115 terms

Public Economics

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Public Economics
The study of the role of the government in the economy
Governments carry out three categories of economic activity:
1. Regulation: They regulate and enact laws to create and amend property rights

2. Price setting: They set prices directly or through taxes and subsidies

3. Production: They produce a wide range of goods e.g. law and order, education, defense
Government actions/activities have two important consequences:
1. They alter incomes

2. They change incentives
When should the government intervene in the economy?
1. Market failure

2. Redistribution
Market failure
Market failure is a situation in which the allocation of goods and services is not efficient or does not maximize efficiency e.g. monopoly, externalities, public goods, asymmetric information
Redistribution
Shifting of resources from some groups in society to others

**This happens due to the fact that efficient outcomes may not be equitable
How might the government intervene?
1. Use the price mechanism: tax or subsidize private sale or purchase

2. Restrict or mandate private sale or purchase

3. Public provision

4. Public financing of private provision
What are the effects of alternative interventions?
1. Direct effects

2. Indirect effects
Direct Effects
Those that would be predicted if individuals did not change their behavior in response to the interventions
Indirect Effects
Effects that arise only because individuals change their behavior in response to the interventions
Political Economy
Theory of how governments make public policy decisions
Government Failure
May not always choose efficient or social desirable outcomes
Market Efficiency
An economy is efficient if it provides the maximum amount of goods that people want, given the resources available

**Widespread belief that production by the private sector is more efficient

General competitive equilibrium, the conditions for Pareto efficiency, Pareto efficiency and the market
Pareto Improvement

(Part of Pareto Efficiency)
Occurs when it is possible to make at least one person better off without making anyone else worse off
Pareto Optimum/Efficiency
A situation where it is no longer possible to make any Pareto improvements

Society has reached a Pareto optimum when it is impossible to make one person better off without making someone else worse off
2 Fundamental Theorems of Welfare Economics
1. A general competitive equilibrium is efficient

2. If preferences and technology are convex, any Pareto efficient outcome is competitive equilibrium for some pattern of initial endowments
General Competitive Equilibrium (GCE)
2 main properties:

1. Competitive behavior: Households and firms are price takers

2. Demand = Supply in all markets

*Characterized by consumer optimization, cost minimization, and profit maximization

*A general competitive equilibrium is a set of prices for the factors of production and goods, where all agents are price takers and all markets clear
Consumer Optimization
Consumers maximize utility subject to income, prices, and preferences
Pareto Efficiency Requires:
1. Efficiency in Consumption or Exchange Efficiency

2. Efficiency in Production or Production Efficiency

3. Efficient Allocation of Resources or Allocative Efficiency
Exchange Efficiency
Goods are distributed so that no one can be made better off without making some else worse off

Occurs at the point of tangency between the two agents' indifference curves & also where their MRS's are equivalent

*Used in understanding Pareto improvements & efficiency
Production Efficiency
Production efficiency is a situation in which the economy could not produce any more of one good without sacrificing production of another good

Pareto efficiency occurs at the point of tangency between the isoquants & where the two agents' MRTS's are equivalent
Allocative Efficiency
Allocative efficiency is where a market produces only the types of goods and services that are most desirable in the society and are also in high demand. Allocative efficiency occurs where a good or service's marginal benefit is equal to its marginal cost.

This occurs where the MRS (how much extra of Y consumers need to be given to compensate them for marginally less of X) for each agent is also equivalent to the general MRT (how much more of Y can be produced if firms produce marginally less of X)
Interpreting Pareto Efficiency
1. No society above and beyond individuals

2. Individuals are the best judges of their own welfare and choose what is best for themselves

3. Social welfare said to increase if at least one person's welfare has increased and no one else's has fallen

*Pareto efficiency says nothing about equity
Rationales for Government Intervention:
1. Market failure including public goods, externalities, asymmetric information, monopoly

2. Merit goods

3. Redistribution

4. Stabilization
Social Welfare
The level of well-being in a society

This is determined both by social efficiency and by the equitable distribution of society's resources

This can be achieved by shifting available resources among individuals and letting them trade freely (2nd fund. theorem of welfare economics)

*Society usually faces an efficiency-equity trade-off
When equality means more efficiency
An increase in equality can sometimes lead to a Pareto Improvement (no efficiency trade-off)

Examples found in:
1. Externalities (Crime and Altruism)
2. Social Insurance
3. Imperfect Capital Markets
Altruism
People may care about aspects of the welfare of other individuals

Some are paternalistic and care about aspects of consumption (health, food)

Others dislike inequality or poverty--have views on just distribution of income which enters their utility function

Each individual has some altruistic feeling towards the other agent--> a transfer from one to the other leads to strict Pareto Improvement

*There is incentive to free-ride on giving to others--could benefit from an income tax system which could lead to a Pareto Improvement and those who care gain also
Crime
Individuals may be affected by others actions

Crime, particularly economic crime is linked to inequality and relative poverty

Reducing poverty would reduce crime generating benefits for society
Social Insurance
Insurance is widely provided but there is some market failure in the insurance market providing a rationale for gov intervention

Private insurance is limited or not available in certain circumstances--disability, unemployment, old age, ill-health, divorce

A significant degree of ex-post redistribution can be associated with a Pareto improvement ex-ante
Imperfect Capital Markets
Some people may not be able to get loans due to asymmetric info

Gov loans or direct provision of subsidized investment goods, such as education and training, provide a means for people lacking assets to invest in their future

May not be Pareto improving if looked at, at a point in time, however, it may be efficient over the lifetime of the investment provided the return on the investment excessed the OC of capital
Income Redistribution Has External Benefits:
1. Makes altruistic donor happier

2. Reduces propensity to engage in economic crime

3. Eases access to capital markets

*Can help correct market failures, sometimes yielding Pareto improvements

*Can also lead to other distortions in the economy
Social Choice
Models the government's equity efficiency decisions in the context of a social welfare function (SWF)

A SWF maps the set of individual utilities in society into an overall social utility function

In this way the gov can incorporate the equity efficiency trade-off into its decision making

*If policy is associated with redistribution that is valued by society, the redistribution might compensate for a decrease in efficiency and lead to an overall increase in social welfare

*If gov cares about efficiency only then a comp. market is most efficient and is also the welfare maximizing outcome

*If gov cares about the distribution of resources the most efficient outcome might by the one that makes society best off
Utilitarian SWF
Society's goal is to max the sum of individual utilities

Utilities of all individuals given equal weight

Summed to get total social welfare

Should transfer from individual 1 to individual 2 as long as the utility gain to person 2 is greater than the utility loss to individual 1

Society is indifferent between one util for a poor person and one for a rich person

Not indifferent between giving $1 to a poor person and $1 to a rich person

In general, wants to redistribute $1 from rich to poor

If individuals are identical and there is no efficiency cost of redistribution,t he Utilitarian SWF is maximized with a perfectly equal distribution of income
Rawlsian SWF
Society's goal should be to maximize the well-being of its worst off member

Social welfare is maximized by maximizing the well-being of the worst-off person in society

If individuals are identical and redistribution does not have efficiency costs, the SWF would call for the equal distribution of incomes, as does the Utilitarian SWD

Only when income is equally distributed is society maximizing the well-being of its worst-off member
Utilitarian and Rawlsian SWF
Once we recognize that redistribution can entail efficiency costs the two SWFs do not have the same implications

In a world of equity-efficiency trade-offs, a Rawlsian SWF will in general suggest more redistribution than will a Utilitarian SWF
Pure Public Goods
1. Non-excludable

2. Non-rival in Consumption
Non-excludable
Once a good is provided, it is either physically impossible or prohibitively expensive to prevent users from consuming the good

Ex: Street lighting, national defense, lighthouses, fireworks
Non-rival in Consumption
A good or service is non-rival in consumption if the consumption of one person does not affect the quantity available for consumption by others

The MC of supplying to an additional user is zero

Ex: Street lighting
Impure Public Goods
Goods that satisfy the two public good conditions to some degree but not fully

Two types of impure public goods:
1. Some goods are excludable but not rival
Ex: Cable TV

2. Others are non-excludable but are rival in consumption
Ex: A crowded public road
Private Goods
Are excludable and rival

Ex: A bottle of water

*Value consumers place on private goods is given by the MB curves

*Overall value of a private good = horizontal summation of individual MB curves
*See graph
Public Goods and Optimal Provision
Partial equilibrium model: efficient level of production is where MB = MC

Public goods are non-rival so all consumption is at the same quantity of the good or service

Once a public good is provided, both A and B benefit so the aggregate value of the goods i given by the vertical summation of individual MB curves

Optimal level of provision of public good is where the sum of MBs = MC
*See graph
Public Goods
Cost of provision of public goods is high

If consumers do not place sufficient value on the good complete market failure occurs and the good is not provided

If the overall MC is greater than an individual's MB then that individual will not want to pay to have the good provided
*See graph

If the overall sum of MBs of individuals are > MC the good should be provided
Free Riding
Consumption or use of a good without making a payment

*The market does not provide the efficient amount of public goods due to the free rider problem

When more than one person is consuming a public good, there is an incentive for others not to contribute to the provision of the good and free-ride

If everyone free rides no one will contribute and the good will not be provided

Ex: Prisoner's Dilemma Game
Private Firms and Public Goods
Private firms will not provide pure public goods because firms supplying public goods will make losses since they cannot exclude free riders

Even if they charge P>0 the outcome is inefficient and results in a loss of consumer surplus
3 Factors Likely to Determine the Success of Private Provision
1. Differences among individuals in their demand for the public good: Higher incomes or stronger tastes for public goods can mitigate the free rider problem toe one extent but are unlikely to solve the problem

2. Altruism/Social Responsibility: People care about the outcomes of others as well as themselves

3. Warm Glow: A model of public good provision in which individuals care about the total amount of the public good and their particular contribution as well
The Free Rider Problem: Economists vs. Sociologists
Economists believe that individuals are self-interested and therefore will free ride and fail to contribute

Sociologists believe that altruism and a belief in the collective motivates people to contribute
Ledyard and Free Riding
Ledyard surveyed experimental work on the levels of contribution toward public goods

Found that nearly every public good experiment results in 30-70% of the participants contributing to the public fund

*Results show that individuals are altruistic and are motivated by social norms and group identity

*Participation is higher in smaller groups and where there is a higher level of communication
Club Solutions
Private solution which is possible only when the good is excludable in some way

Important that the good is excludable so that it is possible to charge a price and there are no free rider problems

Incentive to set up clubs to provide the good

Ex: Swimming pool or Golf club

*Incentive to encourage membership to share the cost

*Optimal club size is where MC = MB
Complementary Goods
Private firm may provide a public good when it is jointly supplied with a private good

Charge for the good that is excludable and cross-subsidize the public good

Ex: Beach and sun-loungers or Trade unit ions and wage negotiations
Gov Provision of Public Goods
Gov has to finance the provision of public goods

Financed through taxes

*Finding the overall valuation of public good requires collective action (due to probe of preference revelation and free riding)
Preference Revelation
Giving details to the provider of the public good of one's own valuation of consumption of the good

*May be problematic for gov to obtain truthful valuation of a public good because consumers may or may not believe that their payment for the public good will be determined by their stated valuations
No Link Between Payment and Stated Valuation (Fixed Cost)
If customers face a fixed charge regardless of their valuation they may overstate or understate their valuation in order to influence the outcome

*See table example
Payment is Determined by the Stated Valuation
Similar to free riding problem

Even those who place a high value on the provision of the public good will be tempted to understate the value of the good in order to reduce the amount they have to contribute
Revelation Mechanism
A scheme that makes it rational for individuals to reveal their true private valuations of a public good

Ex: Clarke Tax
Clarke Tax
A tax solution to the problem of consumers failing to reveal their true preferences (designed to make revelation of true preferences the dominant strategy)

Make each consumer feel that their behavior is critical, so that they are not tempted to free-ride by failing to contribute or over/understate their valuations

Consumers asked to state their net value (NV) of the public good--good produced if the sum of NV > 0

*Each consumer treated as a possible 'pivotal agent' where the revelation of their preferences could change the level of provision of the public good

*Use tax to make people pay (or get rewarded) for the externality
Pivotal Agent
Consumer who changes the decision from provision to non-provision or vice versa

The Clarke Tax is designed to impose the full social cost of the decision of pivotal agent upon that consumer, i.e. to internalize the externality

*A consumer is pivotal if their inclusion changes the group's decision

A pivotal person influences the collective outcome and imposes an external cost or benefit on others

*Not pivotal = no tax
Clarke Tax Summary
Eliminates the incentive to lie about valuations

Difficult and costly to administer when numbers increase

If taxes are not redistributed--loss in consumption

Will only work if the agent's valuation of the public good does not depend on their income
Public Provision of Public Goods Problems
Crowd-out

Measuring costs and benefits of public goods: preference revelation, preference knowledge, preference aggregation

Political Economy
Externalities
Externalities arise whenever the actions of one party make another party worse or better off, yet the first party neither pays the costs nor receives the benefits of doing so

Externalities can arise either from the production of goods or from their consumption and can be negative or positive
Negative Production Externality
When a firm's production reduces the well-being of others who are not compensate by the firm

Ex: Water pollution, fumes, noise, smog

*Too much of the good is produced by the market--inefficient outcome (SMC curve lies above PMC curve)
Negative Consumption Externality
When an individual's consumption reduces the well-being of others who are not compensated by the individual

Ex: Smoking, driving SUVs, listening to loud music

*Too much is consumed--inefficient market outcome (SMB curve lies below PMB curve)
Positive Production Externality
When a firm's production increases the well-being of others but the firm is not compensated by those others

Ex: R&D, developing new production methods or new products which can be used by others

*Too little of the good is produced by the market--inefficient outcome (SMC curve lies below PMC curve)
Positive Consumption Externality
When an individual's consumption increases the well-being of others but the individual is not compensated by those others

Ex: Improving one's garden, education, vaccinations

*Too little is consumed--inefficient market outcome (SMB curve lies above PMB curve)
Depletable Externality
The consumption of the externality by one agent means it cannot be consumed by another

Ex: If a bee pollinates a tree in one orchard it cannot be pollinating another
Non-Depletable Externality
One person's consumption of the externality does not diminish another agent's ability to suffer/benefit from the externality

Externality is non-rival and will share some of the characteristics of a public good

Ex: Climate change and global warming, depletion of the ozone layer, acid rain
Externalities and Market Failure
In the absence of market failure social costs = private and social benefits = private benefits and competitive markets yield a Pareto-efficient outcome

Whenever there is a divergence between private costs and social costs or between private benefits and social benefits the result is inefficiency
Private Benefits and Costs
Costs and benefits borne directly by the actors in the market (consumers and producers)
Social Benefits and Costs
Private benefits and costs plus the benefits and costs to any actors outside the market who are affected by production or consumption
Private Marginal Cost (PMC)
The direct cost to producers of producing an additional unit of a good
Social Marginal Cost (SMC)
The private marginal cost to producers plus any costs associated with the production of the good that are imposed on others
Private Marginal Benefit (PMB)
The direct benefit to consumers of consuming an additional unit of a good by the consumer
Social Marginal Benefit (SMB)
The private marginal benefit to consumers minus/plus any costs/benefits associated with the consumption of the good that are imposed on others
Externalities and Efficiency
Pareto efficiency requires that SMC = SMB

Markets produce where PMB = PMC

If SMC = PMC and SMB = PMB the market outcome is efficient and is inefficient otherwise (there are externalities)
Private Sector Solutions to Externalities
Internalizing the externality: when either private or gov actions lead the price to the party to reflect fully the external costs or benefits of that party's actions

Integrating different types of businesses may be a way of dealing with externalities e.g. a firm may incorporate another firm that generates externalities as part of its business
Ex: orchard and bee-keeper

Contracting between parties
Ex: orchard owner and bee-keeper
Coase Theorem
When there are well defined property rights and costless bargaining, then negotiations between the party creating the externality and party affected by the externality can bring about the socially optimal market quantity

Private parties will be able to solve the problem of externalities

Coase Theorem suggest a very particular and limited role for the gov in dealing with externalities:
-Establishing property rights: If the gov can establish and enforce those property rights, then the private market will do the rest

The efficient solution to an externality does not depend on which part is assigned the property rights, so long as someone is assigned those rights

*Won't help with large-scale, global externalities like climate change or global warming--meant for small-scale, localized externalities
Problems with Coasian Solutions
Assignment Problems: Coasian solutions are less likely to occur as the number of parties involved increases (effective for small, localized externalities)


The Holdout Problem: Shared ownership of property rights gives each owner power over all the others--one or more owners of the property rights may hold out for a bigger payout in terms of compensation

The Free Rider Problem: When an investment has a personal cost but a common benefit, individuals will underinvest

Transaction Costs and Negotiating Problems:
Very difficult to negotiate when there are large numbers of individuals on one or both sides of the negotiation
Public Sector Solutions to Externalities
3 types:

1. Corrective Taxation
2. Subsidies
3. Regulation

*Govs prefer regulation, economists say taxes and subsidies
Corrective Taxation
Taxes change the PMC and can be used to internalize the eternality

"Pigouvian tax"
A tax that corrects an externality
Subsidies
Government payment to an individual or firm that lowers the cost of consumption or production
Regulation
Government can use regulations to deal with externality problems e.g. quantity restrictions, bans, input or technological requirements
Social Insurance Programs
Government interventions to provide insurance against adverse events e.g. earnings loss due to retirement, death, job loss or disability
Asymmetric Information
Occurs when one individual or organization knows something that another individual or organization does not

2 forms:
Hidden action and hidden knowledge
Moral Hazard
Hidden action is called moral hazard

Moral hazard is when information about action is hidden from one party to a transaction e.g. when insurance company cannot observe the insured person's behavior

A person who is insured against an adverse event may be less careful e.g. may drive faster
Adverse Selection
Hidden knowledge is called adverse selection

Adverse selection is when knowledge about characteristics is hidden from on party to a transaction e.g. when an insurance company does not know about health risks such as family history of heart disease
Insurance
Individuals or firms pay insurance premiums to an insurer (which can be a private firm or government) and in return the insurer promises to make some payments to the insured party, or to others providing services to the insured party

Payments are conditioned on a particular event or series of events
Consumption Smoothing
The translation of consumption from periods when consumption is high, and thus has low marginal utility, to periods when consumption is low, and thus has high marginal utility

Individuals value insurance as it allows them to smooth consumption over states of the world
States of the world
The set of outcomes that are possible in an uncertain future

Individuals choose across consumption in states of the world by using some of their income today to buy insurance against an adverse outcome tomorrow
Why do Individuals Value Insurance?
Individuals will demand full insurance in order to fully smooth their consumption across states of the world

In a perfectly functioning insurance market, individuals will want to buy insurance so that they have the same level of consumption regardless of whether the adverse event happens or not
Expected Utility Model
The weighted sum of utilities across states of the world, where the weights are the probabilities of each state occurring
Actuarially Fair
An insurance premium that is set equal to the insurer's expected payout
Optimal Insurance
Full insurance is optimal even if it is expensive so long as the premium is actuarially fair individuals will want to insure themselves fully against adverse events
Risk Aversion
The extent to which individuals are willing to bear risk

Very risk averse--rapidly diminishing MU(C)--happy to sacrifice some consumption in the good state to insure against large reductions in consumption in the bad state

Less risk averse--slowly diminishing MU(C)--aren't willing to sacrifice very much int he good state to insure against the bad state

Individuals with any degree of risk aversion will want to buy insurance when it is priced actuarially fair
Asymmetric Information and Adverse Selection
Information asymmetry can arise in insurance markets when individuals know more about their underlying level of risk than do insurers--adverse selection

Can cause the failure of competitive markets

Used car market example: 'lemon'

Buyer of insurance knows more than the seller

Seller worried only high risk individuals will purchase insurance
*Will charge higher than actuarially fair premiums or may not sell at all
Risk Premium
The amount that risk averse individuals will pay for insurance above and beyond the actuarially fair price

*Risk averse persons willing to pay a risk premium
Pooling equilibrium
A market equilibrium in which all types of people buy full insurance even though it is not fairly priced to all individuals

Efficient outcome--both types fully insured, market willing to supply insurance
Does Asymmetric Info Lead to Market Failure?
Even if there is no pooling equilibrium the insurance company can address adverse selection by offering separate products at separate prices

Insurance company would like consumers to reveal their true type--individuals may not voluntarily want to do this

However, they may make choices that involuntarily reveal their types (full coverage or partial coverage)
Separate Equilibrium
A market equilibrium in which different types of people buy different types of insurance products designed to reveal their true types

*Adverse selection can still impede markets from achieving the efficient outcome

The optimum would be full insurance for both groups, at different prices that reflect each group's relative risk of injury
Government and Adverse Selection
Gov interventions:

Could mandate that everyone buys full insurance at the average price

Public provision--provide full insurance to both types of consumers

Subsidize the purchase of full insurance to try to induce full coverage

Financed through taxes--everyone charged equally--careful consumers paying more than they would voluntarily choose to pay

*Gov can address the problem of moral hazard but they involve redistribution from the healthy to the sick (could be unpopular)
Other Reasons for Gov Intervention in Insurance Markets
1. Externalities--negative externalities may be imposed on others through underinsurance e.g. car insurance
*Can subsidize, provide, or mandate insurance coverage

2. Administrative Costs--administrative inefficiencies in the private insurance market may lead to higher (actuarially unfair) premiums
*Not very risk averse people may opt not to purchase insurance
*Not everyone is insured--inefficient outcome

3. Redistribution--Full information--optimal outcome--more risky consumers pay more for insurance--may not be satisfactory form a distributional point of view
*Gov may want to intervene by taxing the low-risk and using the revenues to subsidize the premiums paid by high risk individuals

4. Paternalism--Governments may simply feel that individuals will not appropriately insure themselves against risk if the government does not force them to do so
*Does not arise due to market failure
*Arises due to failure of individuals to maximize their own utility
*Flood insurance and the Samaritan's Dilemma
Self-insurance
The private means of smoothing consumption over adverse events, such as through one's own savings, labor supply of family members, or borrowing from friends

*The availability of self-insurance determines the value of social insurance to individual suffering adverse events

*Social insurance may still be valuable--may be more efficient
Importance of Social Insurance for Consumption Smoothing
Two factors:

1. Predictability of the Event--benefits are highest when events are not predictable
2. Cost of the Event--benefits are highest when events are most costly
Problem with Insurance
Moral hazard--adverse actions taken by individuals or produces in response to insurance against adverse outcomes

Existence of moral hazard means that it may not be optimal for the government to provide the full insurance that is demanded by risk-averse consumers e.g. workers' compensation insurance

Moral hazard is an inevitable cost of insurance, private or social
Consequences of Moral Hazard
1. The adverse behavior encouraged by insurance lowers social efficiency e.g. labor supply, health insurance

2. Encourages adverse events which raise the cost of social insurance programmes--increases taxes and lowers social efficiency
Public Provision of Healthcare
Prevent the adverse selection problem by making health coverage compulsory and universal
Cost Benefit Analysis
The comparison costs and benefits of public projects to decide if they should be undertaken

All social costs and social benefits should be considered

Net Benefits (NB) = Benefits (B) - Costs (C)
*If NB > 0 project should go ahead and if B > C there is an overall welfare gain to society
Potential Pareto Improvement (PPI)

also known as...

The Kaldor-Hicks Criterion
Recommend project if NB > 0

As long as NB > 0 the winners from the project could employ lump sum transfers to compensate the losers and everyone would still gain
2 Problems with PPI
1. Projects that pass the PPI criterion may result in a reduction in welfare and projects that fail the PPI criterion may result in an increase in welfare

2. The PPI criterion can produce contradictory results--Kaldor-Scitovsky Pardox

*Main weakness of PPI is unfairness due to compensation not being paid
Shadow Pricing
Market failure: Price does not equal true resource cost
*May be necessary to use shadow pricing

Ex: externalities, monopoly, asymmetric info, unemployed labor
Discounting
Discounting is used to express future costs and benefits in their present value

Costs and benefits are multiplied by a discount factor, d_n, to give their discounted value or present value

The discount rate will influence which projects are adopted
*If NPV > 0 proceed with project

A higher value of r (discount rate) favors projects where payoffs are immediate
Arguments for Discounting
Inflation

Time preference (impatience, uncertainty)

Capital productivity argument
Shadow Pricing Techniques
Two categories:
Revealed preference and stated preference
Revealed Preference
Uses info about actual behavior to infer values for the good in question
Stated Preference
Is based on asking consumers to rank or value goods in hypothetical markets
Revealed Preference Methods
Market Behavior: Ideally there is some related good that is marketed e.g. private healthcare demand may reveal something about values for publicly provided healthcare

Wages may be used to value time savings

Travel Cost Method:
Individuals can reveal the value they place on a good by the amount they are willing to pay to visit the attraction and the amount of time they are willing to devote to its consumption

Hedonic Pricing:
A method for valuing amenities based on the implicit prices revealed by the market place
Ex: Sea view, noise, pollution, extra bedroom

Problems: had to disentangle factors that may influence house prices
Stated Preference Methods
Contingent Valuation:
A method for valuing amenities based on individuals' willingness to pay (or willingness to accept compensation)
*Widely used in environmental economics

Problems: Individuals have incentives to misrepresent their preferences for collective goods

Instead use: Dichotomous Choice:
Respondents asked 'are you willing to pay x'? with x varied over the sample, and a bid curve is estimated--overcomes strategic bias
*Embedding problem

Isolation of issues matters, order of issues matters