Consumer Surplus Under Uncertainty: An Application to Dam-Reservoir Projects

Abstract

The use of cost-benefit analysis to evaluate the net welfare payoffs from water projects has now been an established practice for many years. One of the interesting aspects of such cost-benefit studies is that water projects involve an uncertain flow of costs and benefits, arising from the stochastic nature of streamflows. Hence a basic problem for the cost-benefit analyst is that of incorporating this uncertainty into his measures of costs and benefits. In the present paper we examine the problem of computing an appropriate consumer surplus measure to evaluate water project benefits under uncertainty. Detailed treatment is given to the case in which a complete set of contingent claim markets exists in the economy as well as to the case of a spot market economy. The consumer surplus measure applicable to the contingent claim economy is a simple generalization of the measure that applies to a world of certainty, but in the case of a spot market economy there is an unobserved component of consumer benefits that limits the applicability of the usual consumer surplus measure.