Environmental Problems: A Market Failure

Abstract

This chapter presents an economic perspective on environmental problems. Pollution, climate change, and all other environmental problems are considered by economists as negative externalities and market failures. To solve environmental problems, economic activity, which is intrinsically linked with nature and natural resources, needs to be controlled in such a way to achieve a social optimum where social welfare is maximized. A Pigouvian tax that puts prices on negative externalities in the form of environmental taxation is examined in this chapter as an example of environmental policy instruments designed to achieve a social optimum.

1 Consumer Benefit and Producer Benefit: Understanding Demand Curve and Supply Curve

Imagine you are sitting in a coffee shop with a cup of coffee in hand, flipping through the pages of this book. This one cup of coffee contains the basic elements of environmental economics. You (the consumer) derive a certain level of satisfaction from the consumption of a cup of coffee. The coffee shop (the producer) is also making some profit by selling a cup of coffee. The burning of gas to boil water for the coffee leads to the emission of carbon dioxide, which causes climate change. A cup of coffee has a lot to do with the benefits of consumers and producers and even environmental issues.

Just like this coffee analogy, the economic activities of consumers and producers, and environmental issues associated with coffee consumption can be viewed on the same footing; this is what environmental economics does. Economics, contrary to what the word sounds like, is not about making money. It studies the roles of the market and government in achieving a desirable society. Using the framework of economics, both environmental issues and economic activities can be understood within a unified framework.

What approach does economics use to clarify the roles of the market and government? This chapter will start with a review of fundamental concepts in economics (e.g., consumer behavior, producer behavior, supply and demand in the market), as they are essential for examining environmental problems from an economic perspective. We will then discuss how markets alone cannot solve environmental problems and consider effective policy options. Readers who already have a basic knowledge of microeconomics may skip this chapter and go on to Chap. 2.

1.1 Consumption of Goods and Consumer Benefits: Consumer Surplus

Even if you have never studied economics, you may have seen a diagram of the supply curve and the demand curve, where the price is determined at the intersection of two lines, as shown in Fig. 1.1. Let us first consider the demand curve to understand the consumer's behavior. In economics, products and services that individuals consume are called goods. The curve that expresses the relationship between the price and the quantity demanded for the good is called the demand curve. As shown in the figure, it is represented by a curve that falls to the right.¹ This curve shows that, as prices fall, the quantity demanded increases.

Fig. 1.1

Demand curve and consumer surplus for a cup of coffee. (Note The value on the y-axis [the price of coffee] determines the value on the x-axis [the quantity demanded])

Why do people consume goods in the first place? An economist's answer would be that it is because people receive utility (benefits) from their consumption. Suppose a coffee lover is willing to pay up to three dollars for a cup of coffee. This means the benefits from a cup of coffee are worth three dollars to this person. The utility obtained from one incremental unit of the good, a cup of coffee in this case, is called the marginal utility (also known as marginal benefits). Marginal utility generally decreases as the consumption of the good increases (which is called diminishing marginal utility).

Suppose you walk into a coffee shop and have a cup of coffee for three dollars. It was delicious, and you want to have more. But also suppose that you do not feel like paying three dollars for the second cup, so you leave the coffee shop. Economics explains this behavior as follows: the first coffee was purchased because its marginal utility is higher or the same as the actual price. However, you did not buy the second cup because the marginal utility was lower than the actual price. In other words, buying only one cup is a sign of diminishing marginal utility at individual level. If we aggregate individual demand curves, we can derive the downward sloping demand curve at the market level.

One could also explain the downward sloping demand curve at the market level as follows. For simplicity, suppose that each individual can have just one cup of coffee. The marginal utility of coffee varies across individuals. It may be zero for those who do not like coffee but remarkably high for those who love coffee. The varying marginal utilities are arranged from left to right in descending order of magnitude, and naturally, the demand curve is a downward sloping (in other words, the demand curve = marginal utility).

Sometimes you get more utility (benefit) than you paid for. Suppose that you desperately want coffee. There is an expensive-looking coffee shop in front of you, where a cup of coffee costs about ten dollars. But, because you really need a cup of coffee, you decide to go into the shop. Comfortable sofas and spacious tables with classical music playing in the background. You open the menu and are surprised to find that the coffee is only six dollars! You enjoy the cup of coffee with great satisfaction.

Here, we are seeing the following economic phenomenon. You really wanted coffee and your marginal utility of a coffee was ten dollars, but since the actual price was six dollars, you derive additional satisfaction from paying a price lower than expected. We can think of this four-dollar difference ($10 – $6) as a gain. This difference is called surplus (surplus = marginal utility – price). The sum of these gains for each individual in society is called consumer surplus. We can express consumer surplus as the difference between the demand curve and the price paid for a product. The consumer surplus of society as a whole corresponds to the gray triangular area in Fig. 1.1. In general, the lower the price, the higher the consumer surplus.

The shape of the demand curve is determined by a variety of factors. For example, consider gasoline, which is inseparable from environmental problems. If an alternative fuel for gasoline becomes cheaper, the demand for that fuel will increase and the demand for gasoline will decrease. In other words, the demand curve for gasoline moves downward. Conversely, the demand curve shifts upward if, for example, people's incomes increase and more people own cars, resulting in an increased demand for gasoline. A demand curve is formulated by taking out just two dimensions—the price and quantity demanded—while taking various factors into account.

1.2 Production of Goods and Producer Profit: Producer Surplus

Now, we turn to the behavior of producers. We will continue with gasoline as an example. For consumers to consume gasoline, there must be producers to produce it. To understand the behavior of producers, we use the supply curve. The supply curve represents the relationship between the price and the goods sold to the market. If the price rises, firms will increase their production in anticipation of profits. If the price falls, they will reduce production by, for example, shortening factory hours. As a result, the supply curve slopes upward to the right, as illustrated in Fig. 1.2.

Fig. 1.2

Supply curve and producer surplus

Suppose that a gas station that opens during the day on weekdays wants to increase its sales. The owner may open the business until late at night or on weekends. However, hiring people to work late at night or on weekends would require paying higher than normal wages. If gasoline sales per unit of time on weekends are the same or lower than on weekdays, the additional cost required to obtain a certain amount of sales will be higher than before.

The incremental cost required to increase the production (in this case, sales) of a good by one additional unit is called the marginal cost. As illustrated in the example of the gas station, the marginal cost increases as a firm's production increases. If the marginal cost is less than the price, then the firm can increase its profits by increasing its production volume. This means that a firm can maximize profits by producing at the output level where the marginal cost equals the price. It should be also noted that the marginal cost curve also tells us at what level of output the firm can maximize profits for a given price. Hence, the marginal cost curve of the firm represents the supply curve of the firm. The idea can be applied to the market as a whole; the marginal cost curve of the market is the supply curve of the market.

Using the supply curve, we can explain a firm's profit (or gain) from production and its behavior. Since the supply curve is a marginal cost curve, the area underneath the supply curve in Fig. 1.2 represents the variable cost of production. When the price is P, the quantity supplied is Q, and the shaded area represents the cost. Since the value of sales in the market is P × Q, it corresponds to just the rectangular area (area OPRQ). Therefore, the gray area, which is sales minus the variable cost of production, corresponds to the producer's “gain.” This gain is equivalent to the firm's profit before subtracting fixed costs (e.g., plant and equipment, rent for the store), and it is called producer surplus. Producer surplus generally increases with higher prices.

2 Why Are Markets Omnipotent?

2.1 Output and Price Decisions

Next, we use the supply and demand curves to show how the output and the price are determined in the market. In this book, we consider a competitive market, in which firms participating in a market act competitively, meaning that one firm cannot determine the price of a product solely on its own initiative. Even if a firm tries to sell for two dollars what others are selling for a dollar, consumers will still be able to buy the good for a dollar. In other words, no firm can ignore the prices of others.

We can find the equilibrium price and output in the market by drawing the supply and demand curves on a single graph, as depicted in Fig. 1.3. The equilibrium price is a price that balances the quantity supplied and the quantity demanded. Let P₁ be the market price. Then the demand curve determines the quantity demanded in the market at Q₁, while the supply curve determines the quantity supplied in the market at Q₃. The quantity supplied (Q₃) being greater than the quantity demanded (Q₁) causes a huge excess supply. The price of the good will then fall to sell the inventory at a lower price.

Fig. 1.3

Market equilibrium and social surplus

To what extent does the price need to fall to balance demand and supply in the market? If the price is P₂, then, contrary to what we saw earlier, the quantity supplied (Q₂) is less than the quantity demanded (Q₃). In this case, a shortage of the goods occurs, and consumers will be willing to pay a little more for them, so prices will rise. Demand and supply coincide and balance at Q₀, the point where the demand and supply curves intersect, i.e., when the price is P₀. A state of balance between supply and demand is called the market equilibrium, and the price at the market equilibrium is called the equilibrium price.

2.2 Socially Optimal Output

Moving away from market mechanism, we now consider the level of output that is optimal (or desirable) from society's point of view. In general, economists consider that society consists of consumers and producers. Hence, economists pursue policies and institutions that can maximizes the benefit for society, which is the sum of the consumers’ benefit and producers’ benefit.

If we increase the production of goods and provide them to consumers, the consumer's utility will increase. However, the production of goods requires costs. From a social point of view, it is necessary to consider not only the consumer's utility but also the cost and benefits of producers. The social surplus involved in the consumption and production of a good is the sum of the consumer surplus (benefits to consumers) and the producer surplus (benefits to the producer).

Let us consider the output level that maximizes social surplus (i.e., consumer surplus + producer surplus) by using Fig. 1.3. Let Q₁ denote the total output in the market. If the price is P₀, then the consumer surplus is represented by area P₀CDF, and the producer surplus by area P₀ABC. Is this output level (Q₁) socially optimal? No, because both the producer and consumer surpluses could increase further by slightly increasing production, which can be done without making any consumers and firms worse off. In other words, point Q₁ is inefficient because it does not realize a socially feasible surplus.

Then, what is the optimal level of output that maximizes social surplus? Suppose that the current output is Q₀. If the output level becomes slightly larger, the marginal cost at that output level will exceed the marginal utility. For example, if production and consumption were to increase to Q₃, the marginal utility would be less than P₀ (This is equivalent to the demand curve falling to the right). If the price remains at P₀, then the consumer is willing to pay is P₂, which is less than the price P₀. So, the consumer surplus will be reduced by the solid gray area.

On the producer's side, the cost (P₁) exceeds the price (P₀) as production increases to Q₃. As a result, the producer surplus also decreases by the amount of the striped gray area. Thus, when production exceeds Q₀, both consumer and producer surpluses decrease, and so does society's overall surplus. Here, the marginal cost is greater than the marginal utility, which means that you invest more than $10,000 to earn $10,000. Obviously, increasing production above Q₀ is not socially desirable. It is at Q₀ where the social surplus is maximized.

Let us recall the market equilibrium from our earlier discussion. In a competitive market, when price is P₀, output and consumption are in equilibrium at Q₀. Now, we can see Q₀ is exactly the socially optimal output.

It should be noted that at this level of output, the marginal cost of all firms is equal to the price because the condition for a firm to maximize its profit is to produce at the point where its marginal cost and the price are equal. Recall also that the marginal utility of every individual coincides with the price. Hence, social surplus is maximized when the price, marginal cost, and marginal utility are equal (price = marginal cost = marginal utility).

In a competitive market, the socially desirable output is naturally achieved by consumers buying as many goods as they want and by firms pursuing profit. The market is efficient in the sense that social surplus is maximized without government interventions and regulations.

3 Why Do Environmental Problems Persist? a Market Failure

So far, we understand that the market economy maximizes social surplus. Can we then leave everything to the market?　Should the government play any role in the behavior of businesses and consumers?

Market prices and output do not necessarily reflect all the factors associated with production and consumption. Production and consumption activities of a firm or individual may affect another firm or individual outside the market transaction. In that case, there is an externality in the sense that firms and consumers have an effect on others outside (or external to) the market. Although our discussion so far has ignored this problem, environmental and pollution problems are exactly this externality problem. Let us consider the social surplus in the presence of externalities.

3.1 External Costs

When gasoline is burned, carbon dioxide is emitted as a byproduct. Consumers of gasoline pay a price for gasoline but not for the byproduct. Climate change caused by carbon dioxide will lead to a rapid climate change and a variety of damages to the environment, which are not traded in the market but directly affect the victims of the environmental damages. These costs (in this case, climate change damage, health costs due to air pollution) that occur external to the market are referred to as external costs (or external diseconomies or negative externalities).

In a competitive market economy, even when people act in their own self-interest and companies pursue only their own profits, the socially desirable output is still achieved. However, this holds only in the absence of externalities like environmental problems. In a competitive market, what is external to the market (e.g., the consumption of gasoline causing climate change through byproduct carbon dioxide) is not considered. Producers are not likely to refrain from selling gasoline by considering the damage caused by climate change while having no quid pro quo. Likewise, few consumers would cut back on their gasoline purchases because they are concerned about the damage. That's because the damage is incurred outside the market transaction and not reflected onto prices. Some firms and consumers who are particularly concerned about the environment may take individual initiatives to reduce their gasoline consumption. However, unless the initiative is integrated in society at large, its effectiveness will be limited. As environmental problems are external to the market, they cannot be solved by market forces alone. In this sense, environmental problems are an example of a “market failure,²” a flaw in the market mechanism.

Box 1.1 Public Goods

Environmental problems persist in the marketplace owing to the characterization of environmental goods as public goods. For instance, people from urban areas with heavy traffic pollution travel to national parks with healthy environments for clean air. This is an example of goods (clean air) consumption.

How does clean air consumption differ from gasoline consumption? One person’s clean air consumption does not reduce another’s consumption. Therefore, people can enjoy the same clean air simultaneously. However, the same gasoline cannot be consumed by two people. This is called consumption rivalry. Clean air does not have rivalry characteristics; it is non-rivalrous in consumption.

Additionally, gasoline consumption can be prohibited to an individual, which is called the excludability of consumption. Meanwhile, clean air consumption cannot be prevented. Therefore, clean air possesses the non-excludability characteristic.

Goods satisfying the conditions of non-rivalry and non-excludability are called public goods. Clean air is a public good that benefits people. However, there are also negative public goods which costs people. Climate change is a negative public good satisfying these two characteristics. The rising water levels in Bangladesh does not reduce those of that in Netherlands (non-rivalry). In addition, no country is immune from the damage caused by climate change (non-excludability).

Conversely, climate change mitigation is a positive public good that mitigates climate change damage, a negative public good. Ratifying the Kyoto Protocol and reducing greenhouse gas emissions will mitigate climate change and benefit all countries (non-rivalry). Additionally, it is impossible to exclude certain countries from benefiting (non-excludability).

This is where the issue of free riding might occur, in which some countries benefit from other countries’ initiative to reduce greenhouse gas emissions but refuse to participate in climate change mitigation. If climate change mitigation is not equally implanted and reliance on others increase, it may discourage climate change mitigation among countries.

The United States (US) withdrew from the Kyoto Protocol, claiming that developing countries are free riders as only industrialized countries are obligated to combat climate change. Therefore, US also free-rides on the precautionary efforts of other developed countries. If all countries followed US, we would not benefit from the positive public good of climate change mitigation and suffer from climate change. Thus, positive public goods should not be supplied in a competitive market where people pursue their own interests. As environmental problems are considered public goods problems, the market is likely to suffer excessive environmental damage.

4 Economic Analysis of Environmental Problems

4.1 Social Loss in a Competitive Market

We have written that environmental issues are external to the market transaction and can cause harm to third parties who are not consumers or producers, but should we eliminate all external costs of pollution and environmental contamination? Should we aim for so-called “zero emissions” immediately, completely eliminating emissions altogether? We will answer these questions using the concept of social surplus.

Figure 1.4 illustrates gasoline consumption and the external cost of climate change resulting from the consumption. Gasoline consumption is expressed in the horizontal axis and the marginal external cost of the climate change damage (i.e., external cost that incurs as gasoline consumption increases by one unit) is expressed in the vertical axis. Similar to the relationship between total and marginal costs of a firm as described above, the area under the marginal external cost curve corresponds to the total external cost. The more production increases, the more the total external costs grow.

Fig. 1.4

Marginal external cost

By drawing the marginal external cost curve in Fig. 1.3, we can see the inefficiency of a competitive market in the presence of externalities, as illustrated in Fig. 1.5.

Fig. 1.5

A market with externalities

The costs of production on the part of the firm are called private costs to distinguish them from external costs. From a social perspective, the costs of producing a good include not only the private costs paid by the producer but also include external costs incurred by environmental problems. The sum of these private costs and external costs is called social costs. In a similar vein, the sum of marginal costs and marginal external costs is called marginal social costs, as illustrated in Fig. 1.5. When output is at Q₀, the social surplus is the sum of the producer and consumer surpluses (area KBC) if there are no external costs. However, given the climate change problem, we must subtract the external costs from the sum of the production and consumer surplus to compute the total surplus. Hence, the social surplus is the sum of the producer and consumer surpluses minus the external costs (i.e., area KBC—area KBDF) when output is Q₀. Here, a portion of the producer surplus and consumer surplus will offset the external costs of the environmental problem for the amount indicated by area KBEF. As a result, the social surplus is area FEC—area EBD. We can see that the social surplus is reduced by the presence of externalities.

4.2 Optimal Levels of Output and Pollution: Social Surplus Maximization

What is the optimal level of output when external costs like environmental problems are present? If we rely on the market mechanism, the external costs (i.e., environmental problems) will be excessive. Let us consider point E in Fig. 1.5 to find the answer. If the output supplied in the market is Q*, then the price is P*. The size of the consumer surplus is area P*EC, and the producer surplus is area KAEP*. In other words, the size of the consumer and producer surpluses combined is area KAEC. In this case, the magnitude of the external cost is area KAEF, so the social surplus is area KAEC—area KAEF = area FEC. Now, recall that the social surplus in the market equilibrium was area FEC—area EBD. By reducing output from Q₀ (the market equilibrium) to Q*, the social surplus increases by area EBD. It turns out that the social surplus is maximized at point Q* where the marginal utility (i.e., the height of the demand curve) equals the marginal cost plus the marginal external cost, namely, the marginal social cost.

Notice that the climate change problem has not been solved entirely, as the damage caused by climate change still exists (area KAEF). However, any further reduction in output will cause greater reduction in the benefits to consumers and producers than the reduction in damage. As a result, society will be negatively affected overall.

Social surplus is maximized when output is determined at Q*, while, in a competitive market, the consumption and production of goods that causes environmental problems will be excessive. Without government interventions, extra output will be produced as indicated by the difference between Q₀ and Q*. As a result, even though corporate profits increase, social surplus is lost by the amount of area EBD. This loss precisely corresponds to the loss to society due to environmental problems.

4.3 Is Achieving Zero Emissions the Right Thing to Do?

The term “zero emissions” has often been used as a keyword for solving environmental problems. The idea is to reduce waste and pollution to zero. In our gasoline example, zero emissions would mean zero gasoline use. In that case, the climate change damage caused by gasoline use may be reduced to zero. However, if this happens immediately, the profits of firms (producer surplus) from producing gasoline will also go to zero and so will the benefit of consumers (consumer surplus) from using gasoline. Many consumers would not agree with zero gasoline consumption (i.e., no benefit from the consumption) while recognizing the importance of environmental initiatives. For the sake of the argument, we assume in this chapter that there would be no change in technology. Technological advancements might enable us to achieve near zero emissions without reducing gasoline consumption. However, it is important to consider how much it will cost to develop the technology because zero emissions at an overly high cost would not be socially desirable, at least, in the short run.

5 How Can a Market Failure Be Solved?

5.1 Regulatory Instruments and Market-Based Instruments (Economic Instruments)

So far, we understood that the production of goods with external costs can be excessive and cause environmental problems if we rely on the market mechanism. It is desirable to reduce output to Q* (Fig. 1.5) by some means, and government intervention is needed to tackle environmental problems.

Here, the government can take two approaches. One is a regulatory instrument. In the simplest form, the government directly controls the output and pollution levels produced by firms. The other is a market-based instrument (economic instrument) with which the government aims to reduce pollution by exploiting the profit-seeking attitude of firms. Let us consider each of them below.

5.2 Administrative Solutions: Command and Control Regulation

With regulatory measures, the government directly regulates the producers and consumers who are responsible for the environmental problems. It is also known as command and control regulation in the example of climate change caused by gasoline consumption, one way is to limit the total amount of gasoline sold. That is, the government controls the output of gasoline in society as a whole as not to exceed Q*. Then, no matter how much price rises, firms cannot increase their production. In this case, the supply curve is perpendicular to horizontal axis at Q*, as illustrated in Fig. 1.6. The equilibrium price is P* where the demand and supply curves intersect as shown in the figure. The price is higher than it was before the regulation was imposed. As a result, the consumer surplus becomes smaller than it was before the implementation (area P*EC). If there is no income transfer, such as compensation for climate change damage, then the producer surplus is area KAEP*, which is not necessarily smaller than before the regulation took place. The damage from climate change remains as indicated by area KAEF. However, the social surplus is maximized, as indicated by area FEC.

Fig. 1.6

Regulatory instruments

Here, notice that the climate change damage by gasoline consumption is not borne by the firms producing and selling gasoline. It is the victims of the environmental harm who bear the cost. Of course, the government could oblige firms to compensate for the damage. In this case, too, it is sensible to choose Q* that maximizes social surplus.

5.3 The Tax Solution

Market-based instruments are designed to achieve a social optimum by exploiting the behaviors of profit-seeking producers and utility-maximizing consumers that cause environmental problems. An example of this approach is an environmental tax, which is a fee charged to the polluter that depends on the quantity of pollutants they release. A per unit tax should be set equal to the marginal external cost at the socially desirable output Q*; the per unit tax should be the line EA, as illustrated in Fig. 1.7. Now let t* denote the magnitude of this tax.

Fig. 1.7

Environmental taxation

The taxed firm will decrease its output because its marginal cost will rise by the amount t*. By recalling that the supply curve = marginal cost, we see the supply curve in the market will move up by t* as a result of taxation. To what extent does the market reduce output overall? The supply curve after taxation intersects the demand curve at P*. That is, the equilibrium price after taxation is P* and the amount of output is reduced to Q* (from Q₀ in Fig. 1.5).

In this case, the consumer surplus is equal to the size of area P*EC, which is the same as that in the case of the regulatory instrument. The difference is that by imposing the tax, the government increases its revenue by the size of area KAEG. As a result of the environmental tax, the producer surplus is area GEP*, which is smaller than in the case of the regulatory instrument. Note, however, that tax revenues will be returned to consumers, producers, or the victims of the environmental harm. As a result, the magnitude of the social surplus subtracting external cost from the sum of producer surplus, consumer surplus and tax revenue³, which is area FEC. Hence, the size of the social surplus would not change with either a tax or a regulatory instrument.

However, the consumer and the producer surpluses will vary depending on how the government distributes the tax revenue. The revenue can also be used to compensate the victims. This distinguishes taxation from regulatory measures where the victims bear the cost of environmental harm.

Environmental taxes put prices on environmental pollution and damages in the form of taxation. They are designed to internalize negative externalities associated with the pollution and damages. Firms are then induced to take account of these externalities in their production decisions. This is called the internalization of externalities. Environmental taxes are designed to maximize social surplus by appealing to profit-orientated firms to reduce their impact on the environment.

5.4 The Subsidy Solution

Another economic tool is the use of subsidies. It is a policy instrument to give polluters an environmental subsidy if they reduce their production. The subsidy gives firms incentives to do so because by reducing their production, they can decrease their costs and they even get subsidized by doing so. It is optimal to give a subsidy equal to the amount of the tax we just imposed (t*) for each reduction in the release of pollution. Then the output level that is in equilibrium output will be reduced to Q*, which is the point where the social surplus is maximized. It may be worth pointing out that subsidies are against the polluter pays principle despite their effectiveness.

5.5 Implementation Issues

The regulatory and market-based instruments share one major drawback: they both assume that policymakers can accurately estimate external costs. On the one hand, it is possible to estimate the demand and supply curves based on factors like market prices prior to the introduction of environmental policies. On the other hand, it may be difficult, if not impossible, to accurately quantify the cost of environmental problems,⁴ i.e., how much people are inconvenienced by them. Therefore, environmental policies in practice may not always be implemented in a way that maximizes social surplus.

Box 1.2 Economic Evaluation of the Environment

To solve environmental problems, internalization, which is internalizing external environment into the market, as an economic solution is necessary. Additionally, in internalization, a price must be attached to the environment. In environmental economics, the amount of money people are willing to pay to protect a certain environment is called Willingness to Pay (WTP).

Measuring WTP in an environment is a difficult task due to the following reasons: First, market prices for the environment do not exist as it is an external factor. Therefore, prices are indicated outside the market. Second, as the environment is considered a public good, free riding might occur and WTP will be difficult to obtain. Therefore, this raises questions such as what methods can determine the economic value of the environment?

The revealed preference method uses people’s WTP indirectly expressed in the market. The hedonic method, which is a part of this category, estimates WTP for environmental quality from asset prices. For instance, to what extent do people value “quietness”? This may sound like a difficult task but people indirectly reveal their WTP for quietness in the market. For example, quiet residential areas are more popular than noisy areas and people's preferences for quietness are reflected in land prices. Therefore, the hedonic method attempts to estimate WTP for environmental quality. Furthermore, land prices do not solely depend on noise level but also on various factors such as distance to the nearest station and town center. Land prices can be classified into these factors and WTP for quietness can be determined.

The travel cost method, another commonly used revealed preference method, measures the value of sites, such as national parks, based on the behavior of people visiting them. People travel to national parks, shoulder transportation costs, and pay entrance fees. This shows that the value of national parks surpass its incurred costs. Utilizing this information to estimate people's WTP for a park forms the basis of the travel cost method.

Contrastingly, the stated preference method involves the direct expression of people’s environmental values. The contingent valuation method (CVM) is a typical approach. A hypothetical questionnaire was used to determine people’s WTP to preserve their actual environment. Researchers conducted choice experiments to reveal respondents' preferences by presenting multiple options with different environmental attributes.

Readers can refer to Kolstad (2010) and Managi and Kuriyama (2017) for further details.