Chapter 5: The impact of perception on human behaviour
5.2 Definition, theoretical framework and limitations
5.2.1 Definition
In the field of economics, the value of natural environment is recognised because of its ability to satisfy human needs and wants. This economic theory of value is based on neoclassical welfare economics, stating that individuals’ well-being depends not only on consumption of private goods and the goods or services provided by the government, but also on quantities and qualities of non-market goods. Prices and quantity demanded in the market are used to measure changes in individual well-being resulting from consumption of goods, and this theory has been extended and applied to non-market goods. This theory assumes that an individual has a well-defined preference among a bundle of goods, and the goods consist of market and non-market goods. It is also assumed that individuals know their preference and this preference has the property of substitutability among the goods. This means that when individuals reduce their consumption of a market good, increases their consumption of a non-market good will put them at the same level of utility (Freeman III, Herriges and Kling, 2014).
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The substitutability between marketed and non-marketed goods creates a trade-off between the goods that matter to a person. By engaging in trade-off activities, this reveals the value that people place on those goods. Prices can be used to express the economic value of a particular good. A contingent valuation method, a method to infer individuals’ values for environmental goods which is based on the substitutability concept, can be divided into two: stated preference75 and revealed preference76 approaches. This dissertation uses revealed preference because, according to Freeman III, Herriges and Kling (2014), it reveals people’s actual choices made as compared to hypothetical responses in the stated preference method. It also avoids problems associated with hypothetical responses (Hicks, 2002), for instance, a tendency to overestimate the value of WTP (Hanley and Barbier, 2009). Thus, revealed preference, particularly averting behaviour (AB), is used in this chapter.
Abdalla et al. (1990) argued that when people are exposed to poor levels of environmental quality, they may choose to do nothing, pay the polluting firm or promote public actions to reduce the pollution, or take protective actions to mitigate the harmful effects. When people have few choices, they will choose an option that can maximise their utility. By selecting one option, they are engaging in a trade-off. The decision to choose a protective action by involving some costs to compensate for poor levels of environmental quality will put them at the same level of utility as they were before the deterioration of environmental quality. Protective or defensive action is known as averting behaviour (AB). In this dissertation AB is defined as any protective action taken with the intention to mitigate pollution emissions produced by LAMP (see Chapter 3 for a detailed definition).
There is an economic cost associated with AB, as the person must decide how much s/he should incur to reduce the environmental unpleasantness (Courant and Porter, 1981). In economic terms, the cost is called ‘averting expenditure’ or ‘avoidance cost’ (Mendelsohn and Olmstead, 2009). For instance, exposure to water pollution may be harmful to one’s health; thus, by purchasing a water filter system (averting expenditure), an individual can reduce the risk of falling ill.
75 A stated preference is a method that asks people directly about how much they are willing to pay
(WTP) or willing to accept (WTA) compensation as a result of environmental changes (Hanley and Barbier, 2009).
76 A revealed preference approach is a method that used to study people’s decisions by observing people’s
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5.2.2 Theoretical framework
The theoretical framework for AB is based on the household production model. This framework is used to examine the interaction between demand for market goods and the availability of the public good (Freeman III, Herriges and Kling, 2014). The AB model is based on the hypothesis of expected utility maximisation, where a household maximises its utility from consuming a composite of good (X) and environmental quality (Q) subject to budget constraints. When environmental quality deteriorates (or is perceived to have deteriorated), the household undertakes AB because this may affect its health and well- being, thus consequently affecting utility and productivity (Vásquez, Mozumder and Franceschi, 2015). Specifically, based on Um, Kwak and Kim (2002) that followed closely the study of Bartik (1988), the utility maximisation problem of a household can be written as follows:
𝑀𝑎𝑥 𝑈 (
𝑋,𝑄
𝑋, 𝑄)
𝑠. 𝑡. 𝑋 + 𝐷(𝑄, 𝑃) = 𝑌 (1)
where Q is environmental quality an individual is exposed to, which directly affects his/her utility; P is pollution level; D() is the averting expenditure (AE) function, showing that AE needs to reach a particular personal environmental quality at a specific pollution level; Y is income; X is the numeraire commodity; and 𝑈𝑥 > 0, 𝑈𝑄 > 0, 𝐷𝑃 > 0, 𝐷𝑄 < 0. Subscripts indicate partial derivatives. To find the change in income in order to maintain constant utility as pollution levels change, the Lagrangian with respect to P and Y is totally differentiated and the utility change is set equal to zero. Compensation in AB needed for a small pollution change is represented as follows:
𝜕𝑦
𝜕𝑥|𝑢𝑡𝑖𝑙𝑖𝑡𝑦 𝑓𝑖𝑥𝑒𝑑=𝐷𝑃 (2)
Thus, 𝐷𝑃 is the cost reduction with lower pollution level, and is also equal to savings in a household’s income. This model refers to the conventional averting behaviour model (ABM). For the perception ABM, pollution level (P) is replaced by the perceived pollution level (PP) and follows the same analysis as the above model. Now, household utility depends on the perceived exposure to pollution (PQ) and commodity (X). Averting expenditure (PD) is also based on the PP and PQ, and thus the household’s utility maximisation problem can be written as,
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𝑀𝑎𝑥 𝑈 (
𝑋,𝑄
𝑋, 𝑃𝑄)
𝑠. 𝑡. 𝑋 + 𝑃𝐷(𝑃𝑄, 𝑃𝑃) = 𝑌 (3)
where 𝑈𝑥> 0, 𝑈𝑃𝑄 > 0, 𝑃𝐷𝑃𝑃> 0, 𝑃𝐷𝑃𝑄 < 0, and PD () is the averting expenditure required to change the environmental quality from PP to PQ. PP is different from actual pollution, but functionally related to it:
𝑃𝑃𝑖 = 𝑃𝑃(𝑃𝑖, 𝐻𝐶𝑖, 𝑊𝐶𝑖) (4)
where 𝐻𝐶𝑖 represents the household’s characteristics and 𝑊𝐶𝑖 refers to other factors such as trust in the waste management processes of the firm, source of information received and distance from the firm. It is assumed that P indirectly affects the household’s utility through perceived pollution (PP), WTP for a perceived small change in pollution is:
𝜕𝑦
𝜕𝑥|𝑢𝑡𝑖𝑙𝑖𝑡𝑦 𝑓𝑖𝑥𝑒𝑑 = 𝐷𝑃𝑃 (5)
5.2.3 Limitations
According to Bartik (1988), ABM relies on four assumptions and these assumptions associated with some problems. First, averting expenditures are perfect substitutes for reduction in pollution and do not serve other purposes except for reducing pollution. However, AB and reduction in pollution are not perfectly substituted because not all health problems that arise from pollution can be totally solved using defensive measures. For example, when humans’ lungs have been affected by pollutants, the impact of having respiratory problems remain in the body. Also, defensive expenditure, for example the purchase of air conditioners, are not only filter out the pollutants, but can also serve as a cooling system.
Secondly, it is assumed that adjustment costs associated with reducing the amount of defensive expenditure are not significant. However, some defensive expenditures are costly to reverse once they have been undertaken, for instance, constructing a new well to avoid water pollution, or building thicker walls to reduce noise pollution. Thirdly, because a defensive expenditure function is assumed to be a well-known technical relationship, it can be calculated using scientific information without the need for behavioural estimation. But, the function is not known and must be estimated using information from household behaviour. Lastly, the model assumes government can
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influence pollution level. However, some pollution such as radon exposure is a naturally occurring phenomenon. Thus, it can be higher or lower than the permissible limit and the exposure of every house may be different.
In addition, according to Courant and Porter (1981), AB is not a good measure of WTP for a reduction in pollution. Let’s rewrite equation (1):
𝑀𝑎𝑥 𝑈 ( 𝐷 𝑄, 𝑋) 𝑠. 𝑡. 𝑄 = 𝑄(𝐷, 𝑃) 𝑌 = 𝑋 + 𝐷 where, 𝐷(𝑄, 𝑃) = 𝐷 → 𝑄(𝐷, 𝑃) = 𝐷−1(𝐷, 𝑃) Therefore, 𝑀𝑎𝑥 𝑈 [ 𝐷 𝑄(𝐷, 𝑃), 𝑌 − 𝐷] (6)
First order condition:
𝑈𝑄.𝑄𝐷 + 𝑈𝑥(−1) = 0
Rearrange the equation:
𝑈𝑄
𝑈𝑋
=
1
𝑄𝐷 (7)
Second order condition:
𝑈𝑄𝑄𝐷𝐷+ 𝑈𝑄𝑄𝑄𝐷2 + 𝑈𝑋𝑋− 2𝑈𝑋𝑄𝑄𝐷 = ∆< 0
The change in environmental quality yields,
𝑑𝑈 𝑑𝑃= 𝑈𝑋 𝑑𝑌 𝑑𝑃+ 𝑈𝑋(− 𝑑𝐷 𝑑𝑃) + 𝑈𝑄 𝑑𝑄 𝑑𝑃+ 𝑈𝑄𝑄𝐷 𝑑𝐷 𝑑𝑃= 0 = 𝑈𝑋 𝑑𝑌 𝑑𝑃+ (−𝑈𝑋+ 𝑈𝑄𝑄𝐷) 𝑑𝐷 𝑑𝑃+ 𝑈𝑄𝑄𝐷 𝑑𝑄 𝑑𝑃 = 0
= 𝑈
𝑋𝑑𝑌 𝑑𝑃+ 𝑈
𝑄𝑄
𝐷 𝑑𝑄 𝑑𝑃= 0
(8)The WTP for a reduction in pollution which refers to the change in income is,
𝑑𝑌 𝑑𝑃
= −
𝑈𝑄 𝑈𝑋𝑄
𝑃= −
𝑄𝑝 𝑄𝐷< 0
(9)However, the change in AB is,
𝑑𝐷 𝑑𝑃
= −
𝑄𝑃 𝑄𝐷+
(𝑄𝐷.𝑄𝐷𝑃−𝑄𝑃.𝑄𝐷𝐷 −𝑄𝐷∆𝑈
𝑄 (10)120
The above equations (9 and 10) show that both AB and WTP are not the same. This result is similar to the finding given by Courant and Porter (1981) that found that when environmental quality does not or does enter directly into the utility function, AB underestimates or does not provide a clear estimate of WTP when environmental quality improves.
In brief, AB is a theoretically incorrect method to value environmental quality because it does not measure consumer surplus. However, this method has been widely used by scholars to indicate people’s willingness to pay for environmental goods. Despite its limitations, AB calculates the costs incurred, although inaccurate, by respondents to protect themselves from their perceived adverse environmental impacts. Moreover, previous AB studies show that people behave according to scientific data and/or perception and hence has a policy implication to reduce costs incurred by the public. Also, people’s actions are not only affecting their welfare, they also affect Lynas’ performance and profit, as mentioned in Chapter 1.