Hyperbolically discount our environment
Nov 29 2012
Several researchers have coined this problem of time preference to be intertemporal choice, which is the study of the relative value people assign to two or more payoffs at different points in time. According to George Loewenstein, professor, Carnegie Mellon University, economists have analysed people’s decisions using the discounted utility (DU) model, which assumes that people evaluate the pleasures and pains resulting from a decision in much the same way that financial markets evaluate losses and gains. This model assumes exponentially discounting the value of outcomes according to how delayed they are in time.
However, recent research has found that individuals are often affected by what is called the temporal myopia. The consumer’s typical response to uncertainty is to sharply reduce the importance of the future of their decision-making. This effect leads one to hyperbolic discounting, rather than exponential discounting, as often is assumed by economists. In the common tongue, it reflects the sentiment “Eat, drink and be merry, for tomorrow we may die.”
This problem of hyperbolic discounting has special applications to our environment. The main problem concerns the choice of the discount rates with which to discount the future environmental costs and benefits of current decisions. According to Julie Rehmeyer, Science News, the important questions are: How much would you be willing to spend now to make your child Rs 100 richer in the future? What about your grandchild in the farther future, or your great-great-great-grandchild in the very distant future?
According to Rehmeyer, most economic analyses of climate change have concluded that we should be spending only small amounts to combat climate change now, ramping up slowly over time. This conclusion mystifies most climate scientists, who argue that immediate action is the only way to forestall dreadful consequences. And at the heart of the disagreement are these very questions, about the value of future generations’ welfare in monetary terms (also called social discounting).
For example, according to Rehmeyer, the worst consequences of climate change are likely to unfold only over decades or centuries, that is, in our children’s or grandchildren’s lifetimes, not ours. The decision of how much to spend now to avert climate changes hinges on assessing how much it is worth to us now to prevent that future damage. Since most of us would prefer money now over money later, economists typically figure that we’re willing to spend only less than a dollar now to prevent a dollar’s worth of damage in a year, or in a decade. The percentage less is called the social discount rate.
So, what should be the social discount rate? According to Rehmeyer, in the short term, there is a simple way to do it: use the market rate on loans. If you can get a bank loan at 10 per cent, then getting a rupee in a year is essentially equivalent to getting a bit over 90 paisa now. That means that, economically, it would make sense to spend 90 paisa today if doing so would save you from a problem that would cost you at least a rupee a year from now. In other words, according to Rehmeyer, a rupee of future impacts has gotten discounted to 90 paisa today.
However, according to Rehmeyer, playing this out over many years creates peculiar consequences. For example, at a 5 per cent annual interest rate, a paisa that belonged to Julius Caesar would have expanded to the huge sum of Rs 3 × 1041 today — more than the entire world economic output over the last 2,000 years multiplied by the number of stars in the sky. So the brutal arithmetic of discounting (at a 5 per cent social discount rate) would shrink any imaginable catastrophe today to far less than a paisa in Caesar’s time, and an economist would have therefore recommended that Caesar not spend even so tiny an amount to avoid it.
In this regard, according to Rehmeyer, hyperbolic discounting has a powerful impact on the math of climate change, because it implies that we’ll spend almost as much to reduce the impact on our great-grandchildren as on our grandchildren. In that case, the long-term consequences of our actions, even those hundreds of years out, no longer fade to complete insignificance as they do with a constant social discount rate. Thus, hyperbolic discounting might help the climate problem in the long term.
(The writer is on the faculty of Indian Institute of Technology, Mandi, India)