The Social Discount Rate, Cost of Public Funds,
and the Value of Information
In this Chapter we consider three issues each of which may call for a modification of the following simple net present value rule: in the absence of risk, undertaking any project with a positive net present value (NPV), calculated using the appropriate shadow-prices and discounting at the market rate of interest, will contribute to economic efficiency.
Firstly, the concept of social time preference reflects the view that the market rate of interest does not accurately reflect society's preference for present as opposed to future consumption, and that a discount rate based on a social time preference rate should be used to calculate NPVs from a public interest viewpoint. For reasons which will be discussed below, the social time preference rate is usually judged to be lower than the market rate of interest.
Secondly, the concept of social opportunity cost is based on the notion that, because of tax-induced distortions to the pattern of resource allocation, the opportunity cost to the economy of raising public funds for government expenditures is higher than the nominal amount raised. This suggests that a public project should have a present value of benefits sufficiently large not only to offset project costs (the NPV>0 rule), but also to offset the premium on the cost of public funds if the project is to make a net contribution to efficiency.
Thirdly, the fact that a project has a NPV>0 does not necessarily imply that now is the most efficient time to implement it. Because additional information about the project variables – prices, costs etc. – may accrue in the future there could be an advantage to keeping open the option of undertaking the project. Once this option has been exercised it ceases to have any value, and the loss of option value should be taken into account in the decision to proceed.
It was argued earlier that the main rationale for social benefit-cost analysis is the existence of market failure. Because of distortions and ill-defined property rights, the actions of private agents operating through the market will not necessarily result in an efficient allocation of resources, thereby creating a possible role for government in the scrutiny and regulation of proposed private projects and the undertaking of public projects. A conspicuous, but unavoidable, market failure is the absence of future generations in the capital markets which determine the quantity of resources to be allocated now to investment to provide consumption goods for the future. If the needs of future generations are not adequately taken into