Discount Rates

CHOOSING A
DISCOUNT RATE
SHADOW PRICING
In the realm of public policy, shadow price (S), or social
opportunity cost is defined as the increase/decrease in the social
welfare resulting from any marginal change in the availability of
commodities or factors of production.

Change in social welfare
Mathematically, S

= -------------------------------
Change in output of good

A shadow price reflects the social evaluation of the input or the
output. This may or may not be equal to the market price.

It is called a shadow price since it does not have an existence apart
from its use in social evaluation.

SHADOW PRICE OF CAPITAL
Due to market distortions, the marginal return on capital
investment and the social rate of discount vary considerably,
and thus provide a wide range for the choice of preferred
discount rate.

This rate is based on shadow price of capital, which involves
assessing the capital investments in terms of loss in future
consumption.

By definition, shadow price of capital is defined as the
present value of lost future consumption from the investment
over the time period of the investment.
APPROACH FOR CALCULATING
SHADOW PRICE OF CAPITAL
1. Estimate the policy's effect on investment versus consumption

2. Annualize the capital costs over the expected lifetime of the
capital budget using the opportunity cost of capital

3. Include these annualize amounts in the net benefits of the
project

4. Discount the stream of net benefits at the consumption rate of
interest
A Case Study
Assume that the US Government is funding a major
policy for education and employment. The program is
fully funded by the Federal government through
borrowing. The project requires an initial capital of
$20 billion, will bring $6 billion in benefits each year
and has an operating cost of $2 billion per year. We
will now calculate the shadow price of capital over a
10 year time horizon.
Step 1: Estimate the policy's effect on
investment versus consumption

Few important points
All borrowed funds can be assumed to displace investment
(the crowding out effect)
Projects funded through taxes mostly displace consumption
(decrease in disposable income)

Let's assume that the project displaces private investment and
consumption equally by $10 billion each (i.e, it is equally
funded via government debt and taxation)

Step 2: Annualize the capital costs
over the expected lifetime
Solve the following present value equation for X.

PV = $10 billion (amount of displaced investment)
r
3
is the rate of return to capital (say 7%)
n = 10

Upon solving, 'X' evaluates to $1.424 billion per year

OR
Next, find the present value of this stream of lost future
consumption (for the 10 year time period) using the social rate
of discount (say 3%)
i.e, find the present value of a series of $1.424 billion costs
incurred for 10 years discounted at 3%

Upon evaluation, the present value comes to $12.5 billion

Therefore, the shadow price (per unit of present consumption
lost) is equal to $12.5 billion/$10 billion = 1.25
Steps 3 and 4: Finalize the present
value estimate
$10 billion in consumption loss in year 0.

Net benefits: $6 billion in benefits (-) $2 billion in operating costs (-) $1.4
billion in lost future consumption = $2.6 billion per year

The Net Present Value evaluates to $14.10 billion

Since the Net Present Value is a positive value, the net benefits exceed the
costs and thus the government can go ahead with the project

INTERGENERATIONAL
EQUITY
The issue of intergenerational equity arises when the project
extends over a very large time horizon and affects many
generations

One of the main reasons the equity problem arises is due to the
relative importance of net benefits to different generations

According to utilitarian theory, discounting long term public
projects at a constant rate will devalue the net benefits to
future generations , especially if the doscounting rate is higher
than the real growth rate of the economy.
DISCOUNTING IN A
LONG-RUN CONTEXT
There are two different models for discounting of net
benefits for future generations
based on declining discount rate (makes use of a
mathematical function in which doscount rate falls with the
passage of time. Also called hyperbolic discounting)

based on expected growth rate of the economy (related to
diminishing marginal utility of income)
Declining (or hyperbolic)
discount rate model
One of the most widely used forms for declining discount rates
is as follows:
PV
ddr
= 1/(1+at) (the present value of $1 in year t)

Comparison between declining and fixed interest rate models

Expected growth rate model
In this approach, the discount rate is calculated by
multiplying the expected growth rate (g) of
consumption in dollars with the estimated rate of
decline of the marginal utility (u) of a dollar of
consumption. Usually, a pure rate of time preference
(p) is added to the product

r
g
= g.u + p
APPENDIX
EFFECTS OF TAXES ON INTEREST RATES

Discount Rates

Uploaded by

Copyright:

Available Formats

Discount Rates

Uploaded by

Document Information

Original Description:

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Discount Rates

Uploaded by

Copyright:

Available Formats

CHOOSING A

You might also like