Social Discount Rate - Use in Cost Benefit Analysis

Use in Cost Benefit Analysis

It may be used in estimating the value of creating a highway system, schools, or forcing environmental protection, for example. All of these things require a cost-benefit analysis where policy makers measure the social marginal cost and the social marginal benefit for each project. Almost all new policies will not even be considered until after a cost-benefit analysis has been completed. The social discount rate can appear in both calculations either as future costs such as maintenance or as future benefits such as reduced pollution emissions.

Calculating the true social marginal cost can be a lot easier than measuring the social marginal benefit. Because of the uncertainty involved with calculating benefits, problems may arise. Should you put a dollar amount on time based on average wages, contingent valuations or revealed preferences? One of the big problems today is putting a value on a life. While some might say that a life is priceless, economists usually state the value to be somewhere between three to ten million dollars. Another problem is that often the current generation will be paying for most of the costs while future generations will be reaping most of the benefit. Should we weight current and future benefits differently?

The proper discount rate should represent the opportunity cost of what else the firm could accomplish with those same funds. If that means that the money could be instead used to invest in the private sector that would yield 5% and that is the next best alternative for using that money then 5% would be the social discount rate. The government uses a variety of discount rates but something around seven percent is what the U.S. Office of Management and Budget (OMB) recommends for a pretax rate of return on private investments.