Question

1. What is the “discounted present value” of future returns and how does it relate to the “interest rate”?  Who do you expect values future returns more: you or your parents? Why?

2. Read Liza Heinzerling and Frank Ackerman, “Pricing the Priceless” Real World Micro, article 6.1.
   1. What is cost-benefit analysis? How would you apply cost-benefit analysis to your decision to go to a public college or a private school? What are the benefits and what are the costs of going to each?
   2. What happens to your analysis if the interest rate rises? What happens if the payoff period shrinks? Would you expect your parents to go to college?
   3. How would you apply cost-benefit analysis to environmental policy? What are the costs of pollution? What are the benefits? Who receives the benefits, and who bears the costs? When the benefits in the costs are received in different times, how can you compare them? What happens if you use a lower discount rate or a higher one?

Answer 1

Discounted Present Value of Future Returns :

The value of money or goods in the present is much higher than the value of goods and financial return in the future.

For e.g: You would probably value $300 today than getting $450 after two years.

So, further the benefit or cost in the future lesser its present value. This process of obtaining the present value of future costs and benefits is called discounting.

So, for the purpose of discounting you use a discount rate and this could be the the interest rate present.

I suppose parents value future returns more because they are always preparing themselves for the future for instance expenses on future tuition fee on their children , future investment in a house etc.

As for us, students we want money or goods now our value for future benefits is very low as we do not think about the future returns as much.

A. Cost- benefit analysis is the process of identifying all the potential costs and benefits of a project and discounting them to present values and then comparing whether the benefits exceed the cost. If it does then the project is feasible else it should not be undertaken. This analysis can also be utilized to compare different alternatives and choose the best one.

To choose between public vs private school , first we need to identify the cost and benefits associated with each. A method called cost-benefit ratio can be used where the benefits are divided by the costs and if the ratio is more than 1 then it is good else not suitable because it means the costs exceed the benefits procured.

So, for a public school the biggest benefit is no tuition fee and no expenses on uniform. Cost could be in terms of purchase of books, transport etc.

For a private school cost would be the tuition fee, expenses on books , uniform etc. Benefits which might not be monetary but converted into monetary terms like better standard of learning, you value a smaller class size.

This could be very subjective based on the individual and cannot be generalized. If I have to choose I would choose public over private because I would be saving a lot on the fees. However, another who values other aspects and has the money to pay for private school would join a private school.

B. So higher the interest rates lesser the value of the discounted returns. Sp, this could make the project not seem feasible.

Pay-back period is the period ( no. of years) within which the cost invested can be paid back because of the benefits generated and after that all benefits are just like profits.

So, if a pay-back period shrinks then it could make a project seem more viable or maybe become a better alternative than another.

C. For an environment policy the costs are the costs involved in implementing it. For instance it is a policy to reduce emission from industries then the costs are placing filters in the chimneys, cost involved in regulating it. The benefits could be reduction in emission so improvement in the air quality. Hence, a better and healthy individuals in that area so reduction in costs on medical care.

Cost of pollution are directly related to the money spent on medical care by individuals. This pollution has a long - lasting effect and hence, even humans being born 20 years later will be affected by this in some way or another.

Benefits are the better quality of air, water, land. So this means lesser money spent on medical care by people who would have been likely affected by the thousands of diseases if other wise.

The individuals affected by the contaminated air,water and soil are the ones who would benefit from any environmental policy. The bearers of costs are the ones who contribute to the contamination such as factories responsible for polluting the air.

If they are in different time discount the future costs and benefits in terms of the present value and then compare them.

A lower discount rate will lead to higher discounted returns and thus might make an investment look more viable and if the discount rate is high then discounted returns are lesser and might make the same investment unfeasible.

So, choosing a discount rate is very important as the viability of the project is highly dependent on that.