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WWRC 88-11
An Analytical Basis for Valuing Potential and Realized Groundwater Protection Benefits in the State of Wyoming

Executive Summary

Groundwater is a valuable, renewable natural resource that, if contaminated by economic activities, may be rendered a nonrenewable, unusable, and mobile public hazard. Overall, 65 percent of Wyoming's population depends to some positive degree upon groundwater for its domestic water supply. This study surveys and synthesizes the existing literature about the economic value of groundwater contamination episodes, giving particular attention to extant knowledge about behavioral responses to parameter perturbations. Literature omissions are identified and an alternative ex ante valuation framework that incorporates risk attitudes, self-protection opportunities, and the use of market insurance to shift income to undesirable states is developed and its properties are derived. Finally, an empirical means to implement this framework by means of contingent valuation and hedonic property pricing methods is outlined.

Modern consumer economies create risks; they also reduce them. Other third parties often involuntarily bear the costs of these risks because of the nonexclusivity (inability to protect an asset) or commons problem and because commercial and industrial interests have neither a great incentive nor disincentive to account for environmental impacts in their decisions. Institutional designs for allocating the environment must often, therefore be created that substitute for simple private property forms. These designs will typically be developed in the legislative and the judicial arenas. Economic analysis helps the contestants in these political arenas to estimate the economic consequences to them of a given design or policy measure.

Assessments of the economic consequences of environmental change try to estimate those differences in wealth equivalents that will leave welfare intact, given a change or the prospect of a change. A complete assessment of economic consequences requires three kinds of information: (1) the differential changes that pollution or its control causes in production and consumption opportunities; (2) the responses of input and output prices to these changes; and (3) the input, output, and consumption changes that affected individuals make to minimize losses or maximize gains from prospective or realized changes in production and consumption opportunities and in the prices of these opportunities. Accurate information on the economic consequences of environmental hazards can be achieved only if the reciprocal relations between physical and biological changes and the responses of individuals and institutions are explicitly recognized.

The individual who is involuntarily exposed to an environmental hazard can self-protect by reducing his exposures (prevention) or by moderating the severity of the consequences of these exposures (cure). Alternatively, he can purchase market insurance or passively await deterrent actions by nonmarket public policy institutions. Determination of the appropriate mix of collective deterrent policies requires knowledge of individual self-protection behaviors.

The sparse existing empirical economics literature, e.g., Rancher (1983, 1986a,b), Sharefkin, et al. (1984), Shechter (1985a, b). Main (1986), Spofford, et al. (1986), and Smith and Desvousges (1986a, b, 1987), on groundwater and soil contamination hazards generally is of quite limited use in helping to determine this appropriate policy mix. All of it assumes that the probabilities of contamination occurrence and detection are fixed and exogenous. Much of it assumes that if a public policy of deterrence is adopted that no contamination will occur, while if no such policy is put in place, contamination will occur with some positive probability. Study settings are typically site specific, thus disregarding the extent of regional contamination and the influence of this contamination upon the availability of substitute water sources for the specific site. From an ex ante perspective, the possibility of regional contamination implies that collective risk and individual risk are indistinguishable.

This existing literature also typically adopts an ex post perspective of value, thus neglecting the influence of attitudes toward risk upon behaviors and the valuations that they imply. In addition, it pays no attention to risks that are less than life-threatening, and it proceeds in terms of objective rather than perceived risks. Explanations of behavior require the use of perceived risk.

The literature also commonly employs a positive discount rate to define future value streams in terms of their present values. In some instances, the presence of risk is said to justify an upward adjustment of this rate; in others, the implicit assumption is made that a high rate is justified because the individual lacks opportunities to shift wealth across time. Since a high discount rate results in smaller present values of the future benefits from risk reduction, an unjustifiably high rate biases future risk reduction benefits downward. If the individual has opportunities to adapt to a risk by redistributing his consumption and investment opportunities across time, a discount rate lower than the riskless rate of time preference is analytically justified.

A correct treatment of the valuation of the risks from groundwater and soil contamination requires attention to preferences over the timing of and the means of resolving uncertainty. At the most fundamental level, an ex ante rather than an ex post perspective is necessary. Because the ex post representation establishes a number of contingent states and proceeds to treat each of them as if it were certain, it is incapable of accounting for the decisionmaker's attitude toward risk; that is, as it measures the economic consequences of each presumed certain state, it disregards the expenditures that the decisionmaker makes in preparing for states that go unrealized. The individual's planned rather than his realized outcomes properly explain his choices. The expenditures on these planned outcomes include a risk premium because the individual is required to make a decision before the state of nature or its associated outcome is revealed. Failure to account for this risk premium can cause risk reductions to be undervalued.

A correct model of individual behavior when confronted by risk of groundwater and soil contamination must also recognize that the individual can influence the probability of a feasible outcome as well as the severity of any realized outcome. For example, he can purchase bottled water and he can obtain medical treatment. We demonstrate that a failure to account for these self-protection activities can lead to substantial underestimates of the value of a risk reduction. We also demonstrate that the marginal value of a risk reduction can be increasing when an ex ante perspective is adopted and individual behavior can influence both the probability and the severity of a particular outcome. It is also shown that these conditions do not allow willingness-to-pay value expressions to be rid of unobservable total and marginal utility terms. Similarly, self-protection expenditures cannot be interpreted as a lower bound on the ex ante value of risk reduction. We conclude that the ex ante value an individual attaches to a risk reduction opportunity will be a function of the relative prices of his self-protection opportunities, collective protection efforts, wealth, the extent and the price of his insurance coverage, and his degree of risk aversion. A random utility [MacFadden (1973)] representation of this function is proposed for empirical implementation by means of a contigent valuation approach and a hedonic propery pricing approach.

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