The welfare cost of uncertainty in policy outcomes

This paper develops a simple index of the bias arising when the environmental quality improvement from policy is uncertain. Two cases are considered. The first assumes the baseline level of environmental quality is not random and that only the level of quality realized with a new policy is random. The second case treats both the baseline and level arising from policy as random. Using a second order approximation for a welfare measure our measure is an approximation for the certainty equivalent. Two parts of this measure can be distinguished. The first is the second order approximation for the Hicksian equivalent surplus for a certain (non-stochastic) increase in the environmental service associated with a policy. The second is a term reflecting the adjustment a consumer would require to this conventional measure due to the effects of uncertainty in the outcome of that policy. The general form of our index is not affected by the definition we adopt for the welfare measure whether certainty equivalent or willingness to pay in the case of one random variable or the equivalent and compensating definitions for the option price when both baseline and policy outcomes are random variables. There is the conventional difference between equivalent and compensating definitions and the associated welfare measures for our cases as a result of income effects.