Does economic analysis shortchange the future?

Decisions made today usually have impacts both now and in the future. In the environmental realm, many of the future impacts are benefits, and such future benefits — as well as costs — are typically discounted by economists in their analyses.  Why do economists do this, and does it give insufficient weight to future benefits and thus to the well-being of future generations?

This is a question my colleague, Lawrence Goulder, a professor of economics at Stanford University, and I addressed in an article in Nature.  We noted that as economists, we often encounter skepticism about discounting, especially from non-economists. Some of the skepticism seems quite valid, yet some reflects misconceptions about the nature and purposes of discounting.  In this post, I hope to clarify the concept and the practice.

It helps to begin with the use of discounting in private investments, where the rationale stems from the fact that capital is productive ­– money earns interest.  Consider a company trying to decide whether to invest $1 million in the purchase of a copper mine, and suppose that the most profitable strategy involves extracting the available copper 3 years from now, yielding revenues (net of extraction costs) of $1,150,000. Would investing in this mine make sense?  Assume the company has the alternative of putting the $1 million in the bank at 5 per cent annual interest. Then, on a purely financial basis, the company would do better by putting the money in the bank, as it will have $1,000,000 x (1.05)3, or $1,157,625, that is, $7,625 more than it would earn from the copper mine investment.

I compared the alternatives by compounding to the future the up-front cost of the project. It is mathematically equivalent to compare the options by discounting to the present the future revenues or benefits from the copper mine. The discounted revenue is $1,150,000 divided by (1.05)3, or $993,413, which is less than the cost of the investment ($1 million).  So the project would not earn as much as the alternative of putting the money in the bank.

Discounting translates future dollars into equivalent current dollars; it undoes the effects of compound interest. It is not aimed at accounting for inflation, as even if there were no inflation, it would still be necessary to discount future revenues to account for the fact that a dollar today translates (via compound interest) into more dollars in the future.

Can this same kind of thinking be applied to investments made by the public sector?  Since my purpose is to clarify a few key issues in the starkest terms, I will use a highly stylized example that abstracts from many of the subtleties.  Suppose that a policy, if introduced today and maintained, would avoid significant damage to the environment and human welfare 100 years from now. The ‘return on investment’ is avoided future damages to the environment and people’s well-being. Suppose that this policy costs $4 billion to implement, and that this cost is completely borne today.  It is anticipated that the benefits – avoided damages to the environment – will be worth $800 billion to people alive 100 years from now.  Should the policy be implemented?

If we adopt the economic efficiency criterion I have described in previous posts, the question becomes whether the future benefits are large enough so that the winners could potentially compensate the losers and still be no worse off?  Here discounting is helpful. If, over the next 100 years, the average rate of interest on ordinary investments is 5 per cent, the gains of $800 billion to people 100 years from now are equivalent to $6.08 billion today.  Equivalently, $6.08 billion today, compounded at an annual interest rate of 5 per cent, will become $800 billion in 100 years. The project satisfies the principle of efficiency if it costs current generations less than $6.08 billion, otherwise not.

Since the $4 billion of up-front costs are less than $6.08 billion, the benefits to future generations are more than enough to offset the costs to current generations. Discounting serves the purpose of converting costs and benefits from various periods into equivalent dollars of some given period.  Applying a discount rate is not giving less weight to future generations’ welfare.  Rather, it is simply converting the (full) impacts that occur at different points of time into common units.

Much skepticism about discounting and, more broadly, the use of benefit-cost analysis, is connected to uncertainties in estimating future impacts. Consider the difficulties of ascertaining, for example, the benefits that future generations would enjoy from a regulation that protects certain endangered species. Some of the gain to future generations might come in the form of pharmaceutical products derived from the protected species. Such benefits are impossible to predict. Benefits also depend on the values future generations would attach to the protected species – the enjoyment of observing them in the wild or just knowing of their existence. But how can we predict future generations’ values?  Economists and other social scientists try to infer them through surveys and by inferring preferences from individuals’ behavior.  But these approaches are far from perfect, and at best they indicate only the values or tastes of people alive today.

The uncertainties are substantial and unavoidable, but they do not invalidate the use of discounting (or benefit-cost analysis).  They do oblige analysts, however, to assess and acknowledge those uncertainties in their policy assessments, a topic I discussed in my last post (“What Baseball Can Teach Policymakers”), and a topic to which I will return in the future.


Using Markets to Make Fisheries Sustainable

Around the world, over-fishing is leading to severe depletion of valuable fisheries.  This is as true in U.S. coastal waters as it is in many other parts of the world.  In New England waters, for example, after two decades of ever more intensive fishing, the groundfish fishery has essentially collapsed.  But, we are not alone.  According to the United Nations Environment Program, fully 25 percent of fisheries worldwide are in jeopardy of collapse due to over-fishing.  Clearly, something needs to be done.  Yet, what has long been considered the obvious answer – restrictions on fishing – has been shown time and time again to be the wrong answer.  The right answer is enlightened use of markets.

The fundamental cause of the depletion of fish stocks is well known to economists:  virtually all ocean fisheries are “open-access,” that is, fishermen – small operations or large corporations – can fish all they want.  These individuals and companies are no more greedy than the rest of us, but because no one holds title to fish stocks in the open ocean, everyone races to catch as much as possible.  Each fisherman receives the full benefit of aggressive fishing (that is, a larger catch), but none pay the full cost (an imperiled fishery for everyone).  One fisherman’s choices have an effect on other fishermen (of this generation and the next), but in an open-access fishery – unlike a privately-held copper mine, for example – these impacts are not taken into account.  What is individually rational adds up to collective foolishness, as the shared resource is over-exploited.  This is the “tragedy of the commons.”  What to do?

Government intervention is, alas, required.  Fishermen don’t welcome such regulation in their economic sphere any more than anyone else does.  And they have a point.  Conventional regulatory approaches have driven up costs, but not solved the problem.  And we know why.  If the government limits the season, fishermen put out more boats.  If the government limits net size, fishermen use more labor or buy more costly sonar.  Economists call this over-capitalization.  Costs go up for fishermen (as resources are squandered), but pressure on fish stocks is not relieved.

The answer is to adopt in fisheries management the same type of innovative policy that has been used for decades in the realm of pollution  control – tradeable permits, called “Individual Transferable Quotas” ( ITQs) in the fisheries realm.  Sixteen countries – some with economies much more dependent than ours on fishing – have adopted such systems with great success.  New Zealand regulates virtually its entire commercial fishery this way.  It’s had the system in place since 1986, and it’s been a great success, putting a brake on over-fishing and restoring stocks to sustainable levels ­- while increasing fishermen’s profitability!

There are several ITQ systems already in operation in the United States, including for Alaska’s pacific halibut and Virginia’s striped-bass fisheries.  More important, the time is ripe for broader adoption of this innovative approach, because a short-sighted ban imposed by the U.S. Congress on the establishment of new ITQ systems has expired.

The first step in establishing an ITQ system is to establish the “total allowable catch.”  The next step – and a crucial one – is to allocate shares of that total limit to fishermen in individual quotas that are theirs and theirs alone (read:  well-defined property rights).  Setting the individual quotas will not be easy.  The guiding principle should be simple pragmatism – using the allocations to build political support for the system.  Making the quotas transferable eliminates the problem of overcapitalization and increases efficiency, because the least efficient fishing operations find it more profitable to sell their quotas than to exploit them through continued fishing.  If you can’t catch your whole share, you can sell part of your quota to someone else, instead of buying a bigger boat.

In addition, these systems improve safety by reducing incentives for fishermen to go out (or stay out) when weather conditions are dangerous.  And it was just such perverse incentives of conventional fisheries regulation that were blamed for the tragic loss of life when a fishing boat was lost in a storm off the New England coast just a few winters ago.

Further, because ITQ systems eliminate the motivation for government to limit the duration of the fishing season, supplies available to consumers improve in quality.  Prior to the establishment of an ITQ system for Alaskan halibut, for example, the government had reduced the fishing season to just two days, but subsequent to the introduction of the system, the season length grew to more than 200 days.

A decade ago, environmental advocates – led by the Environmental Defense Fund – played a central role in the adoption of the sulfur dioxide allowance trading program that’s cut acid rain by half and saved electricity generators and rate-payers nearly $1 billion annually, compared with conventional approaches.  The time has come for environmentalists to join forces with progressive voices in the fishing industry and in government to set up ITQ systems that can keep fishermen in business while moving fisheries onto sustainable paths.