1. Social Discount Rate Guest Lecturer: Paulina Jaramillo 12-706 / 19-702 /73-359 Lecture 5

2. Admin Issues zPipeline case study writeup - due Monday zFormat expectations: yFraming of problem (see p. 7!), yAnswer/justify with preliminary calculations yDon’t just estimate the answer! yDo not need to submit an excel printout, but feel free to paste a table into a document zLength: Less than 2 pages.

3. Real and Nominal Values zNominal: ‘current’ or historical data zReal: ‘constant’ or adjusted data yUse deflator or price index for real zGenerally “Real” has had inflation/price changes factored in and nominal has not zFor investment problems: yIf B&C in real dollars, use real disc rate yIf B&C in nominal dollars, use nominal rate yBoth methods will give the same answer

4. Nominal Discount Rates zMarket interest rates are nominal yThey ideally reflect inflation to ensure value zBuy $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. yWhenever people speak of the “interest rate” they're talking about the nominal interest rate, unless they state otherwise.

5. Real Discount Rates zSuppose inflation rate is 3% for that year yi.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. zIf buy the $100 CD at 6% nominal interest rate.. ySell it after a year and get $106, buy the basket of goods at then-current cost of $103, we will have $3 left over. ySo after factoring in inflation, our $100 bond will earn us $3 in net income; a real interest rate of 3%.

6. Example zReal rate r, nominal i, inflation m yReal = nominal - inflation xSince inflation usually positive, real < nominal ySo Simple method: r ~ i-m r+m~i yMore precise: yExample: If i=10%, m=4% ySimple: r=6%, Precise: r=5.77%

7. Garbage Truck Example zCity: bigger trucks to reduce disposal $$ yThey cost $500k now ySave $100k 1st year, equivalent for 4 yrs yCan get $200k for them after 4 yrs yMARR 10%, E[inflation] = 4% zAll these are real values (why?) zSee “RealNominal” spreadsheet for nominal values

8. Other Real and Nominal Values zEconomic metrics like GDP, income, wages, etc. all come in real, nominal forms zExample: real vs. nominal GDP yIf GDP is $990B in $2000.. (this is nominal) yand GDP is $1,730B in $2001 (also nominal) yThen nominal GDP growth = 75% yIf 2000 2001 GDP equal to $1450B “in $2000”, then that is a real value and real growth = 46% xThen we call 2000 a “base year” yUse this “GDP deflator” to adjust nominal to real yGDP deflator = 100 * Nominal GDP / Real GDP y=100*(1730/1450) = 119.3 (changed by 19.3%)

9. Similar Idea : Exchange Rates / PPP zBig Mac handout zCommon Definition of inputs zShould be able to compare cost across countries zInteresting results? Why? zWhat are limitations?

10. zIs it worth to spend $1 million today to save a life 10 years from now? zHow about spending $1 million today so that your grand children can have a lifestyle similar to yours?

11. Discounting Handout zHow much do/should we care about people born after we die? zEthically, no one’s interests should count more than another’s: “Equal Standing”

12. Social Discount Rate zRate used to make investment decisions for society zMost people tend to prefer current, rather than future, consumption yMarginal rate of time preference (MRTP) zFace opportunity cost (of foregone interest) when we spend not save yMarginal rate of investment return

13. Intergenerational effects zWe have tended to discuss only short term investment analyses (e.g. 5 yrs) zEconomists agree that discounting should be done for public projects yDo not agree on positive discount rate

14. Climate Change zDiscussions ongoing about how best to manage global CO 2 emissions to limit effects of global change. zShould we sacrifice short-run economic growth to do something to improve environment and leave resources for the future?

15. Two Questions zWhat duty do we have to make sacrifices for future generations? zIf we sacrifice, what is the optimal policy to maximize benefit? ySo we should compare global change proposals with alternatives yPerhaps higher R&D spending on science or medicine would have higher benefits!

16. Government Discount Rates zUS Government Office of Management and Budget (OMB) Circular A-94 yhttp://www.whitehouse.gov/omb/circulars/a094/a094. html yDiscusses how to do BCA and related performance studies yMatch real values with real discount rates, etc yHow to do sensitivity analysis / which inputs to vary yWhat discount, inflation, etc. rates to use yBasically says “use this rate, but do sensitivity analysis with nearby rates”

17. OMB Circular A-94, Appendix C zProvides the current suggested values to use for federal government analyses yhttp://www.whitehouse.gov/omb/circulars/a094/a94_appx- c.htmlhttp://www.whitehouse.gov/omb/circulars/a094/a94_appx- c.html yRevised yearly, usually “good until January of the next year” yHow would the government decide its discount rates? yWhat is the government’s MARR?

18. Historic Nominal Interest Rates (from OMB A-94)

19. Real Discount Rates (from A-94)

20. What do people think zCropper et al surveyed 3000 homes yAsked about saving lives in the future yFound a 4% discount rate for lives 100 years from now

21. Hume’s Law zDiscounting issues are normative vs. positive battles zHume noted that facts alone cannot tell us what we should do yAny recommendation embodies ethics and judgment yE.g. focusing on ‘highest NPV’ implies net benefits is only goal for society

22. Some Issues Arise zEqual standing does not imply different generations have equal claims to present resources! yHarsanyi says only do so if their marginal gain is higher than our loss

23. zIf future generations will be better off than us anyway yThen we might have no reason to make additional sacrifices zThere might be ‘special standing’ in addition to ‘equal standing’ yImmediate relatives vs. distant relatives yDifferent discount rates over time yWhy do we care so much about future and ignore some present needs (poverty)

24. A Few More Questions zCurrent government discount rates are ‘effectively zero’ zWhat does this mean for projects and project selection decisions? zWhat does it say about intergenerational effects? zWhat are implications of zero or negative discount rates?

25. Comprehensive Everglades Restoration Project zComprehensive project to restore natural water flow to the Florida Everglades. zEnhance water supply to South Florida region. zProvide continuous flood protection. See more info at http://www.evergladesplan.org/

26. Indian River Lagoon-South (IRLS) zPart of Everglades Restoration Project. zTotal Cost of $1.21 billion. zAnnual Benefits of $159 million after project is completed in 2015. zFind NPV of first 25 years of project.

27. IRLS Cash Schedule 000102030405060708091011121314 1516171819202122232425 $0.425 $748.3 $2.043 $447.3 $12.62 $159 per year All values are in millions

28. NPV of Project What would NPV be if we used a negative discount rate?

29. NPV of Project

30. Next Up: zFriday’s review: microeconomics ySupply, demand, pareto efficiency, etc. zMonday - Pipeline Case zSensitivity Analysis (next wed) ySkim Clemen Chapter 5 Refers to decision/trees, etc that we have not done yet (ignore that part) zNext Friday: Using @RISK