Social Discount Rate 12-706 / 19-702

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

Similar to Real/Nominal : Foreign Exchange Rates / PPP Big Mac handout Common Definition of inputs Should 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 grandchildren can have a lifestyle similar to yours? Ask for someone to give a summary of handout!!!!!!

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” Higher the discount rate, the less future values will count compared to today Implies there is no justification for discounting across long time periods

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 What about effects in distant future? Called intergenerational effects

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” The document in this website explains how the OMB calculated this rates. The numbers in the basic document are for 1992. The Apendix is updated every year and it is where we can find current 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? MARR is Minimum Acceptable Rate of Return 2008: 2.5 to 3.0 % for real discount rate

Historic Nominal Interest Rates (from OMB A-94)

Real Discount Rates (from A-94) Depending on the length of project, use different rates. If project is between 7 and 10 years, you can do a linear approximation. What is implication of a 2% real discount rate for government projects?

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 We should sacrifice for future generations only if their average well-being of future generations goes up by more than we lose today

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) Based on these arguments, what discount rates should we use for policy problems (eg climate)

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? It basically means we don’t discount very much. There are really no preferences for time. Generations equal.

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 All values are in millions $159 per year $0.425 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 What would NPV be if we used a negative discount rate?

NPV of Project

Which is the right discount rate? What are implications of each?

Show of Hands Example Choice #1: Choice #2: $50 today or $100 paid 1 year from now? Why? Choice #2: $50 to be paid in 5 years or $100 in 6 years?

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

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 We have high short-term discount rates, but lower in the distant future IF we are time inconsistent, we should plan for the future knowing that. Eg we otherwise think that we know we will act in year 10 the same way we would today - but in 10 years, we will again have a preference for short term versus long term gains.

Next Up: Friday’s review: more discounting Monday Loans, taxes, etc. Pipeline Case Sensitivity Analysis