Discounting and Uncertainty: A Non-Economist’s View

When asked to choose between immediate and delayed rewards or costs, both human and (other) animal respondents will equate a small reward sooner with a larger one later. This is the well-known phenomenon of individual “discounting.” The capital interest rates that prevail in market economies are a related phenomenon. Most economists agree that “social” discounting should be applied to compare costs and benefits that accrue to society at different times due to, for example, actions to reduce environmental degradation. They cannot agree, however, on appropriate rates to use. This is important since the policy implications tend to hinge on the assumed rate, as benefits often lag investment costs by times that can exceed 1/δ for plausible discount rates δ. A high discounting rate makes investments (for example, intervention to reduce future climate change) appear unattractive if rewards do not accrue very quickly, even if they eventually far exceed costs. This may seem unjust or unethical. Omitting discounting, on the other hand, can indicate that we should be engaged in radically large investments. Much discourse has ensued over discounting, often pitting economists against others. However, as long as comprehensive cost-benefit analysis is to be attempted, discounting or something equivalent cannot be avoided. A recent review of the economics literature (Spackman, 2004) discusses discounting justifications and the many controversies surrounding them. Previous editorials in this publication (Heal, 1997; Nordhaus, 1997) have also touched upon important aspects. Two key points will be discussed here. First, individual and social discounting differ in fundamental ways, so it is important to understand the former deeply before any inferences can be drawn regarding the latter. The distinction is appreciated by many but not acknowledged in foundational models of macroeconomics1 . Second, uncertainty in future events qualitatively affects how discounting should be done. While each of these points has been made elsewhere, poor cross-disciplinary appreciation of some key