Chapter 13. Revealed Preference Methods

Nonmarket Valuation Methods

Travel Cost Method

• Most applications of the travel cost method (TCM) have been to value recreational sites. Suppose that we want to estimate the value of a particular recreational site. We expect that the quantity of visits demanded by an individual depends on its price, the price of substitutes, the person’s income, and variables that reflect the person’s tastes.
• The TCM recognizes that the full price paid by persons for a visit to a recreational site is more than just the admission fee. It also includes the costs of traveling to and from the site. Among these travel costs are the opportunity cost of time spent traveling, the operating cost of vehicles used to travel, the cost of accommodations for overnight stays while traveling or visiting, and parking fees at the site. The sum of all of these costs gives the total cost of a visit to the site.
• The clever insight of the TCM is that, although prices are usually the same for all persons, the total cost faced by each person varies because of differences in the travel cost component. Consequently, usage also varies, thereby allowing researchers to make inferences about the demand curve for the site

The Hedonic Price Method

• The hedonic price method can be used to value an attribute, or a change in an attribute, whenever its value is capitalized into the price of an asset, such as houses or salaries. This method offers a way to overcome problems from omitted variables and self-selection bias. It consists of two steps. Suppose one wants to estimate the value of a scenic view.
• The first step estimates the effect of a marginally better scenic view on the value (price) of houses (a slope parameter in a regression model), while controlling for other variables that affect house prices. This equation is called a hedonic price function or implicit price function. The change in the price of a house that results from a unit change in a particular attribute (i.e., the slope) is called the hedonic price, implicit price, or rent differential of the attribute.
• The second step estimates the WTP for scenic views, after controlling for “tastes,” which are proxied by income and other socioeconomic factors. To account for different incomes and tastes, analysts should estimate a WTP function.
• Value of statistical life: Similarly, if a person is willing to forgo an extra \$3,500/yr to increase the probability that he will not have a fatal on-the-job accident by 1/1,000, then he values his life at \$3.5 million (or more). The imputed value of life varies according to the initial risk and the additional level of risk people are asked to assume due to diminishing marginal utility for safety.

Defensive Expenditures Method

• A defensive expenditure is an expenditure in response to something undesirable, such as pollution. If smog improves (worsens) you may spend less (more) on having your windows cleaned. The change in expenditures can be used as a measure of the change in pollution.
• There are at least five problems with this method:
1) Reduced spending on a defensive expenditure underestimates the benefits of cleaner air.
2) It assumes people adjust quickly to the new equilibrium, such as new smog levels.
3) Defensive expenditure may not remedy entire the damage.
4) Defensive expenditures may have benefits other than remedying damage, which should be included.
5) Not all defensive expenditures are purchased in markets, for example, some people clean their own windows; changes in these “expenditures” should also be included.
• Value of a statistical life: This method estimates the value of life by observing how much people pay for life-saving devices, such as safety belts. If people are willing to pay an extra \$300 to reduce the probability that they will die by 1/10,000, then they value life at \$3 million.

Simple Valuation Methods

The Value of Time Saved, VTTS

In the absence of market imperfections (i.e., people can choose the number of hours they work and there is no unemployment), the wage rate is a first approximation of the marginal value of time. However, there are some problems in using the wage rate to value time saved:

• First, wages ignore benefits. As benefits are a form of compensation for work, they should be added to wages.
• People could be working while traveling or waiting and, therefore, time saved would be worth less than the wage rate (plus benefits).
• It should take account of taxes and, for people who are not working, use the after-tax wage rate (plus benefits).
• People value different types of time differently. Importantly, many people enjoy traveling.
• The wage rate may not be appropriate due to rigidities in the market or market failures.
• Firms may not pay employees their marginal social product.

The Value a Statistical Life, VSL

• Forgone earnings method - This method suggests the value of a life saved equals the person’s discounted future earnings. It generates higher values for young, high-income males than old, low-income females. For retired people, the resultant value of life may be negative. Conceptually, the main problem with this method is that it does not reflect what people are WTP for a small reduction in risk of their death.

Intermediate Good Method

• If a project produces an intermediate good that is not sold in a well functioning market, then its value can be imputed by determining the value added to the “downstream activity”: Annual Benefit = Income(with project) – Income(without project)
• This method can be used to value improvements in human capital, such as training programs, by comparing the average incomes of those in the program to those who are not.

Asset Valuation Method

• The impacts of a project or policy can be imputed from changes in the price for certain capital goods. For example, the “value” of noise can be inferred from comparing the price of a house in a noisy neighborhood to the price of a similar house in a quiet neighborhood. Changes in the market values of firms following a regulatory change can be used to estimate the change in producer surplus of the new regulations (an event study). An advantage of using prices is that information is quickly and efficiently capitalized into prices so that price changes or price differences provide a good estimate of the value of the policy change. Also, appropriate data are often available in machine readable form.

Problems with Simple Valuation Methods

• Omitted variable problem
• Self-selection bias