Question

Explain in words why it makes sense to “discount” future benefits relative to benefits today.

Answer 1

Discounting the future

For the purposes of investors, interest rates, impatience and risk necessitate that future costs and benefits are converted into present value in order to make them comparable with each other. The discount rate is a rate used to convert future economic value into present economic value. This is realised through the mechanism known as discounting. For instance, if somebody offers to pay to you EUR 105 an year from now, the present value is EUR 100 if you would earn interest of EUR 5 on a deposit of EUR 100.

There are two main reasons for discounting. The first, called ‘pure time preference’, refers to the inclination of individuals to prefer 100 units of purchasing power today to 101, or 105, or even 110 next year, not because of price inflation (which is excluded from the reasoning) but because of the risk of becoming ill or dying and not being able to enjoy next year’s income.

Economists continue to discount the future, because of the second reason. Economists assume that today’s investments and technical change will produce economic growth. Our descendants will be richer than we are. They will have three, four or even more cars per family. Therefore, the marginal utility or incremental satisfaction they will get from the third, fourth or fifth car will be lower and lower. Discounting is justified by the expectation of economic growth. However, Ramsey did not take environmental considerations and resource exhaustion into account.

We generally discount future amounts of money using constant discount rates, that is, discount factors of the form 1/(1+ r)t. This is called ‘exponential discounting’, and it implies that values in the distant future tend to have present values close to nothing. High discount rates imply giving low values to future damages, and thus, betting against the environment and future generations. A distinction can also be made between public or social discount rates and private discount rates. Both sectors use a positive discount rate (that is r > 0), but there is a difference in the fact that the social discount rate is lower than the private discount rate. This is because individuals (private sector) are mostly concerned with their own welfare in the very short term, and they are risk-averse, discounting future benefits heavily. On the other hand, the public sector (society as a whole) tends to have a longer-term perspective, entailing lower discount rates.