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What is cost benefit analysis?

CBA is the social appraisal of investment projects or policies that have consequences over time, using welfare rather than 'commercial' data.


Why use CBA?

1) CBA is a model of rationality, forcing the decision maker to look at who are the beneficiaries and losers in both spatial and temporal dimensions
2) CBA considers all costs an benefits of a policy, not limited to particular aspects
3) CBA takes into account time through discounting
4) In CBA it is individuals preferences that count, and is therefore a democratic procedure. Opponents of CBA say that this is not ideal since taking into account preferences means that even badly informed individuals may have a large say


Define benefits, costs and preferences in cost benefit analysis

Benefits are defined as increases in human well being (utility) and costs are defined as reductions in well being.

Preferences are measured as a willingness to pay (WTP) for a benefit/to avoid a cost and willingess to accept (WTA) compensation for a cost/forego a benefit.


What is the issue of standing?

The issue of who counts in a CBA analysis


Explain the need for a discount factor, 1/(1+s)^t, which represents a temporal weighting where s is a social discount rate.

Costs and benefits will accrue over time and the general rule will be that future costs and benefits are weighted such that a unit of benefit/cost in the future has a lower weight than the same benefit/cost occuring now.

The rationale behind this is that individuals are impatient and have a time preference and also that a pounds worth of resources now will generate more than a pounds worth of resources in the future because capital is productive and due to economic growth.


Briefly describe the two different options for choosing the discount rate.

a) Traditional view, s should reflect the opportunity cost of the capital invested in the social project, namely the foregone return paid by an alternative project

b) Alternative view, s should reflect the social rate of time preference. The minimum return that individuals demand for giving up some of their current consumption in exchange for additional consumption in the future.


Explain the tyranny of discounting

Lives of future generations are not treated as lives of current ones, and the higher the discount rate the worse we treat future generations.

The basis behind this is that a constant discount rate used across periods of time will generate 'exponential discounting'. The process of discounting has a strong theoretical rationale however bears consequences that some environmental literature finds morally unacceptable. It also doesn't align with the concept of sustainable development where future generations should be regarded equally or at a greater sensetivity. However zero discounting has its own implications and is not a solution to the discounting dilemma.

Advocates of discounting claim however that is social preferences do matter and people prefer now to the future then these preferences must be accounted for in project social appraisal.


State the Ramsey Equation which aims to address the discounting dilemma.

Static time: r = ρ + θg
Continuous time: r(t) = ρ + θ(x(t)) g(t)

Optimal productivity of capital = the rate of pure time preference plus the product of the consumption elasticity of marginal utility and the growth rate of consumption.


What are the approaches to the Ramsey equation?

i) Prescriptive
The prescriptive approach derives discounting rates based on fundamental ethical views, even if the results do not match with current market rates. i.e. ρ = 0

ii) Descriptive
An approach which states that discount rates should reflect observed behaviour in the markets


What does the Stern review state?

We shoul immediately invest 1% of global GDP annually to reduce the impact of global warming. Failing to do so could result in a loss of 20% of global GDP. The Stern review believes in a low discount rate, 0.1% arguing the only ethical reason to do is is the chance that future generations may not be there at all.


What is a possible solution to the dilemma of discounting?

The use of time declining discount rates. Weitzman (1998) and Gollier (2002) have both produced separate but related rationales for the use of time declining discount rates.

For both, the key reason for the use of time declining discount rates is based on the uncertainty of the future.


How does Weitzman (1998) explain time declining discount rates?

Interest rates provide valuations of the future relative to the present. These relative valuations are uncertain and hence weights attached are also uncertain.

Weitzman's approach was to take a probably weighted average of the likely discount factors. The simple average of the discount factors was known as the certainty equivalent discount factor and this was discovered to decline with time.


What was Weitzman's key result?

In the limit the certainty equivalent discount rate tends to the lowest possible discount rate.


How does Gollier (2002) explain time declining discount rates?

Gollier showed that when there is uncertainty about future economic growth, individuals may respond to this uncertainty by saving more (the prudence effect).

The prudence effect induces society to employ a discount rate which is lower than the one that should be used if there were no uncertainty about growth.

If individuals are prudent with a risk aversion that declines over time, then discount rates for long term investments should not be constant but decreasing over time.


What is the basic decision rule for accepting a project or policy?

PV(WTP) - PV(WTA) > 0


What is an alternative rule for project appraisal?

To calculate the internal rate of return (IRR). This is the discount rate which would give the project a NPV of 0 and then to compare this to the pre determined social discount rate.

The rule to adopt the project is to accept any proposal which has an IRR in excess of the social discount rate. IRR > s*.