In this chapter we present the conceptual basis for applied welfare analysis. We begin with a review of consumer welfare theory, and how economists have used the theory to develop standard empirical techniques for measuring the welfare effects of changes in private good prices. We present the well-established duality results linking estimable demand functions to preferences, and ultimately to monetary measures of economic value. Since most of non-market valuation involves examining the welfare impacts of changes in quasi-fixed goods (such as the level of an environmental indicator), we then discuss how the standard price-change techniques must be modified when we consider quantity changes. We show that while duality can still be used to link demand for the quasi-fixed good to the preference function, the absence of market exchange rules out the use of observed behavior to directly estimate a demand function. Instead, extra-market information is needed to infer individuals’ monetary values for these goods, the sources of which we consider in subsequent chapters. We close this chapter by discussing generalizations needed to define welfare measures that are appropriate for use under state of the world uncertainty, and then by examining the conceptual relationship between different types of welfare measures.

It is useful at the outset to carefully define what we mean by monetary value, since it plays such a large role in the discussion. As described at the book's outset, the concept of value that we rely on is individualistic and based on consumer sovereignty, so that a person's preferences determine how outcomes (e.g. consumption levels, states of the environment, or his own health) translate to value. Outcomes can, of course, change through any number of channels. Prices can adjust, indirectly shifting consumption levels, or policy might directly alter environmental quality, thereby impacting the level of well-being that a person obtains. Establishing a monetary value for any action that directly or indirectly changes outcomes involves (a) defining a baseline state and an ending state, and (b) computing the person's willingness to pay (WTP) to secure the ending state, or his willingness to accept (WTA) to forgo it. The key points here are twofold.