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Pricing the Planet's Future

Pricing the Planet's Future: The Economics of Discounting in an Uncertain World

Copyright Date: 2013
Pages: 296
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    Pricing the Planet's Future
    Book Description:

    Our path of economic development has generated a growing list of environmental problems including the disposal of nuclear waste, exhaustion of natural resources, loss of biodiversity, climate change, and polluted land, air, and water. All these environmental problems raise the crucial challenge of determining what we should and should not do for future generations. It is also central to other policy debates, including, for example, the appropriate level of public debt, investment in public infrastructure, investment in education, and the level of funding for pension benefits and for research and development. Today, the judge, the citizen, the politician, and the entrepreneur are concerned with the sustainability of our development. The objective ofPricing the Planet's Futureis to provide a simple framework to organize the debate on what we should do for the future.

    A key element of analysis by economists is the discount rate--the minimum rate of return required from an investment project to make it desirable to implement. Christian Gollier outlines the basic theory of the discount rate and the various arguments that favor using a smaller discount rate for more distant cash flows.

    With principles that can be applied to many policy areas,Pricing the Planet's Futureoffers an ideal framework for dynamic problems and decision making.

    eISBN: 978-1-4008-4540-8
    Subjects: Business, Political Science
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Table of Contents

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  1. Front Matter (pp. i-iv)
  2. Table of Contents (pp. v-vi)
  3. Preface (pp. vii-xii)
  4. Introduction (pp. 1-14)

    Many books have described how civilizations rise, blossom, and then fall. Underlying this observed dynamic are a myriad of individual and collective investment decisions affecting the accumulation of capital, the level of education, the preservation of the environment, infrastructure quality, legal systems, and the protection of property rights. This vast literature, from Adam Smith’sWealth of Nationsthrough Gregory Clark’sFarewell to Almsto Jared Diamond’sCollapse, is retrospective and positive, examining the link between past actions and the actual collective destiny. In contrast, this book takes a prospective and normative view, analyzing the problem of investment project selection. Which...

    • 1 Three Ways to Determine the Discount Rate (pp. 17-25)

      In this chapter, we present the simple two-period model that is used in classical economics textbooks to examine the problem of consumption, saving, and investment in a competitive economy. This model reminds us of the key role of the interest rate for the determination of economic growth. Its equilibrium level balances the demand and the supply of liquidity, which are themselves characterized by time preferences and investment opportunities. From a simple arbitrage argument, any new investment opportunity in the economy should be evaluated by using the interest rate as the rate at which the future benefits of the project should...

    • 2 The Ramsey Rule (pp. 26-40)

      In this chapter, we present the main argument in favor of a positive discount rate. In a growing economy, future generations will consume more goods and services than we do. In this context, investing for the future is equivalent to asking poor consumers to sacrifice more of their consumption for the benefit for wealthier people. Because of inequality aversion, one would be ready to do so only if the rate of return of these investment projects is large enough to compensate for the increased intertemporal inequalities that these projects would generate. The Ramsey rule quantifies this wealth effect.

      The most...

    • 3 Extending the Ramsey Rule to an Uncertain Economic Growth (pp. 41-58)

      It is commonly accepted that individuals are ready to sacrifice more in the present for the future when this future becomes more uncertain. Keynes was the first to mention this idea by pointing out the precautionary motive for saving. What is desirable at the individual level is also desirable at the collective one. A society that wants to reinforce the incentive to invest for the future because of its uncertain nature should select a smaller discount rate to evaluate the set of all possible investment projects. We formalize these ideas in this chapter.

      Uncertainty is a feature of everyday life....

    • 4 Random Walk and Mean-Reversion (pp. 61-73)

      The first part of this book concluded that there is a solid scientific basis to recommend the use of a discount rate around 3.6% in the western world for cash flows occurring in the next few years. Does this imply that the same rate should be used to discount all sure cash flows, irrespective of when they occur? The theoretical answer to this question is, in general, “no.” The socially efficient discount rate need not be constant with respect to the time horizon. However, our benchmark result in this chapter is that the discount rate should be independent of the...

    • 5 Markov Switches and Extreme Events (pp. 74-83)

      The economic history of the world has one obvious feature: for thousands of years, per capita consumption remained close to subsistence level. Society followed Malthus’ Law, whereby any technical progress led to an increase in population rather than an improvement in welfare. For example, Clark (2007) estimates that the daily wage in Babylon (1880–1600 BC) was around 15 pounds of wheat. In the golden age of Pericles in Athens, it was approximately 26 pounds. In England in about 1780, it was only 13 pounds.

      Thanks to the industrial revolution, the western world escaped this miserable economic trap toward the...

    • 6 Parametric Uncertainty and Fat Tails (pp. 84-97)

      This book started the analysis of discount rates by considering a sure rate of growth of consumption. The analysis was extended by recognizing that economic growth is uncertain. In the previous chapter, it was noted that the parameters governing this uncertainty may be unstable. In this chapter, we go one step further by recognizing that the probability distribution for economic growth is itself subject to some parametric uncertainty.

      Estimation of the parameters governing a stochastic process, such as the mean or the volatility, can be performed using a data set of past realizations of this process. However, this sample may...

    • 7 The Weitzman Argument (pp. 98-110)

      In the first chapter, it was shown that there are essentially two methods to determine the socially efficient discount rate. The first method is based on the marginal rate of intertemporal substitution. It leads to the Ramsey rule and to a variety of extensions that have been analyzed in detail in the previous chapters. The other method is based on the rate of return of capital. At equilibrium, the two methods should lead to the same result, which is the equilibrium interest rate.

      Let us re-examine the reason why the discount rate should be equalized to the rate of return...

    • 8 A Theory of the Decreasing Term Structure of Discount Rates (pp. 111-128)

      This chapter completes part II of the book. It aims to provide a unified theoretical foundation to the term structure of discount rates. To do this it develops a benchmark model based on two assumptions: individual preferences toward risk, and the nature of the uncertainty over economic growth. We have shown that constant relative risk aversion, combined with a random walk for the growth of log consumption, yields a flat term structure for efficient discount rates. In this chapter, these two assumptions are relaxed by using a stochastic dominance approach.

      The first step is to explore the link between the...

    • 9 Inequalities (pp. 131-148)

      In the canonical models of the term structure presented earlier in this book, a single agent was assumed to benefit from the cash flow that the investment project under scrutiny generates. Another way to interpret this model is that there is more than one person, perhaps many people, who all have the same (perfectly concordant) consumption levels and the same share of the project’s cash flows. Of course, the real world is quite different. In particular, our societies are unequal, and people are unequally affected by macroeconomic shocks. Moreover, the costs and benefits of most public policies are not spread...

    • 10 Discounting Non-monetary Benefits (pp. 149-167)

      Environmentalists are often quite skeptical about using standard cost-benefit analysis to shape environmental policies because environmental damages incurred in the distant future are claimed to receive insufficient weight in the economic evaluation. From their viewpoint this may be caused either because future environmental assets are undervalued, or because the economic discount rate is too large. In this chapter, we address these two questions together by defining an ecological discount rate compatible with social welfare when the representative agent cares about both the economic and ecological environments faced by future generations. This ecological rate at which future environmental damages are discounted...

    • 11 Alternative Decision Criteria (pp. 168-182)

      The discounted expected utility (DEU) model that is used in this book is not without its critics. Since Allais (1953), many researchers have found contexts in which human behavior is incompatible with the DEU model. It is clear that the model is violated by many people, in many contexts. Some of these violations are informative about the true nature of individuals’ actual preferences, whereas others are generated by errors, biased beliefs, lack of information, or a lack of time and effort spent on finding the optimal strategy. These violations imply that the DEU model is not very good for explaining,...

    • 12 Evaluation of Risky Projects (pp. 185-202)

      This book is mostly devoted to the evaluation of safe investment projects. However, most real projects are not safe, and indeed many of them are very risky. This is particularly the case for those yielding cash flows in the distant future. For example, the size of the damages associated with climate change is vastly uncertain. How should this affect the way in which we discount the reduction of these damages obtained from our green investments? In a highly uncertain distant future, how do we value R&D; yielding uncertain distant benefits and costs, as is the case for genetically manipulated organisms,...

    • 13 The Option Value of Uncertain Projects (pp. 203-214)

      Up to now in this book, an investment project was described by its flow of costs and benefits. When we introduced uncertain cash flows in the previous chapter, we did not allow the decision maker to react to the potential new information that could arise about the profitability of the project. The only decision was whether or not to invest in the project. This is quite counterintuitive. Indeed, the most basic idea of risk management is that flexibility is crucial to behaving efficiently in an uncertain world. According to this idea, an investment project is not univocally characterized by its...

    • 14 Evaluation of Non-marginal Projects (pp. 215-224)

      The beauty and usefulness of cost-benefit analysis is that it relies on a few numbers, which represent the social value of the different dimensions of costs and benefits: the value of life, the value of environmental assets, the discount rate, or the risk premium for example. Once these values are determined, the evaluator is just required to estimate the flows of these multi-dimensional impacts, and to value them according to these prices. We show in this chapter that this simple toolbox can be used only if the actions under scrutiny are marginal, that is, if implementing them has no macroeconomic...

  9. Global Conclusion (pp. 225-226)

    The discount rate is a key parameter in economics because it determines how our societies value their future. The aim of this book was to help build a consensus on the social discount rate to use in the NPV decision rule: to find the discount rate which gives a positive NPV only for those projects that raise the sum of present and future generations’ felicity. In this book, I advocated the following set of principles:

    1. The driving force of discounting is the collective aversion to (intertemporal) inequalities which in the models in this book is represented by a concave...

  10. Index (pp. 227-232)