Monday, February 26, 2007

Oil Drum on Discounting

A long essay on the evolution of the discount rate. There are some interesting points raised in this rather left-field analysis.

The interview to start the article off is highly amusing but I suspect depressingly representative. Neoclassical economics also gets a kicking.

The whole Peak-Oil brigade post a lot of "interesting" stuff for those that like conspiracy stories - this is one of the better, but still amusing, posts.

There is also a great "evolutionary" cartoon in there as well.

Climate Change, Sabre Tooth Tigers and Devaluing the Future
The debate on the realities of both climate change and Peak Oil has moved from 'are they real?' to questions concerning timing, magnitude and impact. At the same time, expanding research in 'temporal discounting' in economics (called 'impulsivity' in psychology), is shedding light on how steeply we value the present over the future, a trait that has ancient origins. Knowing this tendency, how can we expect factual updates on peak oil and climate change to behaviorally compete with Starbucks, sex, slot machines, and ski trips?

Science is rapidly increasing our knowledge about the planet. To affect change however, we must become equally knowledgeable about ourselves. The time has come to integrate ecological science with insight about human behavior derived from new findings in anthropology, hunter gatherer studies, evolutionary psychology and the neurosciences. Below the fold is an overview on human discount rates, their evolutionary origins, and their relevance to the mitigation and adaptation to climate change and peak oil.

Here is a nice little definition and take on discount rates for all those Stern Report readers out there who want to know what all the fuss is about:
Everyone is familiar with the 'discount rate' in the financial markets. It's the rate that the Federal Reserve charges its member banks. Its also the rate that a stock analyst might use to discount a companies future earnings stream back to the present. Imagine a company whose entire business plan is to sell a product in 10 years – say at the Olympics – they make no money until then but a lot of money in that one year, say $100 million. How much would investors pay for this company? Certainly something less than $100 mil, as that money wont come for 10 years. They would determine what the risk was of actually getting that $100 mil 10 years hence, then determine what an appropriate rate of return would be, say 15% per year. Discounted at 15% per year, $100 mil is $24.75 mil- that is what they should be willing to pay. So in this example, the discount RATE is 15% and the discount FACTOR is 24.75%, or how much something in the future is worth today. The higher a discount rate the lower the discount factor will be. A discount rate approaching 1, means things in the future have no value at all in the present moment. A discount rate of zero means that $1 dollar in 2050 is worth $1 today.

The original neoclassical assumption was that the discount rate curve was exponential, meaning that we discounted the same from period to period. Actual economic experiments however show that the shape of the discount curve is hyperbolic, or as Harvard economist David Laibson prefers quasi-hyperbolic. This means that the early periods have much steeper discount rates than later periods. Laibsons research indicates that peoples discount rates are 12% during days 0-5 but drop to 4% in days 20-25. We REALLY prefer the present.

Hat-tip: Gristmill.

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