Valuing the Environment as a Factor of Production

This chapter explores the theory and practice of measuring the economic costs and benefits of environmental changes that influence production, both in the context of firms and of households. The theory uses models of household and firm decision making to map the influence of environmental changes to changes in human welfare. The goal is to measure, by compensating or equivalent changes in incomes, the welfare effects on people, in their roles as owners of firms, owners of factors of production, and consumers. The developing country context is most common for valuing the environment as an input, because agriculture and natural resource extraction are so much more important than in industrialized countries.When households or firms produce goods for sale on the market, and the environment influences the costs of production, we show the circumstances when one can use information embodied in the supply curve of the marketed good or the demand curve for an input into the production of the good to extract welfare measures for environmental change. When the environment affects the cost of production of goods households produce and consume, we show the restrictions on production technology that will permit welfare measure for changes in the environment. We also look at circumstances that permit the calculations of bounds for the exact welfare measures. We explore welfare measurement under a variety of institutional structures, including government support for agricultural commodities and open-access fisheries. Exact welfare measurement makes extensive demands for data. Because these demands are not often met in practice, researchers resort to a variety of approximations of welfare measures. We assess these approximations, comparing them with the more exact measures.