Discounting and relative prices

Abstract

Environmentalists are often upset at the effect of discounting costs of future environmental damage, e.g., due to climate change. An often-overlooked message is that we should discount costs but also take into account the increase in the relative price of the ecosystem service endangered. The effect of discounting would thus be counteracted, and if the rate of price rise of the item was fast enough, it might even be reversed. The scarcity that leads to rising relative prices for the environmental good will also have direct effects on the discount rate itself. The magnitude of these effects depends on properties of the economy's technology and on social preferences. We develop a simple model of the economy that illustrates how changes in crucial technology and preference parameters may affect both the discount rate and the rate of change of values of environmental goods. The combined effect of discounting and the change of values of environmental goods is more likely to be low -or even negative -the lower the growth rate of environmental quality (or the larger its decline rate), and the lower the elasticity of substitution between environmental quality and produced goods.

New Frontiers in the Economics of Climate Change

“…Put another way, the relative prices of environmental and man-made goods and services do not directly change. Yet as Hoel and Sterner (2007) and Sterner and Persson's (2008) show, the relative price of environmental goods and services should rise over time if, as seems reasonable, output of man-made goods and services continues to expand, while the resulting changes in climate limit the supply of environmental goods and services. 7 In Sterner and Persson's (2008) empirical application, incorporating 5 Although Harsanyi (1955) and Broome (1991) have argued that, given certain assumptions, they may, as a matter of consistency, be very similar.…”

On the Relation Between Discounting of Climate Change and Edgeworth-Pareto Substitutability

“…_________________________ 6 Further, also using the framework as in Hoel and Sterner (2007) and adding uncertainty to it, Guesnerie (2004) argues that a plausible long-run value for the environmental discount rate is close to zero. In addition, it is fair to mention that a feedback effect from environmental resource scarcity to the discount rates had already been recognised in Hoel and Sterner (2007) itself and has been confirmed in that paper in numerical simulations.…”

“…Suppose now that there is environmental resource scarcity in such a manner that > ( ) ( ) C E g t g t (as is assumed in Hoel and Sterner (2007) and as seems reasonable). We can then distinguish between the following two cases:…”

“…More specifically, they assume each period's composite consumption index of environmental quality and goods consumption to be a CES function. Contrary to Tol (2004), Hoel and Sterner (2007) assume stable preference parameters, implying no direct effect of income growth on the WTP. However, they assume environmental resource scarcity in such a manner that growth of environmental quality falls short of growth of goods consumption.…”

“…Next, section 3 introduces a utility function along the lines of Hoel and Sterner (2007), and derives in that framework a definition of substitutability in the Edgeworth-Pareto sense. Finally, section 4 derives the implication of substitutability in the Edgeworth-Pareto sense for the change of the discount rates over time, while section 5 concludes.…”