Solutions Manual To Accompany Cost Benefit Analysis 4th Edition 0137002696
Solutions Manual To Accompany Cost Benefit Analysis 4th Edition 0137002696
Purpose: This chapter deals with the theoretical issues pertaining to the selection of an
appropriate real social discount rate (SDR). When evaluating government policies or projects,
analysts must decide on the appropriate weights to apply to policy impacts that occur in different
years. Given these weights, denoted by wt, and estimates of the real annual net social benefits,
NBt, the estimated net present value (NPV) of a project is given by:
n
NPV = wt NBt (10.1)
t=0
Selection of the appropriate social discount rate (SDR) is equivalent to deciding on the
appropriate set of weights to use in equation (10.1). Sometimes the weights are referred to as
social discount factors.
Discounting reflects the idea that a given amount of real resources in the future is worth less
today than the same amount is worth now because:
1) Via investment, one can transform resources that are currently available into a greater
amount in the future.
2) People prefer to consume a given amount of resources now, rather than in the future.
Thus, it is generally accepted that the social discount weights decline over time; specifically, 0 <
wn wn-1 ... w1 w0 = 1. However, there is less agreement about the values of the weights.
The key issue in this chapter concerns these values.
Yes – choice of the rate can affect policy choices. Generally, low discount rates favor projects
with the highest total benefits, while high SDRs rates favor projects where the benefits are front-
end loaded.
To understand the theoretical foundation of discounting, one must recognize that it is rooted in
the preferences of individuals. Individuals tend to prefer to consume a given amount of benefits
immediately, rather than in the future. Individuals also face an opportunity cost of forgone
interest if they postpone receiving a given amount of funds until later because they could
In a perfectly competitive capital market, an individual’s MRTP equals the market interest rate, i,
as shown in Figure 10.1. In this two-period model, an individual may consume her entire budget
(T) in the first period, she may invest it all in the first period and consume T(1 + i) in the second
period, or she may consume at any intermediate point represented by the budget constraint in
Figure 10.1, which has a slope of -(1 + i). Consumption is maximized at the point at which the
indifference curve is tangent to the budget constraint, i.e. at point A. At point A, the slope of the
indifference curve is -(1+p), the marginal rate of substitution (MRS) is 1+p, and the MRTP is p.
Consequently, i = p. Note that as current consumption increases, MRS and MRTP decrease.
The text next presents a more general two-period model that pertains to a group of individuals in
a hypothetical country and that incorporates production. It is assumed that this country does not
trade with other counties. Moreover, the chapter initially ignores taxes and transaction costs
associated with making loans. Consequently, the net rate of return on savings corresponds to the
market interest rate. In addition, the chapter initially ignores market failures such as externalities
and information asymmetry, which could cause private and social discount rates to diverge from
one another.
The optimal point is at X in Figure 10.2. At X, the slope of the social indifference curve, -(1 +
px), equals the slope of the consumption possibility frontier, -(1 + rx). Consequently, the
marginal social rate of time preference, px equals rx, the marginal rate of return on investment.
Furthermore, at point X these rates would also equal the economy-wide market interest rate, i.
Finally, at X, all individuals have the same MRTP because, if their MRTP > i, they would
borrow at i and consume more in the current period until their MRTP = i and, if MRTP < i, they
would postpone consumption by saving until their MRTP = i. Since everyone’s MRTP equals i,
it would be the obvious choice for the SDR.
An actual economy (with taxes and transaction costs) would not operate at the optimal point X,
but at a point such as Z. Here, society would under invest and rz > pz. Furthermore, because
In 1928, Frank Ramsey proposed a model with infinite periods in which society (or a single
representative individual) attempts to maximize a social welfare function that reflects the values
that society places on per capital over time. Through investment, consumption increases over
time. Following Ramsay it was shown that if an economy was on its optimal (welfare
maximizing) growth path, the SDR would be given by:
px = d + ge (10.6)
where, px is the SDR, d is the pure rate of time preference, g is the growth in per capita
consumption, and e is an elasticity that measures how fast the social marginal utility of
consumption falls as per capita consumption rises. This model is known as the “optimal growth
rate method.” Society discounts future consumption for two reasons: (1) society is impatient and
prefers to consume more now than in the future; (2) there is economic growth and social welfare
would increase if consumption were “smoothed out” (made more equal) over time: made more
equal than it otherwise would be. This adjustment should be proportional to the product of the
per capita growth rate and e, an elasticity that measures how fast the social marginal utility of
consumption falls as per capita consumption rises. For example, if e = 1, a 10 percent reduction
in consumption today from (say) $40,000 to $36,000 would be viewed as an acceptable trade-off
for a 10 percent increase in consumption (say) from $80,000 to $88,000 at some future point.
This section discusses four potential social discounting rates that are derived from rates
observable in markets. SDRs based on the optimal growth rate method are discussed later.) Use
of all these market rates presume that that resources used for a public project should return more
than they would if these resources remained in the private sector, an opportunity cost concept.
The argument for using the marginal rate of return on private investment as the social discount
rate is that, before the government takes resources out of the private sector, it should be able to
demonstrate that society will receive a greater rate of return than it would have received had the
resources remained in the private sector. Therefore, the return on the government project should
exceed rz, the marginal return on private investment.
The most compelling case for the use of rz was made by Arnold Harberger, who analyzed a
closed domestic market for investment and savings, such as the one presented in Figure 10.4. In
the absence of taxes and government borrowing, the demand curve for investment funds by
private-sector borrowers is represented by Do and the supply curve of funds from lenders (or
savers) is represented by So. With corporate taxes and personal income taxes, the demand and
supply curves would shift to DI and DS, respectively, resulting in a market clearing rate of i and a
divergence between rz and pz, as discussed previously. Harberger assumed that a government
where a = ΔI/(ΔI + ΔC) and b = (1 - a) = ΔC/(ΔI + ΔC). Finally, Harberger asserts that savings
are not very responsive to changes in interest rates. This assertion, which has some empirical
support, implies that the SS curve is close to vertical and, as a consequence, ΔC is close to zero.
This, in turn, suggests that the value of the parameter a is close to one and, hence, the value of (1
- a) is close to zero. In other words, almost all of the resources for public-sector investment are
obtained by crowding out private-sector investment. Thus, Harberger suggests that the marginal
rate of return on investment, rZ, is a good approximation of the true social discount rate.
Numerical Values of rz. Perhaps, the best proxy for rz is the real before-tax rate of return on
corporative bonds, which is on the order of 4.5 percent.
Criticisms of the Calculation and use of rz. There are several criticisms of both the use of rz and
of its estimation, suggesting that using an SDR of 4.5 percent is an upper limit.
1) Private sector returns may be pushed upward by distortions caused by negative
externalities and market prices that exceed marginal costs.
2) Private sector rates of return incorporate a risk premium. Therefore, if benefits and costs
are measured in “certainty equivalents,” as recommended by the text, then using private
sector rates would result in “double counting,” i.e. it would account for risk in two ways.
3) A project might be financed by taxes, rather than by loans – hence, consumption would
also be crowded out.
4) A project may be partially financed by foreigners at a lower rate than 4.5 percent.
2) There may not be a fixed pool of investment so that government may not displace private
investment dollar for dollar. If the government is not fully employing all its resources,
then complete crowding out of private investment is unlikely.
Many analysts hold that the SDR should be thought of as the rate at which individuals in society
are willing to postpone a small amount of current consumption in exchange for additional future
consumption (and vice versa). In principle, pz represents this rate. Consequently, many believe
that the SDR should equal pz. This rate can also be justified if a government project is financed
entirely by domestic taxes and if taxes reduce consumption, but not investment. It is then
appropriate to set a = 0 and b = 1 in equation (10.8), yielding an SDR equal to pz.
The case for using government’s long-term borrowing rate, i, is that it reflects the government’s
actual cost of financing a project.
Numerical Values of i. Starting with the average monthly yield on 10-year U.S. Treasury bonds
for the period between April 1953 and December 2001 and then adjusting for inflation yields a
value for i of 2.7 percent, with a plausible range for sensitivity analysis of 1.7 to 3.7 percent.
If a is the proportion of a project's resources that displace private domestic investment, b is the
proportion of the resources that displace domestic consumption, and 1-a-b is the proportion of
the resources that are financed by borrowing from foreigners, then this approach, called the
weighted social opportunity cost of capital (WSOC), computes the social discount rate as the
weighted average of rz, pz, and i. Specifically:
As pz < i < rz, it follows that pz < WSOC < rz. Obviously, the previous methods are special cases
of this more general approach.
Criticisms of the Calculation and Use of WSOC. Criticisms about the calculation of pz and rz
and i also apply to calculating the WSOC. In addition, the value of the WSOC depends on the
source of a project’s funding and thus would vary among projects. Governments usually prefer a
single discount rate.
If all the resources used in a project displace current consumption and all the benefits produce
additions to future consumption, then the social discount rate should reflect social choices in
trading present consumption for future consumption and pZ would be the natural choice for the
discount rate. However, projects could produce costs and benefits in the form of consumption
or investment. Due to market distortions, the rate at which individuals are willing to trade
present for future consumption, pZ, differs from the rate of return on private investment, rZ, as
previously discussed. Thus, flows of investment should be treated differently from flows of
consumption. The shadow price of capital converts investment gains or losses into consumption
equivalents. These consumption equivalents, like consumption flows themselves, are then
discounted at pZ.
The shadow price of capital method requires that discounting be done in four steps:
1) Costs and benefits in each period are divided into those that affect consumption and those
that affect investment.
2) Flows into and out of investment are multiplied by the SPC to convert them into
consumption equivalents.
3) Changes in consumption are added to changes in consumption equivalents.
4) Resulting amounts are discounted at pz.
(r z + )(1 − f)
SPC = (10.11)
pz − r z f + (1 − f)
where rz is the net return on capital after depreciation, δ is the depreciation rate of the capital
invested, f is the fraction of the gross return on capital that is reinvested, and pz is the marginal
social rate of time preference.
Using the SPC. It is unnecessary to apply the SPC if a project is strictly tax financed and all of
the impacts affect consumption. The case for the SPC is strongest for deficit-financed projects.
Criticisms of the Calculation and Use of the SPC. Although this method is theoretically
appropriate:
1) It is difficult to explain to policymakers how and why NPV calculations are made.
2) The method has heavy information requirements relative to other discounting approaches.
3) The allocation of costs and benefits to investment and consumption may be subjective.
4) The value of the SPC depends on the values of pz and rz and there can be subject to the
criticisms that apply to determining these parameters.
As discussed earlier, the SDR based on the optimal growth rate method, px, can be computed
from the following formula:
px = d + ge,
where
d = the pure rate of time preference
g = the growth in per capita consumption
e = the absolute value of the rate at which the marginal value of consumption declines as
per capita consumption increases
The authors of the text estimate that real per capita consumption grew at 2.3 percent per annum
between1947-2002. The authors suggest that e = 1.3 and, following Arrow, suggest that d =1
percent. These values imply that px = 3.5 percent approximately. Using alternative values for g,
e, and d suggests a range for px of between 2.0 and 6.0 percent for sensitivity analysis.
The Shadow Price of Capital to Use with the Optimal Growth Rate
Given px = 3.5 percent, equation 10.11 suggests that the SPC = 1.1. For sensitivity analysis with
px = 2.0, SPC = 1.32 and with px = 6.0 percent, SPC = 1.0.
INTERGENERATIONAL DISCOUNTING
So far we’ve discussed only constant (time-invariant) SDRs. There are at least four reasons,
however, to suggest the use of time-declining SDRs instead:
1) Empirical evidence suggests that people are time inconsistent – they use lower discount
rates for events that occur farther into the future.
2) Long-term environmental and health consequences have very small present values when
discounted using a constant rate, often implying that spending a relatively small amount
today to avert a costly disaster several centuries in the future is not cost-beneficial.
3) Constant rates do not appropriately take into account the preferences of future, as yet
unborn, generations.
4) Constant rates do not appropriately allow for uncertainty as to market discount rates in
the future. The text demonstrates that allowing for this uncertainty implies that lower and
lower discount rates should be used to discount consumption flows that occur father and
farther in the future. This results from averaging the discount factors, not the discount
rates.
Based on research by Newell and Pizer, the text suggests the following time-declining rate
schedules:
Year px
0 - 50 3.5 percent
50-100 2.5 percent
100-200 1.5 percent
200-300 0.5 percent
Over 300 0.0 percent
inflation. In 2003, the British Treasury recommended using an SDR of 3.5 percent, which is
based on the optimal growth rate method. It also recommended using a time-declining discount
rate for projects with effects that occur after 30 years.