Presentations THIS WEEK (W) Roosth: Kyoto Protocol (W) Shrum: Clean development mechanism (F) Dorfman: Carbon markets NEXT WEEK (M) Bhargava: international protocols (W) Wang: cap and trade v. tax (W) Octaviano: alternative instruments

Schedule THIS WEEK Monday: Discounting Wednesday: Kyoto Protocol Friday: Kyoto Protocol /Go over IA problem NEXT WEEK Monday: Uncertainty Wednesday: Alternative instruments (cap and trade/ carbon taxes) Friday: Wrap up

Discounting in economics: The fundamental determinants Economics 331b 3

Philosophical-ethical foundations of environmental economics Religious and Kantian views: Largely absent Utilitarianism: Bentham, J.S. Mill (Utilitarianism), Peter Singer (on animals) In modern bioethics: Maximize QALYs Happiness research and hedonic psychology (among behavior psychologists and some economists) Welfarism (of the social welfare function): Bergson, Samuelson, Foundations Paretianism: An incomplete ordering of social states based on welfarism used throughout economics Critiques of Utilitarianism, conequentialism, and welfarism: Ordinalists: cannot measure utility Positivism: ethics as esthetics J. Rawls, Theory of Justice: emphasis on equality and justice Amartya Sen, (Sen and Williams, Beyond Utilitarianism), emphasis on capabilities and equity

Ethical fundamentals Alternative universes: {c 1 (t), …, c n (t)} Process values, rules, religions,…Consequentialism Human values, non-human (intrinsic)Human values values, … Dynamic one-sided game Welfarism and individualistic “social among generations welfare function”: W = V(U 1, … U n )

Ethical fundamentals States of the world: {c 1 (t), …, c n (t)}... Welfarism and individualistic “social welfare function” Complex welfare functions Pure 19 th century (non-separable, “add them up” altruistic, dynastic,…) Standard approach in modern economics: DU

Ethical fundamentals States of the world: {c 1 (t), …, c n (t)}... Standard DU approach DU: Alternative preference functions Rawlsian: maximin or leximin Environmental (E) or W=min[c 1, …,c n,… ] other constraints (1) U=V(c); E > E* (2) U=V(c) + Z(E) Standard economic approach: can trade off environmental and non-environmental values U = U(c, E)

The optimal growth setup with exogenous technological change 8

The solution In optimal economic growth, we choose the path of K(t) to maximize the utility of future consumption (alternatively, the savings rate). Here is the semi-technical version (this is in the spirit of the calculus of variations). “Splish splash” optimal growth experiment: Suppose that we invest in period t with a return in period (t+θ). An investment is a withdrawal from consumption of Δ, with the return being an increase in consumption with real rate of return r. The fundamentals are the following (with no population growth): (8) (9)

Splish-splash 10

The solution So the change in total welfare is:

To add population growth, we change the objective function to the following: If population growth is constant at rate n, we see that the new Ramsey equation is: (12) More… 12

Key distinction, often confused Utility discount rate (pure rate of social time preference), ρ: This refers to the comparison of well-being or utilities over time, space, or generations. Goods discount rate (tradeoff in markets), r: This refers to the return on private or social investments in goods, services, etc.

More… The debate on discounting generally will use the framework of the Ramsey model. Begin with the Ramsey equation from (12) above: This shows the relationship between the equilibrium real interest rate and underlying parameters. Observables: r = real interest rate or real return on capital g = rate of growth of real consumption per capita Non-observables:

Which is the preferable path? c 1 (t) c 2 (t) time

Which is the preferable path? c 1 (t) c 2 (t) time

Which is the preferable path? c 1 (t) c 2 (t) time

Two schools of discounting theory What real interest rate on goods shall we actually use for discounting costs and benefits of long-term investments (climate, radioactive wastes, dams, technology,…)? Descriptive: Argues that we can observe the rate of return and should make sure that our decisions are consistent with opportunity cost on other investments. This leads to a relatively high utility discount rate (Feldstein, Eckstein, Lind, Nordhaus): Prescriptive: Argues that we can know the normative parameters on philosophical grounds and derive the interest rate from that (Cline, Stern):

Problems with each Major criticism of descriptive is that a positive ρ is unethical and violates intergenerational fairness. (Good point) Major criticism of prescriptive is that it leads to distorted investment decisions because actual return on investment is much higher than the prescriptive discount rate. (Good point) Is there any way to reconcile all this?

Let’s do a low-discounting example using DICE model The standard DICE-type model uses market rates of return (circa 5-6 percent per year for goods and services). Assume g = 2 % per year In the Ramsey framework, this can be interpreted as a solution of the following equation: 5.5 = ρ + α 2 We take the solution of ρ = 1.5 and α = 2. The prescriptive approach (Cline, Stern) argues that it is ethically indefensible to have generational discounting. Stern also assumes that α = 1. With their assumed g = 1.4 % per year, this yields: r = (1.4) = 1.5 % per year

Go through low discount/Stern type preferences and DICE model to see the results

Global temperature

Carbon tax

Consumption

Conclusions on discounting Remember the ethical foundations. A key question is whether you take the mixed-market solution (prices) as a constraint on decisions; or whether you want to argue that the preferences as revealed (by market prices) in the market are wrong. In the ethical/prescriptive view, the goods discount rate will be determined by both time discounting and view on income distribution over time. These issues are particularly important for very long-run decisions (global warming, radioactive wastes, …). The arguments also involve questions such as market imperfections, taxes, the equity premium – pretty horrible.