Question

Why is the choice of social discount rate important in cost-benefit analysis? Critically examine when it is most appropriate to use the (1) Social Opportunity Cost of Capital, (2) Social Rate of Time Preference, and (3) Ramsey approach for discounting in Cost- Benefit Analysis.

Answer 1

The social discount rate is a critical parameter in cost-benefit analysis whenever costs and benefits differ in their distribution over time, especially when they occur over a long time period. The cost and benefit estimates should involve a comprehensive and systematic evaluation of all the impacts of a project, accounting for all the effects on all the people in society: not just the immediate or direct effects, not just financial effects, and not just the consequences for one group.

Social Opportunity Cost of Capital: If government investment comes at the expense of private investment, the cost to the economy is measured by the social returns that would have been generated by that investment. This has been variously labelled the investment rate of interest, the producer rate of interest, the marginal rate of return to investment or capital, the marginal efficiency or product of capital, or the social opportunity cost of capital. Cost benefit analysis of a project values the stream of costs and benefits that accrue to consumers.

Social Rate of Time Preference: Social rate of time preference is used to determine the relative weights put on the welfare of different generations in the social welfare function. If ongoing economic growth is expected to make future generations better off and if the social welfare function values equality in utility, the social rate of time preference should be positive. The social rate of time preference is zero with a utilitarian social welfare function, but this an extreme representation of social preferences that is unconcerned with equality between generations.  

Ramsey Approach :  Ramsey formula can be used to examine intergenerational discounting issues and to evaluate policies that would reduce catastrophic risks to the economy and in case where uncertainty about the rate of growth in consumption