 1994; Diamond and Hausman, 1994.

46 The Cost of Illness Handbook will be available online. The website will be continuously updated as additional COI estimates are completed. baseline health status of the populations, the age of the populations, and other demographic characteristics.

Evaluating plausibility: The analyst should conduct some initial checks to evaluate whether the study case values are plausible or reasonable. For example, if the estimated value of avoiding an acute, reversible effect exceeds other reasonable estimated values for avoiding long term, chronic effects, then the value for the acute effect is probably too large and will be difficult to defend. On the other hand, WTP values that are less than cost of illness values for the same effect are probably too low, particularly if the effect clearly results in pain or otherwise impairs activity.

Using the results of multiple studies: After reviewing the quality and applicability of available studies, the analyst can apply the valuation estimates to the data on cases averted by each policy option. Because the value of morbidity avoidance is difficult to quantify precisely, it is useful where possible to apply estimates from more than one valuation technique Where multiple studies are available that provide differing estimates, the range of values should be presented with a discussion of the advantages and limitations of the studies used. Estimates based solely on cost of illness values should be flagged as potentially understating total values. WTP studies of health effects that are similar in severity and duration may be used as a point of comparison.

Addressing Uncertainty and Related Concerns Available estimates of non fatal effects may suffer from several limitations. They may be derived from cost of illness methods that do not fully measure WTP to avoid the effect or may be transferred from studies of effects that are similar, but not identical to, the effect of concern. The extent to which adjustments or new research are needed to address these concerns will depend largely on the value of new information to the decision making process. If morbidity values are a small component of total benefits and unlikely to influence the choice among policy options, then a qualitative discussion of uncertainty may be appropriate Where morbidity values are a significant concern, quantified sensitivity analysis and additional data collection may be desired.

Some of the major sources of uncertainty are described below. Because of the diversity of the health effects of concern and of the studies used to value morbidity effects, this discussion is relatively general. The limitations and potential adjustments or analyses of uncertainty that are appropriate will vary greatly depending on the approach used for a particular policy analysis. More information on these issues is provided in EPA's Non Cancer Valuation Handbook ( EPA, 1999c).

Ex ante and ex post valuation estimates: Environmental contamination will generally not cause an adverse health effect with certainty, but rather will increase the probability that the effect occurs, increase its severity given that it occurs, or both. People are likely to value these changes in risk differently than they would value certain changes in health status. While contingent valuation and other methods can adopt an ex ante perspective and obtain estimates for risk changes, many available studies provide ex post value estimates for morbidity effects. For minor health effects this difference in perspective may not be important, but for severe health effects the difference may be significant and ex post estimates may understate the benefits of a policy action. Analysts should address this issue at least qualitatively in these cases.

Incomplete estimates of willingness to pay: The widespread availability of health insurance and paid sick leave shift the costs of illness from individuals to others. While this cost shifting can be addressed explicitly in cost of illness studies, it may lead to problems in estimating total WTP through contingent valuation surveys. If the researcher does not adequately address these concerns, respondents may understate their WTP, assuming that some related costs will be borne by others.

Timing of health effects: Environmental contamination may cause immediate or delayed health effects and the value of avoiding a given health effect likely depends on whether it occurs now or in the future. Recent empirical research confirms that workers discount future risks of fatal injuries on the job; that is, they are willing to pay less to reduce a future risk than a present risk of equal magnitude ( Viscusi and Moore, 1989). In addition, a separate study concluded that individuals value policies that yield health benefits in the present more highly than policies that 97 Chapter 7: Benefits yield the same benefits in the future ( Cropper et al., 1994).

<IP_ADDRESS> Summary Morbidity benefits valuation can be a difficult process, often requiring careful judgment decisions by the analyst. Whether the analyst is conducting original research that supports the policy action or is drawing upon existing studies, clarity and transparency in the analysis is vital. When employing benefits transfer, some shortcomings in the " fit" of the study case to the policy case is to be expected Addressing these shortcomings explicitly, conducting appropriate sensitivity analysis, and clearly stating assumptions can greatly enhance the credibility of the benefits analysis.

7.6.3 Ecological Benefit Valuation In estimating ecological benefits, one is generally forced to value individual ecological service flows separately and then sum these estimates rather than constructing prices for changes in the structure and function of entire ecosystems Alternative approaches that estimate the total value of ecosystems based on the replacement cost of the entire ecosystem or its embodied energy ( e. g., Costanza et al., 1997; Ehrlich and Ehrlich, 1997; Pearce, 1998; Pimentel et al., 1997) have received considerable attention as of late. However, the results of these studies should not be incorporated into benefit assessments. The methods adopted in these studies are not well grounded in economic theory nor are they typically applicable to policy analysis. Pearce ( 1998) contains a critical review of the total value approach, as does Bockstael et al. ( 2000).

Although the economics literature is replete with benefit studies, the coverage is patchy considering the broad range of services and stressors addressed by EPA programs. Especially rare in the literature are examples of wide scale changes, very small changes, or the consequences of long term ecological and economic change. Ongoing research has begun to address these data limitations. Examples include recent contingent valuation studies undertaken for purposes of natural resource damage assessments that attempt to elicit WTP for marginal changes in long term environmental quality ( Kopp et al., 1994). In addition, Layton and Brown ( 1997) attempt to elicit from respondents the value of one attribute of the long term ecological changes expected to be associated with climate change.

Available Methods for Estimating Ecological Benefits Economists have employed a variety of methods to estimate the benefits of improved ecological conditions. Issues particular to their implementation for this benefit category are discussed below.

Market models: The benefit of changes in commercial crop, timber, or fish harvests can be estimated using a variety of available market models. Several studies have assessed the social welfare implications of changes in yields for a number of crop species. For example, Taylor et al. ( 1993) apply the Agricultural Sector Model and Kopp et al. ( 1985) apply the Regional Model Farm Agricultural Benefits Assessment Model to estimate welfare impacts of agricultural yield changes. Adams et al. ( 1997) use the Agricultural Simulation Model to estimate the economic effects associated with yield changes resulting from climate change.

When dealing with timber or fisheries, bioeconomic models are designed to deal explicitly with time to account for the fact that environmental and market changes are not coincident. EPA has used the Timber Assessment Market Model ( TAMM) to estimate ozone effects on commercial timber harvesting. The welfare impacts of changes in commercial fish harvests have also been examined, e. g., Alaskan king crab in Greenberg et al. ( 1994); herring in Mendelsohn ( 1993); and lobster in Wang and Kellogg ( 1988).

If changes in service flows are small, current market prices can be used as a proxy for expected benefit. For example, a change in the commercial fish catch might be valued using the market price for the affected species. This approach can only be used in cases where fishing effort and price are unlikely to be affected by the policies. If these conditions do not hold, a market model should be applied to assess the effects of increased catch rates on supply conditions and market price, as discussed earlier in the section on consumer and producer surplus.

98 Chapter 7: Benefits Production function approach: Values for indirect, non market benefits can be estimated when their contribution to production processes are expressed explicitly in a production function. As service flows increase, the welfare gain is essentially the marginal product of the service for small changes or is reflected by the shift in the marginal cost curve. Several studies have examined the relationship between environmental quality and crop production, such as measurement of ozone impacts by Heck et al. ( 1983). Moreover, researchers have applied this approach using household production functions to examine ecosystem services that benefit individuals directly or to establish the link between some services and their off site benefits. Bell ( 1997) values wetland contributions to recreational fishing and Barbier ( 1994) values a range of indirect wetland benefits. Smith et al. ( 1993) estimate the impact of nitrogen and pesticide loadings on coastal water recreational fishing.

Averting behaviors approaches: One such approach, the replacement cost method, uses purchases of market goods to infer the value of indirect, non market services. Willingness to pay is revealed by efforts made to substitute for services provided by ecosystems. For example, since water treatment infrastructure replaces wetland functions, investment and operations and maintenance costs provide an estimate of the value of the water filtration service provided by wetlands. This method is justified only when individuals are proven willing to incur such replacement costs, through either their voluntary purchases or their support for public works projects. If so, the value of the service is at least as much as the replacement cost.

Another variation on this theme applies to actions that reduce the cost of complying with existing policies For example, a reduction in atmospheric nitrogen deposition in the watershed of an estuary may ultimately reduce the costs incurred in reducing other sources of nitrogen to the system, such as added controls on POTWs. This approach is generally useful in situations satisfying two criteria: alternative pollution control methods are prescribed through existing policies and the new policies under consideration would provide a lower cost method for achieving the desired level of environmental protection. Hedonic methods: Hedonic property models can isolate the relationship between environmental quality and housing prices from the effects of variation in other attributes such as size, location, and security. This method is often used to use to value regional difference in air quality. Smith and Huang ( 1995) conduct a meta analysis to examine how well the models perform in this context and discern a statistically significant relationship between housing prices and air quality measures in general. Hedonic models have also been used to estimate the impact of landfill closure ( Kohlhase, 1991), nuisances from odors ( Palmquist et al., 1997), and the existence and remediation of toxic contaminated sites ( Kiel, 1995) on nearby property values. Other applications have addressed the costs of land use restrictions ( Parsons, 1992) and the benefits of water quality improvements ( Rich and Moffitt, 1982). A promising development involves the application of hedonic methods in a model of land use change to explore the ecological and economic consequences of landscape alteration ( Bockstael, 1996). In addition, Geoghegan et al. ( 1997) estimate the impact of land uses adjacent to and near one's home.

Recreation demand models: Recreation demand models are discussed in detail in Section 5.2.1 of this chapter. Recreation demand models are based on the tradeoff between travel expense and environmental quality. While early travel cost models dealt with single sites, did not consider environmental quality, and suffered from a range of limitations and biases, more recent efforts overcome these problems. For example a travel cost model was used to estimate the WTP by Chesapeake Bay beach users for a 20 percent improvement in water quality as measured by nitrogen and phosphorous loadings ( Bockstael et al., 1989).

Random utility models have been used in a wide variety of studies to estimate the recreational fishing benefit of fresh water quality improvements. Montgomery and Needelman ( 1997) apply a random utility model to fishing behavior and estimate the benefits of eliminating toxic contamination from New York lakes and ponds. Recreation demand models also have been used in the context of forest management ( Englin and Mendelsohn, 1991; Dwyer et al., 1983), the ecological effects of natural resource 99 Chapter 7: Benefits damages ( Hausman et al., 1995; Morey and Rowe, 1995), health risks associated with fish advisories ( Jakus et. al., 1997), and non point source pollution controls in estuaries ( Kaoru et al., 1995).

Stated preference approaches: As discussed earlier stated preference methods represent the only means of obtaining a value for non use benefits. For instance, research has tried to measure how much better people feel that various wildlife species are alive and well ( Stevens et al., 1991). Individuals have also expressed a willingness to pay to protect visibility in national parks, whether or not they plan to visit these parks ( Crocker and Shogren, 1991). Contingent valuation has been applied to the other ecological benefit categories as well. EPA has regularly used the results of one such study to value water quality improvements in fresh water ( Mitchell and Carson, 1986b).

7.6.4 Materials Damage Market methods are the primary technique used to quantify benefits falling in this category. Materials damages can include changes in both the quantity of the materials and in the quality. Linking changes in environmental quality with the provision of service flows from materials can be difficult because of the limited understanding of the physical effects ( e. g., scientific information), the timing of some effects ( e. g., long term), and risk responses of producers and consumers of these service flows. When feasible, assessment typically involves combining the output of an environmental model with stressor response function and/ or price information to estimate the impact of the change in environmental quality on production ( inputs) or consumption ( output) of the material service flows. The market response to this impact serves as the basis for the welfare change and benefits assessment. In practice, these market methods may be implemented as reduced from economic models that relate averting or mitigating expenditures to ambient pollutant levels. The degree to which behavioral adjustments are considered when measuring the market response are important and models that incorporate behavioral responses are preferred to those that do not. Refer to Adams and Crocker ( 1991) for a detailed discussion of this and other features of materials damagesbenefits assessment. See the analysis of household soiling in EPA ( 1997b) for an example that employs a reduced form economic model relating defensive expenditures to ambient pollutant levels.

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112 Chapter 7: Benefits 8.1 Introduction The goal of a benefit cost analysis is to determine the net change in social welfare brought about by a new environmental policy, as measured by changes in the producer and consumer surpluses. In general, the economic effects of a new environmental policy result in many different people and firms being affected, both positively and negatively. The previous chapter looked at the positive effects ( or social benefits This chapter considers the negative effects ( or social costs). It is the sum of these changes, when combined with the social benefits, that yield a measure of the net changes in social welfare.

As with social benefits, when computing the social cost of a policy ( i. e., the negative impact on social welfare), monetary sums that measure changes in individuals' welfare are all weighted equally in benefit cost analysis. Other methods for evaluating the welfare consequences of policies on particular individuals groups, or sectors should be examined using either economic impact analysis, equity assessment techniques, or social welfare functions ( all described in Chapter 9).

This chapter is organized into four major sections followed by a concluding section. Section 8.2 reviews the theoretical foundations of social cost estimation for environmental policies. Section 8.3 discusses how to estimate and model total social cost. 1 Next, four types of models for estimating social cost are examined in Section 8.4. Then the estimation of the costs of specific regulatory approaches is reviewed in Section 8.5. Finally, Section 8.6 provides a discussion of the choice of tools for each type of policy . 8.2 The Theory of Social Cost Analysis The total social cost is the sum of the opportunity costs incurred by society because of a new regulatory policy; the opportunity costs are the value of the goods and services lost by society resulting from the use of resources to comply with and implement the regulation, and from reductions in output. These costs, however, do not take into account any of the health, environmental, safety, or other benefits which offset the social welfare costs.

The five basic components of total social costs are listed here in the general order of relative ease of estimation, and hence inclusion, in most social cost analyses of environmental policies. They include:

Real resource compliance costs: These direct costs are the principal component of total social costs and are associated with: ( 1) purchasing installing, and operating new pollution control equipment, ( 2) changing the production process by using different inputs or different mixtures of inputs, or ( 3) capturing the waste products and selling or reusing them. ( The last two options can actually result in negative compliance costs.)

These real resource costs should also include unpriced resources that have opportunity costs associated with them, such as unpaid labor diverted from other productive uses, and extra administrative costs associated with compliance. However, the pre tax compliance costs do not include any transfers, such as emissions taxes, licensing fees, or subsidies ( which are included in the firm's private costs).

113 Chapter 8 Chapter 8: Analyzing Social Costs 1 Several texts on applied microeconomics and policy evaluation provide substantially more theoretical depth and examples than the overview presented in this chapter, such as Arnold ( 1995), Gramlich ( 1981), and Just et al. ( 1982). Government regulatory costs: These include the monitoring, administrative, and enforcement costs associated with new regulations. This also includes the cost of setting up a new market when incentivebased regulations are established, such as tradable permits.

Social welfare losses: These are the losses in consumer and producer surpluses associated with the rise in the price ( or decreases in the output) of goods and services that occurs as a result of an environmental policy.

Transitional costs: These include the value of resources that are displaced because of regulationinduced reductions in production, and the private real resource costs of reallocating those resources. Offsetting these costs, in theory, are regulationinduced increases in resource use in both primary and related markets ( e. g., more workers and equipment are needed for pollution control).

Indirect costs: These other costs include the adverse effects policies may have on product quality, productivity, innovation, and changes in markets indirectly affected by the environmental policy, all of which may have impacts on net levels of measured consumer and producer surplus. 8.2.1 An Illustration of Social Costs and Externalities Exhibit 8 1 illustrates an externality ( pollution) associated with the production of a good or service ( Q). In this figure:

MR is marginal revenue from selling the good;

MPC is the marginal private real resource cost of production;

MSD is the marginal social damage from pollution associated with production; and MSC is the total marginal social cost of supplying the good.

The producer operates where marginal revenue ( MR) equals marginal private real resource costs ( MPC), so it produces Q1 items at a price of P1 per item. In this example the producer also is assumed to impose a social cost on society due to pollution associated with its production of Q. Here the actual pre policy total social cost of supplying the good is measured by the marginal private realresource cost ( MPC) plus the marginal social damage ( MSD, also known as an externality) caused by pollution. Together the MPC plus the MSD gives the true marginal social cost ( MSC) of supplying the good.

114 Chapter 8: Social Costs Price P4 P*

P1 P2 P3 0 Q* Q 1 Quantity DWL MSD MPC MSC F E G H MR Exhibit 8 1 Producer and Consumer Surplus with an External Cost The producer surplus is indicated by the area of triangle P1GP3 and the consumer surplus is measured as the area of triangle P1GP4, but the total social damage is indicated by the area of P3GF P2. Therefore, the deadweight loss to society ( DWL) is equal to the area of triangle EFG. If producers have to pay for the damage caused by the pollution, their producer surplus is reduced to area of triangle P2HP1 minus the area of triangle HGF. In this case the firm would be making negative profits since the area of triangle HGF is larger than their producer surplus. Net social welfare in this case would be the area of triangle P2EP4 less the area of triangle EFG ( the deadweight loss).

If, however, the optimal amount of the product is produced ( i. e., where MR equals MSC), then the firm's output is Q* at a price of P*. In this case, consumer surplus is equal to the area of triangle P4EP* and producer surplus is the area of triangle P2EP*. Since there is no deadweight loss to society, net social welfare has increased and is equal to the area of triangle P2EP4.

Suppose that producers can do nothing to reduce the pollution damages other than decrease the amount of output supplied. If the government places a tax equal to the MSD on each unit of pollution, this would increase private production costs ( but not private real resource costs) by the amount of the MSD, which would cause a rise in consumer ( taxpayer) welfare. This occurs because of the reduction in adverse health effects. Depending on the revenue policy of the government, it could lead to a possible reduction in consumer taxes, since producers are now paying an additional tax ( the double dividend hypothesis, which is described in greater detail later in this chapter). Although there is a decrease in the producer surplus ( and the obvious consumer surplus), the overall social welfare has increased because of the reduction in the externality costs. 2 Adding all of these surplus changes together, and subtracting the transfers to the government ( i. e., taxes), yields the net social cost of the policy.

If instead of an emissions tax, a firm is required to install pollution control devices, the private compliance costs will raise the firm's supply curve ( or MPC) up by the amount spent on the new equipment. Under a permit system, where a set number of permits are issued for each unit of pollution, and firms are allowed to buy and sell these permits then each firm will consider buying permits if the private cost of a permit is less than the unit cost of reducing pollution. Conversely, a firm that can reduce its pollution by less than the cost of a permit will consider selling its " extra" permits. In both cases, the firms' MPC curves will shift up by the price of the permits, just as it did in the case of an emissions tax.

8.3 A General Approach to Social Cost Analysis The challenge in developing an estimate of the social cost of an environmental policy is to consider the market( s) being affected by the policy, assess the available data and analytic methods, and adopt an analytic approach that will yield an estimate suitable for use in the benefit cost analysis An important requirement in measuring social costs is to characterize the supply and demand equations of the regulated market or behavior. This section briefly reviews the estimation of supply and demand equations and their relevance to social cost, but concentrates on the variety of social costs that may be encountered from different types of environmental policies: ( 1) direct social costs, ( 2) transitional costs, and ( 3) indirect costs. Finally, some other issues that arise in characterizing and presenting social costs are examined, including discounting, difficulties in monetizing costs, consideration of sensitivity analyses, and simplifying market effects.

8.3.1 Estimating the Supply and Demand Equations of All the Affected Markets Empirical estimates of the supply and demand curves for each market are usually needed to calculate the social costs of proposed regulations and policies. In addition to private sources, government reports and academic studies can provide useful information needed to estimate the 115 Chapter 8: Social Costs 2 If the regulation causes social costs to be greater than the MSD, then net social welfare may actually fall because of the new regulation; one cause being the diversion of investment capital to excess pollution control and away from its highest valued use. Chapter 8: Social Costs 116 supply and demand equations. 3 Solving these equations will yield equilibrium quantities and prices in each market that approximate the baseline figures.

In most situations, the supply and demand functions can be derived based on engineering cost estimates. For example a step function demand curve for a particular good can be computed based on the prices at which various segments of the market will turn to substitute goods. This technique is relatively more successful for products that are used as inputs to other processes and consumer goods that have well defined alternatives. Similarly, an estimate of producer surplus can be derived based on the value of plant and equipment dedicated to supplying a particular good, and the ease or difficulty with which this capital can be deployed in other markets to supply different goods. In the long run, the supply curve is often assumed to be horizontal

Information on the elasticity of demand is available for the aggregate output of most industries. When such information is unavailable, as is often the case for intermediate goods, the elasticity of demand may be quantitatively or qualitatively assessed. Econometric techniques, such as multiple regression, can be used to estimate a demand curve when sufficient data are available. For example, when dealing with intermediate products, econometric models can be constructed using engineering cost data to estimate both the supply and demand curves. In general, econometric tools are frequently used to estimate supply and demand equations and the factors that influence them.

Information on the availability of product or service substitutes the impact of price increases on final goods ( where the product or service is an intermediate good), the amount of a person's income devoted to the good or service and the necessity of the final product or service can be used to qualitatively assess demand elasticities. The estimate selected for the point elasticity should be consistent with the equilibrium point ( the time allowed for adjustments to occur) used in the analysis. Estimating the equations that govern market supply and demand may be time and resource intensive, in addition to the formidable tasks of developing the means to structure and compute the considered models. While many types of markets have been researched in detail by the academic community, others may be too new to have much information available. It may be difficult to obtain data from the affected firms or industries because of confidentiality provisions or the proprietary nature of some data and models. Achieving sufficiently reliable results will often depend on the quality of the data, and overcoming problems with data will be a primary hurdle in many social cost analyses.

<IP_ADDRESS> Definition of Elasticities In general, economists use the term " elasticity" to refer to the sensitivity of one variable to changes in another variable 4 The price elasticity of demand ( or supply) refers to changes in the quantity demanded ( or supplied) that would result from a change in the price of a good or service Changes are measured assuming all other things, such as incomes and tastes, remain constant. Demand and supply elasticities are rarely constant and often change depending on the quantity of the good. Therefore, when calculating elasticities, it is important to state the price and quantity of the good.

" Elastic" demand ( or supply) indicates that a small percentage increase in price results in a larger percentage decrease in quantity demanded ( or supplied). How much of the price increase that will be passed on to consumers is determined by the elasticity of demand relative to supply ( as well as the degree of competition within the industry and existing price controls). All other things equal, an industry facing a relatively elastic demand is less likely to pass on costs to the consumer because increasing prices will result in reduced revenues.

3 Sources can include trade publications, financial studies, and data collected through surveys administered in support of the regulation ( e. g., Section 308 surveys administered under the Clean Water Act for promulgation of effluent discharge limitations). Government agencies and the private sector also publish data and studies on the economic activity of the public and private sector and households. A more complete listing of examples is provided in Exhibit 9 3 on sources used to prepare economic profiles of industries. Additional illustrations can be found in existing EPA economic reports, several of which are referenced later in this chapter.

4 Own price elasticity of demand is defined as the percentage change in quantity demanded divided by the percentage change in price. Own price elasticity of supply is defined as the ratio of the percentage change in quantity supplied divided by the percentage change in price. <IP_ADDRESS> Determinants of Demand Elasticity Among the many variables that affect the elasticity of demand are: ( 1) the availability of close substitutes, ( 2) the percentage of income a consumer spends on the good, ( 3) how necessary the good is for the consumer, ( 4) the amount of time available to the consumer to locate substitutes ( 5) the level of aggregation used in the study, and ( 6) the expected future price of the good. In this section, only the first four will be discussed.

The availability of close substitutes is one of the most important factors that determine demand elasticities. A product with close substitutes tends to have an elastic demand, because consumers can readily switch to substitutes rather than paying a higher price. Therefore, a company is less likely to be able to pass through costs if there are many close substitutes for its product.

Whether the affected product represents a substantial or necessary portion of customers' costs or budgets is another factor that affects demand elasticities. When price increases occur for products that represent a substantial portion of downstream producers' costs or consumers' budgets, these producers or consumers may be more likely to seek alternatives. Where the product subject to the price increase is less important in customers' budgets, customers may be less motivated to use substitutes ( even if they are available) or to forego consumption entirely. A similar issue concerns the type of final good involved. Reductions in demand may be more likely to occur when prices increase for " luxuries" or optional purchases than for basic requirements.

The time frame considered is a third important factor in determining elasticity. Elasticities tend to increase over time, as firms and customers have more time to respond to changes in prices. A company facing an inelastic demand curve in the short run may experience greater losses in demand in the long run, as customers have time to make adjustments that allow use of substitutes or as new substitutes are developed. It is important to keep in mind that elasticities differ at the firm versus the industry level. For example, if twenty companies are producing pesticide formulations that are equally effective, each firm may face an elastic demand curve because of competition within the industry, although the industry as a whole may face an inelastic demand curve for its products as a group. In this example, it would not be appropriate to use an industry level elasticity to estimate the ability of only one firm to pass on compliance costs when its competitors are not subject to the same costs.

<IP_ADDRESS> Determinants of Supply Elasticities The elasticity of supply depends, in part, on how quickly costs per unit rise as firms increase their output. Among the many variables that influence this rise in cost are:

the availability of close input substitutes;

the amount of time available to adjust production to changing conditions;

the degree of market concentration among producers;

the expected future price of the product;

the price of related inputs and related outputs; and the speed of technological advances in production that can lower costs.

Supply elasticities will tend to increase over time as firms have more opportunities to renegotiate contracts and change production technologies.

Characteristics of supply in the industries affected by a regulation can be as important as demand characteristics in determining the economic impacts of a rule. For highly elastic supply curves, it is likely that costs will be passed through to consumers. The main determinants of industry supply curves are the structure of costs and the time period of the analysis. Industry supply curves are defined as the aggregation of the supply curves of individual firms within an industry.

If detailed financial profiles of individual establishments or categories of establishments and production data are available they can be used to define an industry supply curve. Explicit information on the cost structure of an industry is 117 Chapter 8: Social Costs very useful in predicting impacts more precisely than is possible using industry average data. A given firm may experience significant impacts if it is already a relatively high cost producer. Such firms would be more vulnerable to closure if subjected to high compliance costs.

<IP_ADDRESS> Obtaining Supply and Demand Elasticities Elasticity estimates may be obtained from existing literature or from original research. The use of published estimates avoids the time and expense of gathering the necessary data. Sources for published estimates include previous agency rule makings or relevant studies found in the economics literature. The analyst will have to employ careful judgement in deciding whether and how to use elasticity estimates from previous studies. Estimates should be drawn from studies based on:

similar market structure and level of aggregation;

sensitivity to potential differences in regional elasticity estimates;

current economic conditions; and appropriate time horizon ( i. e., short or long run).

This is not an exhaustive list of issues which must be considered in applying existing estimates to new analyses. There are a number of statistical and technical issues that may influence the quality of elasticity estimates. Relevant texts cited below should be consulted and technical assistance sought when necessary.

New or original estimates of elasticities are derived from demand and supply functions for goods or services that have been estimated using econometric methods. Econometrics is the use of statistical analysis in applied economic research. For example, the demand for a good or service is often estimated as a function of its price, the price of related goods ( substitutes and complements), consumer demographic characteristics, as well as variables that may represent institutional or technological characteristics of a market. Supply and demand elasticities may be derived from a variety of functional forms that embody various assumptions about the relationships between the data. Methods of calculating elasticity estimates differ according to the specification of the function. The analyst should consult relevant texts and seek technical assistance.

The availability of sufficient data, both in terms of quantity and quality, is the first threshold that determines whether econometric tools can be used. Only with sufficient data can elasticity estimates be considered reliable. The analyst should carefully document data sources. Once the decision to employ econometrics is made, there are a number of issues which the analyst must address, including the choice of an appropriate modeling technique, proper functional form, and ensuring that the mathematical properties required for the chosen technique to yield proper results are achieved. For example, ordinary least squares ( OLS) requires that:

values of independent variables are non stochastic or fixed;

expected mean value of the error term is zero;

expected value of the variance of the error term is constant;

no correlation exists between error terms; and no correlation exists between error terms and independent variables.

If any of these conditions are violated, the analyst will have to make a corrective adjustment to the OLS or consider an alternative econometric technique. For example, if one of the independent variables is endogenous, the first and last condition will be violated, resulting in a biased and inefficient coefficient estimate. In the context of estimating a demand function, the price variable is likely to be endogenous which would render the coefficient estimate and derived elasticity incorrect. A method known as two stage least squares ( TSLS) represents one means of accounting for endogeneity. The number of potential econometric approaches, mathematical requirements, and corrective measures is beyond the scope of this guidance document. Analysts should consult relevant texts for a more thorough discussion of all of these issues. 5 118 Chapter 8: Social Costs 5 For detailed review of econometric modeling and technical issues see Greene ( 1996), Maddala ( 1992), or Pindyck and Rubinfeld ( 1991). Kennedy ( 1998) provides a more intuitive discussion in the main text with detailed technical notes provided in appendices. <IP_ADDRESS> Uses and Substitutes Analysis A " Uses and Substitutes Analysis" may provide useful information on the characteristics of demand as a supplement to or substitute for elasticity estimates. 6 This is "... an indepth examination of each significant use of the substance in question, and an assessment of the costs, performance, and useful life of substitutes, on a product by product basis." 7 A " Uses and Substitutes Analysis" includes four steps:

1) define markets and segments of markets that are relatively homogeneous;

2) assess the cost and performance characteristics of the products in question;

3) identify the most appropriate substitutes; and 4) estimate the incremental costs and performance characteristics of the substitutes in each specific application.

The results of the analysis can then be used to generate demand functions, based on the price at which substitute products become economical for different uses. This analysis can be time and information intensive and may produce relatively crude results. It is nonetheless a useful alternative to estimating demand functions when elasticities are not available.

8.3.2 Determining the Different Types of Social Costs Having established measures of supply and demand, the analysis then considers how equilibrium price and quantities will change from measured baseline conditions. Social cost changes in each of the affected markets are assessed by examining the direct, indirect, and transitional effects that occur as a result of the new policy. The types of social costs that need to be examined to determine how the supply and demand equations change are summarized with examples in Exhibit 8 2. A short description of direct costs, which include private and public compliance costs, government regulatory costs, and other types of social costs, is presented. Other social costs less routinely included in empirical analyses of social costs, including indirect costs and the transitional costs, are then reviewed.

<IP_ADDRESS> Direct Social Costs The direct social costs of a new environmental policy arise from: ( 1) changes in the private real resource compliance costs, ( 2) additional government regulatory costs, ( 3) social welfare losses, and ( 4) transitional social costs. The largest fraction of direct social costs arises from the realresource compliance costs due to the new regulation. These new compliance costs arise from the installation, operation, and maintenance of new capital equipment, or are a result of changes in the production process that raise the price of producing the good.

The additional compliance costs can be used to estimate the new equilibrium price and quantity in the affected markets which will change social welfare. However, these changes will affect other markets, resulting in further price and quantity changes in other goods, giving rise to additional changes in social welfare. The significance of the changes in other markets will influence the type of model necessary for the economic analysis ( see Section 8.4, " Modeling Tools"). Changes in social welfare also result from increased government regulatory costs and transitional costs from plant closures and unemployment.

Private real resource compliance costs can arise from: ( 1) the capital costs associated with the purchase, installation, operation, and maintenance of new pollution control equipment, ( 2) changes in the inputs or mixtures used in the production process, or ( 3) the capture of waste products that can either be disposed of, sold, or reused.

Real resource costs are theoretically straightforward to calculate if they arise from the purchase of new pollution control equipment. For example, having information on the number of factories and the price of purchasing and operating new equipment required to meet a policy would provide a means of estimating the compliance costs for the industry. However, since all factories are not identical, costs may be estimated based on cost studies of representative factories 119 Chapter 8: Social Costs 6 Uses and substitutes analysis is described in Arnold ( 1995).

7 Ibid., p. 21. chosen by random sampling procedures, which can be extrapolated to the universe of affected factories.

Additional costs involve the operating expenses, maintenance and training associated with the new equipment Further costs may occur from maintenance changes in other equipment. Also, additional administrative costs may be associated with obtaining permits and preparing required monitoring reports. 8 In the two other methods of compliance, the private costs may actually be negative and thus need to be included for an accurate estimate of social costs. When waste products are captured and then disposed of, sold, or reused, the cost calculation is also straightforward. Disposal charges are easily determined and the selling price of the waste product ( if it is used as an input for other goods) can also be obtained. However, if the production process is changed so that different inputs are used or the mixture of the inputs is altered, the costs involved will be difficult to determine before the change takes place. In addition, the changes may be considered proprietary information.

Government regulatory costs are incurred by federal, state, or local governments to administer and enforce new policies. Government regulatory costs include: administration, training, monitoring/ reporting ( if they are not included in compliance costs), enforcement, litigation, and the cost of developing and distributing permits. These incremental costs must be financed through additional taxation or other governmental financing mechanisms.

Because they are hard to translate into producer and consumer surplus terms, governmental administration and enforcement costs are typically examined in terms of their dollar costs and staffing requirements ( expressed as full time equivalent employment ( FTEs)). Ultimately, these costs are borne by taxpayers unless other administrative costs are reduced to accommodate a new policy. Since government costs are usually small compared to the explicit compliance costs, they are not usually included in partial 120 Chapter 8: Social Costs 8 A good recent illustration of the measurement of compliance costs can be found in EPA ( 1997), Economic Analysis for the NESHAPS for Source Categories: Pulp & Paper Production; Effluent Limitations Guidelines, Pretreatment Standards: Pulp, Paper, and Paperboard Category, Phase I. For useful empirical presentations on engineering approaches, see Vatavuk ( 1990) for air pollution controls and EPA ( 1984) for a wider variety of pollution control technologies. Social Cost Category Examples Real resource Compliance Costs ° Capital costs of new equipment ° Operation and maintenance of new equipment ° Waste capture and disposal, selling, or reuse ° Change in production processes or inputs ° Maintenance changes in other equipment Government Sector Regulatory Costs ° Training/ administration ° Monitoring/ reporting ° Enforcement/ litigation ° Permitting Social Welfare Losses ° Higher consumer and producer prices ° Legal/ administrative costs Transitional Social Costs ° Unemployment ° Firm closings ° Resource shifts to other markets ° Transaction costs ° Disrupted production Source: Adapted from Harrington et al. ( 1999). Exhibit 8 2 Examples of Social Cost Categories equilibrium models. However, if they are significant, they should be estimated separately and added to the surplus based social cost estimates.

Monitoring and enforcement costs, incurred by the government, can be either ( 1) the opportunity costs of other activities that are discontinued because of fixed government budgets, or ( 2) the private costs imposed on taxpayers to support the increased government expenditure necessary for the program. The costs of government monitoring and enforcement efforts are normally based on the cost of necessary administrative activities. 9 Social welfare losses occur when real resource compliance costs result in higher prices for the good or service and when additional government regulatory costs result in higher taxes passed on to the consumer. New regulations may lead to increased legal and administrative costs for the government, as well as for the regulated entities. The change in social welfare resulting from an increase in taxes or fees assessed in order to pay for government regulatory costs will typically be small relative to social welfare losses attributable to the real resource compliance costs.

If the imposition of real resource compliance costs leads to an increase in the price of the good, this will lead consumers to either buy less or switch to substitutes thereby leading to a fall in the consumer surplus The amount of the private costs passed through to the consumer is determined by the market structure and the elasticities of demand, supply, and income. Once the prices, quantities, and elasticities are known, the process of calculating changes in producer and consumer surpluses is also theoretically straightforward. 10 Transitional effects vary depending on the length of the time period examined; therefore, social cost analyses should be explicit about the time frame being studied. In the short run, the private annualized costs of compliance, both for consumers and producers, will be higher relative to the annualized long run costs. This is because the shortrun analysis will not provide for possible adjustments in the production process, or allow consumers to find substitutes. Some workers may become unemployed in the short run, but will almost certainly find other jobs in the long run.

However, over time the impact of a policy can easily spread out to a variety of markets and result in a number of unanticipated adverse effects. Therefore, it is not always appropriate to assume that social costs arising in the short run as a consequence of transitional effects will be resolved in the long run. For EPA economic analyses, the four transitional effects most frequently considered include: ( 1) plant closings and resultant unemployment, ( 2) resources shifting to other markets, ( 3) transactions costs associated with setting up incentive based programs, and ( 4) disruptions in production.

Firm closings and unemployment: In the simplest static models, the time frame is assumed to be a period of time in the near future ( e. g., the first year after a new policy is promulgated). Surplus based measures of social cost are therefore short run estimates. But as time passes, adjustments are likely to occur. Workers who suffer transitional unemployment will usually find new jobs, and new plant and equipment installed in the future might require relatively less costly pollution control. These long run changes should be considered as the yearly social costs of a policy are calculated into the future.

In most cases, involuntary unemployment and plant closings are consequences that are difficult to model using a conventional partial equilibrium framework ( which will be discussed in the following section on modeling tools). Predicting these specific consequences would require far more detailed analysis and data than are usually available for practical assessments Unemployment rates for each group of workers the duration of unemployment, and the cost of job training programs are just some of the factors that 121 Chapter 8: Social Costs 9 A useful illustration of the measure of government regulatory costs for a rule can by found in EPA ( 1995a), Economic Analysis of the Title IV Requirements of the Clean Air Act Amendments.

10 An example of the steps taken to estimate the measurement of social welfare losses from a rule is EPA ( 1998), Economic Analysis of Effluent Limitation Guidelines and Standards for the Centralized Waste Treatment Industry. need to be taken into account when estimating how the transitional costs decline over time.

These temporary effects are typically assessed and reported as part of an " economic impact" of the policy and are incorporated into the development of the social cost section of an economic analysis. Chapter 9 of this document reviews such methods to assist in detecting situations in which a policy's private costs are sufficiently large to induce social costs from occurring as a consequence of business closures, reduced employment, or other such impacts.

Shifts of resources to other markets: These shifts occur when the payments to factors of production ( labor, land, and capital) are reduced. These shifts are partly responsible for the decreased output level of the product or service. Those that remain earn less than before, at least in the short run, which is reflected in the lower net price received by producers for the good or service. Some of the resources no longer employed in producing this good or service might even become unemployed for a while, such as labor, or be permanently and prematurely scrapped, such as plant and equipment. These and other realworld phenomena can change the position and slope of the supply functions in other markets. Likewise, consumers of the product either pay more for the same good or purchase substitutes that are less suitable or more costly, which can change the position and slope of several demand functions. The analysis of these types of effects is also treated more fully in Chapter 9.

Transaction costs: These costs are encountered with incentive based policies, such as with a tradable permits program. A market must be established so that the efficiency gains from trading permits are maximized and rules for trading are developed that enable the market to function under the rules of perfect competition. Therefore, initial short run costs associated with setting up the market will be high, but are expected to diminish over time as the created market begins to function with less government oversight The private cost of buying and selling permits will then become similar to the purchase of any other resource needed to produce a good or service. Disruptions in production: This may take place when new equipment is installed or new production processes or inputs are applied. These costs can be estimated as the amount of time the production line is stopped or slowed down to allow for the necessary changes to comply with the new policy regulations. However, if the changes are made during previously scheduled down time or required maintenance, then downward adjustments should be made to the estimated costs to reflect this.

To conclude, in many cases transitional costs are considered to be small enough that their inclusion in the overall social cost estimate would not appreciably alter the quantitative conclusions. However, when these are expected to be significant, the costs should be estimated. For example, lost wages and job search costs during the time workers are unemployed can be used as a proxy for this transitional social cost. Similarly, the value of prematurely retired plant and equipment can be calculated and added to the surplus based social cost estimates to capture this transitional effect, as long as this is not reflected already in the supply and demand framework.

<IP_ADDRESS> General Equilibrium ( Indirect) Effects Other possible components of social costs, such as effects on product quality, productivity, innovation, and market structure, can require fairly complex dynamic models to quantify. Although most individual regulatory policies will not have such dramatic effects, these costs can be quite significant in certain instances, such as when a policy's requirements delay industrial projects or affect new product development. Such policy effects have implications for future social costs but are difficult to measure and express in social cost terms. However, an effort should be made to qualitatively describe these factors and look at approaches that can quantify these effects when data and resources can support this level of detailed analysis of social costs.

Changes in market structure may occur if the expense of pollution control is sufficiently high that it drives out enough firms to cause changes in the market concentration and competitiveness of firms remaining in the industry. Such a change often results in shifts of both firm and industry supply curves, which can lead to changes in output and 122 Chapter 8: Social Costs prices in several markets affecting both producer and consumer surpluses.