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OAQPS Economic Analysis Resource Document

5.4 Economic Impact Results

This section summarizes the measures of economic impacts that result from the modeling approach described above.  The model results are summarized below as market-level, facility- or industry-level, company-level, and community-level impacts, as well as the social costs impacts due to implementation of a proposed regulatory action.  The sample results tables in this section are taken from the EIA conducted in support of the Polymers and Resins III NESHAP.  Although the EIA results presented here are not large in magnitude, these tables provide good illustrations of the broad array of impact measures that can result from this modeling approach.
  5.4.1    Market-Level Results
Table 5-3 provides an example of the market-level impacts of a proposed regulatory action.  These impacts include the market adjustments in price and quantity for affected products, as well as the changes in foreign trade (if applicable).  The increased cost of controlling air emissions from existing affected sources is shown to reduce their production, which subsequently causes price and output changes in each market.  As expected, the proposed regulation is projected to increase the prices and reduce market output.  In this case,  the reduction in market quantities of each product is the net effect of reductions in domestic production and increases in foreign imports.  Furthermore, as shown in Table 5-3, the reduction in domestic production is the net of changes at affected producers (reductions) and unaffected producers (increases).  Thus, the market-based approach allows the analyst to evaluate the distributional impacts within the U.S. industry and across U.S. versus foreign producers.

5 EIA Framework

 5.0 Intro

 5.1 Alternative
   for Economic
   Impact Analysis

 5.2 PEIS Modeling

 5.3 PEIS Modeling

 5.4 Economic
   Impact Results
  5.4.2    Industry-Level Results
Table 5-4 provides an example of the industry-level impacts associated with a proposed regulation.  Industry-level impacts include an evaluation of the aggregate changes in revenue, costs, and operating profits across individual producers; facility and product-line  closures; and the change in employment attributable to projected closures and changes (increases/decreases) in production from directly and indirectly affected facilities.  The industry revenues and costs change as market prices and individual facility production levels adjust to the imposition of the regulation.  The post-regulatory compliance costs account for market adjustments and, thus, will be less than the initial engineering estimate of compliance costs due to reductions in production and/or market exits.
Based on projected individual and market responses, the economic analysis estimates changes in industry profits.  The ultimate impact of the regulation on industry profits will depend on the incidence of compliance costs and the nature of demand and supply curves.  In fact, under certain circumstances, the regulation may cause aggregate industry profits to increase.  Assuming that demand is not perfectly inelastic, if the supply curve were to shift upward in a parallel manner, then the effect on producer surplus, or profits, would be
negative.  For this type of shift, the incidence of compliance costs across affected producers is independent of their baseline production costs.  In some cases, however, the compliance costs may be higher for those producers that have the highest baseline production costs.  Under this scenario, the supply curve movement will be a combined pivotal and parallel shift as shown in Figure 5-13.  As shown by  Miller, Rosenblatt, and Hushak (1988), depending on the value of the slope and intercept of the supply and demand curves, the joint effect of this type of shift may cause an overall increase in producer surplus rather than the expected decrease resulting from the parallel shift alone.  In an extreme case, the new market price could be solely
determined by the increased costs of the marginal producer who would  account for the entire reduction in output and profits with all inframarginal producers gaining profits at its expense.
As shown in Table 5-4, the projected reduction in profits is less than the regulatory costs they incur because producers reduce their production, resulting in higher market prices for each resin, which effectively shifts a portion of the regulatory burden onto consumers. Furthermore, the aggregate increase in industry profits is a result of the net change in profits at affected and unaffected U.S. producers.  Table 5-5 provides results on distributional impacts of the rule within the industry that are not apparent from the aggregate industry-level impacts shown in Table 5-4.  As discussed previously, in a market context, producers are able to adjust their production levels in response to the increase in costs as well as the projected  increase in market prices.  As shown in Table 5-5, affected resin producers are projected to incur a decrease in operating profits, while unaffected resin producers are expected to incur an increase in operating profits.
The economic analysis may also project closures of facilities or product lines associated with imposition of the regulatory action.  In response to added costs of compliance, it could be that the optimal choice for a facility is to shutdown particular product lines, processes, or the entire operation altogether.  The sufficient condition for production at a facility or production unit is defined as nonnegative net profits, that is,
Profits = TR – TC $ 0
where total revenue (TR) is the sum of product revenue at the facility, and total cost (TC) is the sum of total variable production costs and total avoidable fixed costs. This closure decision does not typically include an annualized value for the liquidation opportunity cost, which is equivalent to assuming that the opportunity cost of fixed assets is offset by costs of closing the facility.  It is important to point out that the estimates of facility and  product-line closures are sensitive to the accuracy of the baseline characterization of these  entities (e.g., prices received for manufactured products, costs of production) and the estimation of their costs of complying with the proposed regulatory action.

Furthermore, the regulatory action may displace workers from jobs through its impacts on levels of production.  The methodology employed to estimate the number of displaced workers depends on the methodology used to project output effects (individual facility or aggregate market response).  If facility output decisions are modeled, then changes in employment at facilities that continue to operate after regulation are estimated by multiplying a facility-specific ratio of production workers per output (i.e., e) by the projected change  in the facility’s production (i.e., q).  If the facility ceases to operate, then the change in employment at the mill equals total employment, both production and nonproduction workers (i.e., E).  Thus, the estimate of the change in employment for the entire industry can be obtained by adding the sum of the employment changes across all facilities that continue to operate and the sum of total employment across all facilities that close.  This produces a net estimate that aggregates the job losses at facilities that close or reduce production and job gains at facilities that increase production.  Therefore, to estimate only employee displacement, or job losses, the analyst may sum the projected change in employment for those facilities that close or reduce their production level.  Alternatively, if only market responses are modeled, then only a net measure of employment change may be computed by multiplying an industry-specific ratio of employment per output by the projected change in aggregate industry production.
  5.4.3    Company-Level Impacts
A regulatory action to reduce air emissions from particular facilities will potentially affect the business entities that own the regulated facilities.  Companies or individuals that own the facilities are legal business entities that have the capacity to conduct business transactions and make business decisions that affect the operations at the facility.  The legal and financial responsibility for compliance with a regulatory action rests with these owners who must ultimately bear the financial consequences of their decisions.  The owners’ response options to a proposed regulatory action potentially include the following:
  • implement the cost-minimizing compliance option and continue to operate the facility,
  • close the facility voluntarily, or
  • close the facility involuntarily.
Owners are assumed to pursue the course of action that maximizes the value of the firm, subject, of course, to uncertainties about actual costs of compliance and the behavior of other companies.  The market approach presented in this section addresses the first two response options listed above.  As mentioned in the introduction to Section 5, the facility and market impacts should feed into the financial analysis to assess the financial viability of the owning companies (i.e., company-level impacts).  In other words, the analyst must identify which companies are likely to have problems meeting their debt obligations in the face of regulation and be required to liquidate facility assets under option three above.  In addition, this type of analysis addresses distributional issues across these companies with special concern for disparate impacts on small businesses.
The financial analysis evaluates the change in firm health by computing the with- regulation financial ratios of potentially affected firms and comparing them to the corresponding baseline ratios or industry-specific standards.  These financial ratios may include indicators of liquidity, asset management, debt management, and profitability.  Although a variety of possible financial ratios provide individual indicators of a firm’s health, they most often do not give the same signals.  Therefore, the company-level analysis should focus only on changes in key measures of profitability, that is,
  • return on sales, which is computed as net income divided by sales;
  • return on assets, which is computed as net income divided by total assets; and
  • return on equity, which is computed as net income divided by owner’s equity, or net worth.
As a result of a proposed regulation, owners will potentially experience changes in profits associated with changes in the costs and revenues of their manufacturing operations.  Net changes in profitability may be derived by summing facility cost and revenue changes across all facilities owned by each affected company.  The net impact on a company’s profitability may be negative (i.e., cost increases exceed revenue increases) or positive (i.e., revenue increases exceed cost increases).  In most cases, there is little reason to go beyond the assessment of changes in profitability.  Although issues of capital availability are important to address, especially in regard to small businesses, they are often difficult to assess accurately and may provide little more information beyond the assessment of firm profitability.

  5.4.4    Community-Level Impacts

Based on the facility- and industry-level impacts, community or region-specific impacts of a proposed regulatory action can be computed for employment and tax revenues.  Changes in employment and tax revenues are linked to the projected change in production and profits at affected and unaffected producers located in the geographic areas of interest (i.e., counties, states, or regions).  Computing the community impacts involves aggregating the facility-specific changes for each measure of interest.

  5.4.5    Social Costs of the Regulation

As stipulated in E.O. 12866, when a proposed regulatory action is deemed “significant,” an estimate of a regulation’s social cost is compared with an estimate of social benefits to determine whether the benefits justify the costs.  Toward that end, the social cost of a regulation should represent its opportunity cost (  OMB, 1996, p. 32), which is the value of the goods and services that society foregoes to allocate resources to the pollution control activity.
The analyst considers three types of social cost in conducting EIAs:
  • the costs of actions taken to comply with the regulation,
  • the costs of administering and enforcing the regulation, and
  • the costs associated with economic impacts.
The first category reflects the opportunity cost of the resources applied to compliance activities.  When regulation takes the form of mandated private actions, the opportunity cost of these actions ideally is captured in measures of producer and consumer surplus from the markets affected by the regulation.  These surplus measures can be directly computed from the market-based approach presented in this section and typically account for the majority of the total cost of a regulatory action.  Thus, this estimate is most often presented in the EIA as the social cost of regulation.,  The methodology for computing these measures is presented below.  When lack of market data and model parameters impedes the computation of producer and consumer surplus measures, engineering or accounting methods must be used to approximate social costs.
However, other components of social cost may not be fully accounted for in the compliance cost estimates and, thus, not reflected in the partial equilibrium framework.  These other components of social costs include government monitoring and enforcement costs and the costs associated with economic impacts such as involuntary unemployment, plant closings, and changes in innovation.  In these cases, other valuation approaches must be used to separately examine and measure these other cost components.  Producer and Consumer Surplus Measures

The value of a regulatory action is traditionally measured by the change in economic welfare that it generates.  Welfare impacts resulting from a proposed regulatory action on the U.S. society will extend to the many consumers and producers of affected commodities.  Consumers will experience welfare impacts due to the adjustments in market prices and consumption levels that result from imposition of the regulation.  Producer welfare impacts result from the changes in product revenues to all producers associated with the imposition of the rule and the corresponding changes in production and market prices.  Based on applied welfare economics principles, Table 5-6 presents an example of the estimates of the social costs and their distribution by stakeholder from the EIA conducted in support of the Polymers and Resins III NESHAP.
The economic welfare implications of the market price and output changes associated with a proposed regulatory action can be examined using changes in the net benefits of consumers and producers.  Figure 5-14 depicts this approach to estimating social costs by first measuring the change in consumer surplus and then the change in producer surplus.  In  essence, the demand and supply curves previously described as predictive devices are now being used as a valuation tool.  This method of estimating the social costs of the regulation decomposes society into consumers and producers.  In a market environment, consumers and producers of the good or service derive welfare from a market transaction.  The difference between the maximum price consumers are willing to pay for a good and the price they actually pay is referred to as “consumer surplus.”  Consumer surplus is measured as the area  under the demand curve and above the price of the product.  Similarly, the difference between the minimum price producers are willing to accept for a good and the price they actually receive is referred to as “producer surplus.”  Producer surplus is measured as the area  above

the supply curve below the price of the product.  These areas can be thought of as consumers’ net benefits of consumption and producers’ net benefits of production, respectively.
In Figure 5-14, baseline equilibrium occurs at the intersection of the demand curve, D, and supply curve, S.  Price is Pl with quantity Ql.  The increased cost of production with the regulation will cause the market supply curve to shift upward to S'.  The new equilibrium price of the product is P2.  With a higher price for the product there is less consumer welfare, all else being unchanged.  In Figure 5-14(a), area A represents the dollar value of the annual  net loss in consumers’ benefits with the increased price.  The rectangular portion represents the loss in consumer surplus on the quantity still consumed, Q2, while the triangular area represents the foregone surplus resulting from the reduced quantity consumed, Ql–Q2.
In addition to the changes in consumers’ welfare, there are also changes in producers’ welfare with the regulatory action.  With the increase in market price, producers receive higher revenues on the quantity still purchased, Q2.  In Figure 5-14(b), area B represents the  

increase in revenues due to this increase in price.  The difference in the area under the supply curve up to the original market price, area C, measures the loss in producers surplus, which includes the loss associated with the quantity no longer produced.  The net change in producers’ welfare is represented by area B–C.
The change in economic welfare attributable to the compliance costs of the regulations is the sum of consumer and producer surplus changes, that is, – (A) + (B–C).  Figure 5-14(c) shows the net (negative) change in economic welfare associated with the regulation as area D.  However, it is important to reemphasize that this measure does not  include the benefits that occur outside the market, that is, the value of the reduced levels of air pollution with the regulations.  Including this benefit may reduce the net cost of the regulation or even make it positive; that is, total benefits, which are private market benefits as estimated above plus the benefits in the quality of the environment, may exceed total costs.  Other Elements of Social Costs
Administrative and enforcement activities involve real resource expenditures that could be spent on the provision of other goods and services thereby imposing social opportunity costs that must be accounted for in the EA.  Administration and enforcement costs are borne by the taxpayers who fund regulatory government agencies such as EPA and state, tribal, or local agencies that enforce environmental regulations.  Once rules are put in place, resources must be expended to administer the regulation and ensure compliance.  The types of costs to consider are staffing, materials, and office rental costs (excluding those associated with rule development).  Typically, these costs do not affect market outcomes and are appropriately added to the surplus-based estimates from above to gain a more complete estimate of social costs.
Government administrative and enforcement costs are usually estimated using straightforward methods based on added administrative activities and their associated costs.  Information on resource requirements (e.g., full-time equivalent staff needs) and the cost (e.g., salary and fringe) can be obtained directly from enforcement agencies.  The difficulty is in determining the extent to which a new regulation incrementally raises these costs.  For example, enforcement agencies exist with or without the regulation.  Rather than increase the size of the enforcement agency, the new regulation may just spread the responsibilities over the existing staff.  Assuming that the staff is not currently being underutilized, this may just reduce the frequency of enforcement activity for each regulation under the agency’s purview.
Finally, the proposed regulatory action might generate economic impacts, the full social costs of which are not captured in the measures of compliance, administration, and enforcement costs.  An example may be transitional costs associated with unemployment, mandated obsolescence of otherwise useful capital, or reductions in long-run economic efficiency due to reduced innovation.  The costs of these impacts are often difficult to quantify and are usually addressed in separate impact analyses to provide decisionmakers with a more detailed and richer characterization of the consequences of a particular regulatory action.  These separate impact analyses are described in more detail in Section 8.


18 This solution mechanism operates in proportional changes and employs the matrix algebra solution of the behavioral equations.
19 This solution mechanism operates in total changes and employs a process of tatonnement, whereby prices approach equilibrium through successive correction modeled as a Walrasian auctioneer.
20 Firms also face financial choices regarding how to fund their compliance responses: diverting dividends from investors (i.e., out of profits), internal equity (i.e., issuing new stock), or external equity (i.e., borrowing).  Although these financial decisions are not addressed in conducting the market-based approach, these decisions will influence the real resource burden to the firm and society.
21 See Section 8 for a detailed discussion of a more comprehensive estimate of social cost for comparison with social benefits that accounts for the effects of discounting at different rate (i.e., private versus social discount rates).
22 It is important to point out that the baseline conditions (excess capacity), model parameters (supply and demand elasticities), and market structure will influence the magnitude and distribution of these surplus-based measures.  The reader is referred to the EIAs conducted for pharmaceuticals (monopoly) and portland cement (oligopoly) for illustrations of the effects of imperfectly competitive market structures on these estimates.
23 These real resource costs are distinguished from tax transfers to or from the government, which have no net effect on social costs.
24 Worker displacement costs have traditionally not been measured in EIAs conducted by ISEG analysts.  The assumption has usually been made that workers costlessly move to new jobs of equal productivity and earnings, despite numerous studies that show costs borne by displaced workers are significant (see  Flaim, 1984;  Hamermesh, 1989;  Maxwell, 1989; and  Anderson and Chandran, 1987).  Building on the work by  Adams (1985) and  Topel (1984),  Anderson and Chandran (1987) constructed incremental willingness-to-pay (WTP) measures for job dislocations in a hedonic wage framework that may be employed to estimate worker dislocation costs.

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