Discount rate

Discount rates are used in economics to allow for the reduced values that are ascribed to deferred occurrences, and have applications both to the cost/benefit analysis of public sector projects and to the appraisal of private sector investments. They are also used in financial theory in connection with the management of interest rates by central banks. The choice of discount rate for the evaluation of the effects of global warming has major policy implications.

Discounting criteria

The preferred method of applying discount rates to cost/benefit analysis and to investment appraisal is by the calculation of the "net present value" of future flows of cost and benefits using the formula set out on the tutorials subpage. Allowances for risks are made, either by adjustments to the risk-free discount rate, or by using specific probability estimates to calculate a "net present expected value"

Discount rates in cost/benefit analysis

The social opportunity cost rate

Many public sector authorities have evaluated their investments using discount rates based upon the returns earned by private sector companies, in order to avoid "crowding-out" private sector investments. Their estimates of the appropriate rates have usually been obtained either from the reciprocal of the aggregate capital/output ratio, or from surveys of discount rates used for investment appraisal in the private sector. In some cases, reductions to the resulting estimates have been introduced to allow for "externalities" that are socially significant, but are not allowed for in company accounts, such as noise and pollution, and for monopoly profits resulting from the exercise of market power. However some economists have questioned the assumption that public sector investments crowd out commercial investments, arguing that any crowding-out might just as well be at the expense of individuals rather than companies. The United States Office of Management and Budget now recommends the use of the real interest rates on Treasury notes and bonds, which in 2008 ranged from 2.1% for 3 years to 2.8% for 30 years

The social time preference rate

The social time preference concept of discounting, arises from the behavioural observation that people prefer immediate satisfaction to deferred satisfaction. Thus the term “discount rate” refers to the compensation in terms of increased utility that a person requires as inducement to defer consumption (usually as a percentage per annum). The discount rate that a person experiences assuming no expectation of changing circumstances, is sometimes termed his “pure time preference rate” - to distinguish it from the inducement that he would require if he expected his consumption to increase. In that case, he would take account of the fact that, as his total consumption increased, he would experience a reduction in the marginal utility of any further increase . The proportionate further compensation that a person requires to take account of its diminishing marginal utility is referred to as that person’s “elasticity of the marginal utility of consumption”. (The derivation of that concept is attributed to a 1928 paper by the economist Frank Ramsey . There is a note on the “Ramsey equation”, and the estimation of the associated elasticity measure, on the tutorials subpage.). A community’s discount rate, taking account of rising consumption, is termed its “social time preference rate”. The social discount rate of a community togeher with its liquidity prefernce are major determinants of its market interest rate.