Costs, benefits and ‘discounting’ the future

Measuring costs and benefits is a crucial part of many microeconomic models. It’s central to understanding the pricing and output decisions firms make. You can’t understand how market failure may arise from the problems presented by externalities without measuring costs and benefits.Yet making those measurements is often tricky, especially when some of the costs or benefits arise in the future.

Let's optimistically assume that you can accurately estimate the size of costs and benefits. Here I’ll use transport as an example, before picking up on the threat posed by climate change, with this week’s news of significant ice loss from Antarctica which poses a cost to the world in terms of higher sea levels in the future.

And that’s the problem, since if a cost (or benefit) arrives in the future, it’s not such a big deal as a cost (or benefit) that arises now. If you don’t believe me, consider this question: would you prefer to have £1m now, or in 10 years? The answer should be obvious. Benefits now are always worth more than benefits in the future, simply because of the immediate value of benefits. They can effectively be ‘banked’. £1m of benefit in 10 years’ time isn’t worth as much as £1m now.

This is relevant when discussing investment decisions in energy, infrastructure and transport economics. Which road improvement is better? One that delivers £100m of benefits this year, or one that will deliver an anticipated £100m of benefit by 2024? The earlier scheme is the clear winner.

In order to do the maths, the 2nd project proposed has to have the £100m of benefit adjusted so a fair comparison could be made. A transport economist may for instance determine that £100m in 10 years is worth £75m in terms of net present value. This is known as ‘discounting’ future returns.

This is a huge issue that has to be considered carefully. With clear heads, we can see that very distant benefits are hardly worth our consideration. This delays, or deters, investment in projects that yield distant benefits. With transport, this tends to mean that we prioritise those projects promising a rapid pay back – but many people argue that this stops us from addressing the real priorities, and tackling root causes.

Back to retreating glaciers. Climate change poses a massive challenge to policy makers, because some choices require a difficult balance between paying now to derive benefits (or reduced costs) in the distant future, as this Economist article explains. Take this statement – “A pair of studies show that part of the ice sheet is melting more quickly than previously thought, and that several of its large glaciers will probably melt into the ocean, raising global sea levels at least 10 feet in the coming centuries”.

Oh. Coming centuries. That’s a future cost, but one which I’m prepared to massively discount. If you believe that we should take drastic action to stop climate change now - even though it might slow economic growth - you have to assume that future costs will be very, very big or that people living today place significant value on benefits realised 50 or 100 or 500 years down the line. And that strikes many economists as implausible. It is easy enough to imagine that people living today care about benefits that might accrue to them in their old age, or that of their children or grandchildren. But look much beyond a century and the beneficiaries become too distant to count much in our calculations. Discount rates, in other words, are high.

This blog isn’t an argument against taking the threats posed by climate change seriously, but it might perhaps shed some light on why it’s so hard to get the right policies in place, since putting a value on costs and benefits in the future is so tricky.