Question

Why must future net benefits be discounted in a cost-benefit analysis? Define social rate of discount in your own words. What are some of the difficulties in choosing an appropriate social rate of discount? How does the discount rate affect the net benefits and the ranking of public projects?

Answer 1

Ans) Future net benefit must be discounted in a cost benefit analysis because a dollar today will have worth more than a dollar five years from now even if there is no inflation because today's dollar can be used productively in the ensuing five years, yielding a value greater than the initial dollar. Future benefits and costs are discounted to reflect this fact.

Social discount rate (SDR) is a parameter used to put a present value on costs and benefits that will occur at a later date. Basically it is used to compute the value of funds spent on social projects.

Determining social rate of discount is not always easy and can be the subject of discrepancies in the true net benefit to certain projects, plans and policies. Because of the uncertainty involved with calculating benefits, problems may arise e.g., should a dollar amount be put on time based on average wages, contingent valuations or revealed preferences?

The discount rate affect the ranking of public projects as 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.