What is a discount rate in cost benefit analysis

In economics we try to choose the optimal way to allocate resources. This includes considering many different types of resources and individuals. The classic way to consider this problem in principle level economics courses is to use the supply and demand graph. This is a good visual way to see how demanders and suppliers consider the quantity and price that they are willing to pay and accept respectively. However, this class problem ignores the question of time and how people and firms include time in their decision making process. In order for economists to consider both current and future benefits and costs, their needs to be a mechanism available that allows the analyst to compare these values over different time periods. In order to do this, we use what is called a discount rate.

A discount rate is a number that is usually reported in percentage terms that essentially tells the analyst how much someone prefers resources now instead of in the future. The larger the discount rate, the higher the preference for consuming goods and services now. You can also think of the discount rate as a number that shows how much someone “discounts” costs or benefits that occur in the future.

A common mistake is to think of the discount rate as a number reducing the price paid for a product or service. This makes sense from a business perspective but not from a cost benefit analysis perspective. It is also common to think of the discount rate as the interest rate that is charged by the Federal Reserve to commercial banks. This makes sense from the macroeconomic and money and banking perspective but is not the discount rate that is considered when conducting a cost benefit analysis.

The discount rate is a way for analysts to include someone’s time preference into the problem. For example, you may often consider whether you would like $100 now or $100 one year from now. Nearly everyone will prefer to have the $100 today because they have a preference for enjoying benefits today (rather than delaying that gratification).  Similarly, people will likely put off costs into the future rather than paying them today. In order to account for this time preference that people exhibit, economists calculate present values using the discount rate.

Discount rates can vary from 0 to infinity. A discount rate of 0% means that someone is indifferent between having a benefit or cost now vs. any time in the future. A discount rate of 0% implies that future generations are treated exactly the same as current generations. This is a little tricky of a concept to grasp and not really realistic at all because it implies that all consumption could be put off with no negative consequences (which would cause mass starvation!).

However, a discount rate of infinity implies that there is no tomorrow. The same sort of principles applies to individuals with terminal diseases or really old people. They know they will not be around for much longer so they tend to consume more now without much regard for the future. We do not want governments or businesses behaving in this way though –although many firms do behave in a similar fashion while trying to reward stock holders.

Between these two extremes, we typically consider discount rates from 1 to 30 percent. The US Federal government mandates using a discount rate of 7% for most analyses but this can changed depending on the policy. Most environmentally based analyses or inter generational policies should use discount rates that are closer to 2 to 5% while businesses tend to use discount rates in the 10 to 20% range in order to justify investing in the current analysis as opposed to other opportunities.