Measuring productivity changes (Production Function Approach):
- The project may create externality that affects the productivity of other producers and consumers. This productivity change can be measured in terms of value of the net output produced.
- For example, the minimum economic cost of the air or water pollution that destroys the local crops will be the market value of these crops over lifetime of the project that produces them or while the damage continues to occur. If some less sensitive or less profitable crop can be grown instead, the difference between the value of the preferred crop and less valuable substitute can be used as measure of the cost of pollution.
Change of earning capital Approach:
- The loss or gain of earning can measure this, or change in the value of human capital or those affected.
- For example, air pollution from local mining or brick factory or project may cause some miners to develop lung disease, reducing their working life or even causing premature death. Their lost earnings will be measure of their decreased productivity and minimal estimate of the cost of pollution.
- The increased earning of workers who received trainings on a project and the go on to work for other employees in another use of the human capital approach to measure the value of externalities. In this case, such earnings are a measure of the positive externalities generated by a project’s trainings
Opportunity Cost Method
- one method of handling this is to measure the Net Present Value (NPV) of the project that generates the externality and compare it with the NPV of the next best alternative project, which does not.
- The difference between the two project’s NPV is the opportunity cost of the externality. The decision-maker can then decide if the cost or benefit of the externality exceeds the difference in the project’s NPV.
Preventive Expenditure Approach
- Another readily identifiable cost of negative externality will be the preventive expenditures that people incur to reduce or avoid the damage from the sun an externality.
- Such expenditures are made in order to maintain the productivity of their economic activities or their level of environmental amenity.
- The cost sound insulation installed be people living near the airports is an example of such preventive expenditure.
Replacement Cost Approach
- The replacement cost method measures the cost of environmental degradation in terms of the resources that must be used to replace the environmental services lost as a result of this degradation.
- For example, the benefits of a project to provide clean river water may be measured in terms of the saving in water treatment costs.
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