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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
BENEFIT-COST ANALYSIS
BENEFIT-COST ANALYSIS
Financial and Economic
Financial and Economic
Appraisal using Spreadsheets
Appraisal using Spreadsheets
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).
What is the appropriate discount rate for public projects?
It is reasonable to employ a utility growth factor in discounting
public projects: if future generations are going to be wealthier than
us, we should take this into account in sacrificing present
consumption to make provision for the future.
It is not reasonable to employ a utility discount factor in
discounting public projects: we should not treat the utility of future
generations as any less important than that of the present
generation.
Developing our simple example: instead of using the real market
rate of interest of 4% as the discount rate for public projects, we
would adjust it downwards by the amount of the utility discount
factor (1%) to get a social discount rate equal to the utility growth
factor (3%).
Using a social discount rate would tend to make investment
projects more attractive, but the 1% difference in discount rate
would be crucial in only a few cases.
The Marginal Cost of Public Funds
Raising public funds to undertake investment projects involves
three types of costs:
•
collection costs: costs of running the tax office;
•
compliance costs: costs incurred by taxpayers;
•
deadweight loss: costs of misallocation of resources as
people
respond to prices distorted by taxes.
Compliance and collection costs are largely fixed costs: they do
not change when the amount of tax collected changes by a small
amount. Since any given project will involve relatively small
changes in the flow of public funds, compliance and collection
costs can be ignored in social benefit-cost analysis.
The amount of deadweight loss tends to rise (fall) as the amount of
public funds raised rises (falls).
A project which requires additional public funds imposes an
additional deadweight loss on the economy; and a project which
contributes to public funds reduces the amount of deadweight loss.
When the additional deadweight loss is taken into account, the
NPV rule becomes:
NPV = B - C - D > 0
where: B is the PV of project benefits
C is the PV of project costs
D is the additional deadweight loss
The NPV rule could also be written as:
B - C[(C+D)/C] >0, or
B/C > (C+D)/C
where (C+D)/C is the marginal cost of public funds.
[...]... increase on the quantity of labour supplied and he quantity of leisure demanded Estimates of the marginal cost of public funds: In Australia and other OECD countries most estimates of the marginal cost of public funds are in the 1.2 - 1.3 range In other words, there is an additional deadweight loss of around 25 cents per dollar of extra tax revenue raised Implications of the marginal cost of public funds... out the cost to the economy of displacing $50 worth of private consumption and $50 worth of private investment: • the loss of $50 worth of private consumption costs $50 • the $50 worth of private investment would have yielded an annual before-tax return of $50r* The present value of this return (at the market rate of interest) is $50(r*/r) = $50*1.5 = $75 The cost to the economy of raising $100 of public. .. that the project should not go ahead immediately? There might be uncertainty about the values of some of the variables used to calculate the NPV e.g future prices Delaying the project might resolve these uncertainties To investigate the value of delaying the project we compare the NPV (at time 0) of undertaking the project immediately (at time 0) with the NPV (at time 0) of delaying the start of the. .. public funds for social benefitcost analysis: All flows of public funds resulting from a project should be shadow-priced (at around 1.25 in Australia) This increases the cost of outflows and increases the benefits of inflows of funds as a result of a project The Value of Information Suppose that you have undertaken a social benefit -cost analysis and find that NPV>0 Is there any reason (other than a budget... illustrates the expected NPVs of the two options Figure 10.2 The benefit and cost of delaying an investment Wait q RH/r – K/(1+r) Invest (1-q) 0 [since {RI/r) – K/(1+r)} .
Chapter 10: The Social Discount Rate,
Cost of Public Funds, and the Value of
Information
© Harry Campbell & Richard Brown
School of Economics
The University. types of costs:
•
collection costs: costs of running the tax office;
•
compliance costs: costs incurred by taxpayers;
•
deadweight loss: costs of misallocation
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