### **Appendix: Chapter 6.** 

To provide an estimate of the social costs associated with the modeled
control strategy, EMPAX-CGE monetizes welfare changes from the general
equilibrium simulation using Hicksian equivalent variation (EV), which
is related in concept to the producer/consumer surplus measures used in
partial-equilibrium models. EV is a long-recognized technique to
estimate welfare gains and losses in economic theory, having been
developed by Sir John Hicks in 1939.[^1] EV provides an estimate of the
change in income that would provide an equivalent change in household
welfare as the policy being considered and includes changes in utility
households receive from both consumption and leisure time.[^2] It is a
technique that is widely used by economists to measure welfare change.
For example, Chipman and Moore (1980) showed that EV is appropriate for
welfare comparisons.[^3] However, as calculated using EMPAX-CGE
currently, it excludes measures of the standard's environmental benefits
(e.g., environment, public health, and labor productivity). In addition,
these social cost estimates from EMPAX-CGE do not incorporate
extrapolated costs since these costs do not have a clear link to
specific industries. The general equilibrium model estimates that the
relative change in infinite-horizon[^4] and average annual welfare
losses are extremely small (approximately 0.025%). Over the 2005-2020
time horizon used in EMPAX-CGE for this analysis, the social costs are
93 percent of the engineering costs for the illustrative modeled control
strategy when estimated in present value terms (2006 dollars).[^5][^6]

We use EV to provide an estimate of social costs in this analysis
instead of a metric such as GDP since changes in GDP are a poor measure
of impacts on consumer welfare. Although GDP is a common metric among
policymakers for expressing "costs to society," it is a poor measure of
"social costs." GDP as a measure of welfare has been criticized for many
years by different economists. Much of that criticism is well summarized
in a response to the 2004 Draft Thompson Report to Congress prepared by
Arik Levinson and quoted as follows: "... GDP growth is a poor measure
of welfare. It measures the flow of economic activity rather than the
flow of assets. If there is over-fishing, regulations that reduce fish
catch will reduce GDP in the short run, but increase long-run economic
prosperity... Finally, GDP excludes non-traded benefits: environmental
quality, health, workplace safety..." [^7] Changes in household
consumption are much closer to changes in the welfare of households
(ignoring leisure) than changes in GDP. For example, since consumption
is around two-thirds of GDP, a ballpark estimate might be that any
changes in consumption will only be around two-thirds as large in dollar
terms as changes in GDP. GDP also does not account for the value of
leisure, which is accounted for directly in estimates of welfare impacts
using an EV approach as mentioned above. Thus, GDP is a poor metric for
estimating welfare impacts, and therefore social costs. [^8]

As part of being a dynamic, forward-looking model, EMPAX uses an
interest rate to place a value on the future (including both the
benefits of consumption and costs of production). We have been using a
5% real interest rate, based on the MIT EPPA model referred to earlier
in this chapter and SAB guidance as discussed in U.S. EPA (2003). This
interest rate will form the basis for how the model reacts to any
engineering costs it sees coming in the future. Following the guidance
provided in OMB's Circular A-4, we also provide social cost estimates in
this appendix over the same 2005-2020 time horizon that reflect a 3%
real interest rate, and a 7% real interest rate. These social cost
estimates are 90 and 91 percent, respectively, of the engineering costs
when costs are calculated in present value terms.

As mentioned in Chapter 6, this is the first application of EV to
estimate social costs as part of analysis using a CGE model in an RIA of
this type. We intend to solicit review and advice from the SAB before
its use in future economic impact analyses using CGE models.

[^1]: Hicks introduced this concept into economic theory in his book
    "Value and Capital: An inquiry into some fundamental principles of
    economic theory," published in 1939.

[^2]: Including leisure time in the model and household decisions allows
    the labor supply to expand or contract in response to changes in
    wage rates, etc. It is also essential when modeling interactions
    between tax interactions and the economy.

[^3]: Chipman, John S., and James C. Moore. 1980. Compensating
    Variation, Consumer's Surplus, and Welfare. American Economic Review
    70 (5): 933-49.

[^4]: By infinite horizon, what is meant is an infinite number of time
    horizons. Since it is not computationally feasible for EMPAX-CGE to
    provide estimates to this many time horizons, the model approximates
    an infinite horizon. Turn to p. 6-9 of the EMPAX-CGE documentation
    at
    <http://www.epa.gov/ttnecas1/models/empax_model_documentation.pdf>
    for details.

[^5]: It should be noted that we will not compare this social cost
    estimate with the benefits estimates for alternate primary standards
    presented later in this RIA. We do not make this comparison for two
    key reasons: 1) the lack of linkage between air quality changes and
    effect categories such as labor productivity and health care costs
    among households; and 2) our inability to provide extrapolated costs
    by industry to serve as input to EMPAX.

[^6]: As mentioned in Chapter 5, the engineering cost estimate for the
    modeled control strategy of \$2.8 billion (2006\$) is calculated
    using the Equivalent Uniform Annual Cost (EUAC) method. The EUAC
    method does *not* generate the present value of the annual costs of
    controls on a year-by-year basis from 2005 to 2020.

[^7]: Levinson, Arik. Response to 2004 Draft Report to Congress on the
    Costs and Benefits of Federal Regulation and Unfunded Mandates on
    State, Local, and Tribal Entities (or "Thompson Report"). Submitted
    to the U.S. Office of Management and Budget. June 2, 2004. Found on
    the Internet at
    <http://www.whitehouse.gov/omb/inforeg/2004_cb/c.pdf>.

[^8]: We provide estimates of the changes in GDP in 2020 from
    implementation of the modeled control strategy in Chapter 6, but
    only to provide information on this commonly known macroeconomic
    metric.