Social Discount Rate

Guest Lecturer:Paulina Jaramillo12-706 / 19-702 /73-359Lecture 5

Admin Issues

Pipeline case study writeup - due Monday

Format 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 document

Length: 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

Nominal Discount Rates

Market interest rates are nominal They ideally reflect inflation to ensure value

Buy $100 certificate of deposit (CD) paying 6% after 1 year (get $106 at the end). Thus the bond pays an interest rate of 6%. This is nominal. Whenever people speak of the “interest rate” they're

talking about the nominal interest rate, unless they state otherwise.

Real Discount Rates

Suppose inflation rate is 3% for that year i.e., if we can buy a “basket of goods” today for $100,

then we can buy that basket next year and it will cost $103.

If buy the $100 CD at 6% nominal interest rate.. Sell it after a year and get $106, buy the basket of

goods at then-current cost of $103, we will have $3 left over.

So after factoring in inflation, our $100 bond will earn us $3 in net income; a real interest rate of 3%.

Example

Real rate r, nominal i, inflation m Real = nominal - inflation

Since inflation usually positive, real < nominal

So Simple method: r ~ i-m <-> r+m~i More precise: Example: If i=10%, m=4% Simple: r=6%, Precise: r=5.77%€

r = (i−m )1+m

Garbage Truck Example

City: bigger trucks to reduce disposal $$ They cost $500k now Save $100k 1st year, equivalent for 4 yrs

Can get $200k for them after 4 yrs MARR 10%, E[inflation] = 4%

All these are real values (why?)See “RealNominal” spreadsheet for nominal values

Other Real and Nominal Values

Economic metrics like GDP, income, wages, etc. all come in real, nominal forms

Example: real vs. nominal GDP If GDP is $990B in $2000.. (this is nominal) and GDP is $1,730B in $2001 (also nominal) Then nominal GDP growth = 75% If 2000 2001 GDP equal to $1450B “in $2000”, then that is a real value and real growth = 46%Then we call 2000 a “base year”

Use this “GDP deflator” to adjust nominal to real GDP deflator = 100 * Nominal GDP / Real GDP =100*(1730/1450) = 119.3 (changed by 19.3%)

Similar Idea : Exchange Rates / PPP

Big Mac handoutCommon Definition of inputsShould be able to compare cost across countries

Interesting 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 grand children can have a lifestyle similar to yours?

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

Match real values with real discount rates, etc How to do sensitivity analysis / which inputs to vary

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 sacrifices

There 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

Next Up:

Friday’s review: microeconomics Supply, demand, pareto efficiency, etc.

Monday - Pipeline CaseSensitivity Analysis (next wed)

Skim Clemen Chapter 5Refers to decision/trees, etc

that we have not done yet (ignore that part)

Next Friday: Using @RISK