Social Discount Rate

12-706 / 19-702

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Pipeline case study writeup - due MondayFormat expectations:

Framing of problem (see p. 7!), Answer/justify with preliminary calculations Don’t just estimate the answer! Do not need to submit an excel printout, but

feel free to paste a table into a documentLength: Less than 2 pages.

Real and Nominal Values

Nominal: ‘current’ or historical data

Real: ‘constant’ or adjusted data Use deflator or price index for real

Generally “Real” has had inflation/price changes factored in and nominal has not

For investment problems: If B&C in real dollars, use real disc rate If B&C in nominal dollars, use nominal rate Both methods will give the same answer

Similar to Real/Nominal : Foreign Exchange Rates / PPP

Big Mac handoutCommon Definition of inputsShould be able to compare cost

across countriesInteresting results? Why?What are limitations?

Is it worth to spend $1 million today to save a life 10 years from now?

How about spending $1 million today so that your grandchildren can have a lifestyle similar to yours?

RFF Discounting Handout

How much do/should we care about people born after we die?

Ethically, no one’s interests should count more than another’s: “Equal Standing”

Social Discount Rate

Rate used to make investment decisions for society

Most people tend to prefer current, rather than future, consumption Marginal rate of time preference (MRTP)

Face opportunity cost (of foregone interest) when we spend not save Marginal rate of investment return

Intergenerational effects

We have tended to discuss only short term investment analyses (e.g. 5 yrs)

Economists agree that discounting should be done for public projects Do not agree on positive discount rate

Climate Change

Discussions ongoing about how best to manage global CO2 emissions to limit effects of global change.

Should we sacrifice short-run economic growth to do something to improve environment and leave resources for the future?

Two Questions

What duty do we have to make sacrifices for future generations?

If we sacrifice, what is the optimal policy to maximize benefit? So we should compare global change

proposals with alternatives Perhaps higher R&D spending on science

or medicine would have higher benefits!

Government Discount Rates

US Government Office of Management and Budget (OMB) Circular A-94 http://www.whitehouse.gov/omb/

circulars/a094/a094.html Discusses how to do BCA and related

performance studies What discount, inflation, etc. rates to use Basically says “use this rate, but do

sensitivity analysis with nearby rates”

OMB Circular A-94, Appendix C

Provides the current suggested values to use for federal government analyses

http://www.whitehouse.gov/omb/circulars/a094/a94_appx-c.html

Revised yearly, usually “good until January of the next year”

How would the government decide its discount rates? What is the government’s MARR?

Historic Nominal Interest Rates (from OMB A-94)

2005 3.7 4.1 4.4 4.6 5.2 2006 4.7 4.8 4.9 5.0 5.2

Real Discount Rates (from A-94)

2005 1.7 2.0 2.3 2.5 3.12006 2.5 2.6 2.7 2.8 3.0

What do people think

Cropper et al surveyed 3000 homes Asked about saving lives in the future Found a 4% discount rate for lives 100

years from now

Hume’s Law

Discounting issues are normative vs. positive battles

Hume noted that facts alone cannot tell us what we should do Any recommendation embodies ethics

and judgment E.g. focusing on ‘highest NPV’ implies

net benefits is only goal for society

Some Issues Arise

Equal standing does not imply different generations have equal claims to present resources! Harsanyi says only do so if their

marginal gain is higher than our loss

If future generations will be better off than us anyway Then we might have no reason to make

additional sacrificesThere might be ‘special standing’ in addition

to ‘equal standing’ Immediate relatives vs. distant relatives Different discount rates over time Why do we care so much about future and ignore

some present needs (poverty)

A Few More Questions

Current government discount rates are ‘effectively zero’

What does this mean for projects and project selection decisions?

What does it say about intergenerational effects?

What are implications of zero or negative discount rates?

Comprehensive Everglades Restoration Project

Comprehensive project to restore natural water flow to the Florida Everglades.

Enhance water supply to South Florida region.

Provide continuous flood protection.

See more info at http://www.evergladesplan.org/

Indian River Lagoon-South (IRLS)

Part of Everglades Restoration Project.

Total Cost of $1.21 billion.

Annual Benefits of $159 million after project is completed in 2015.

Find NPV of first 25 years of project.

IRLS Cash Schedule

00 01 02 03 04 05 06 07 08 09 10 11 12 13 14

15 16 17 18 19 20 21 22 23 24 25

$0.425

$748.3

$2.043

$447.3

$12.62

$159 per year

All values are in millions

NPV of Project

-$700

-$600

-$500

-$400

-$300

-$200

-$100

$0

3% 7% 20%

(Millions)

Discount Rate

NPV of Project

What would NPV be if we used a negative discount rate?

-$800

-$600

-$400

-$200

$0

$200

$400

$600

$800

$1,000

3% 7% 20% 0% -1%(Millions)

Discount Rate

NPV of Project

NPV of Project

Which is the right discount rate?

What are implications of each?

Show of Hands Example

Choice #1: $50 today or $100 paid 1 year from now? Why?

Choice #2: $50 to be paid in 5 years or $100 in 6

years? Why?

Hyperbolic Discounting

Behavioral economics: We generally prefer smaller, sooner payoffs

to larger, later payoffs when the smaller payoffs would be imminent;

When same payoffs are distant in time, we tend to prefer the larger, even though the time lag (e.g., 1 year) would be the same

Hyperbolic Discounting

Our “preferences” follow a hyperbolic curve rather than the conventional, exponential curve that would produce consistent choice over time

We are time inconsistent (we don’t perceive the same tradeoff values today vs. in 5+ years)

Recall: Continuous P=F * e-in

P=F /(1+kn) Where k is still the steepness of our tradeoff

Hyperbolic versus standard

0

200

400

600

800

1000

1200

0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 32 34 36 38 40time

Present Value

F-standard F-hyperbolic

Hyperbolic Discounting-Implications

If we actually have hyperbolic preferences

What do our discount rates look like?

How would that affect our preferences for social projects, especially those with long time horizons? Time inconsistency known in advance

Next Up:

Friday’s review: more discounting Loans, taxes, etc.

Monday Pipeline Case Sensitivity Analysis