The Social Discount Rate, Cost of Public Funds, and the Value of Information

BENEFIT­COST ANALYSIS Financial and Economic Appraisal using Spreadsheets Chapter 10: The Social Discount Rate, Cost of Public Funds, and the Value of Information © Harry Campbell & Richard Brown School of Economics The University of Queensland Three reasons why NPV>0 may not be the appropriate rule to identify projects which are efficient from a social viewpoint: • the social discount rate may be lower than the market rate of interest; • the marginal cost of public funds may exceed unity (ie. $1 of public funds costs more than $1); • undertaking an irreversible investment involves a loss of option value. The Social Discount Rate Why does the market discount future benefits and costs? • impatience: people value utility today more highly than utility tomorrow. In making choices, future utility is discounted in comparison with utility in the present; • diminishing marginal utility of consumption: people expect to be wealthier in the future. An extra dollar in the future will add less to utility than an extra dollar today. The observed market rate of interest is the sum of the utility discount factor (reflecting impatience) and the utility growth factor (reflecting diminishing marginal utility of consumption). Example: economic growth rate: 2% elasticity of marginal utility of income: 1.5 utility growth factor: 1.5 x 2% = 3% utility discount factor: 1% real market rate of interest: 3% + 1% = 4% Why do people argue that a social discount rate, lower than the market rate of interest, should be used to discount public projects? We should not be discounting the utility of future generations who are not able to participate in markets which determine levels of current investment, and, hence, future utility levels. It is argued that there is, in effect, a ‘missing market’ and we need to use non-market methods to determine the appropriate price (in this case an inter-temporal price in the form of a discount factor). ... - tailieumienphi.vn