David K.H. Begg, Gianluigi Vernasca-Economics-McGraw Hill Higher Education (2011)

CHAPTER 13 Welfare economics
benefits, a topic we discuss in Activity 13.1. The decision about how much to discount the welfare of future
generations affects the present value of the benefits of tackling climate change today, and hence both the
optimal pace of action and estimates of the cost of inaction. Although the quantitative conclusions change,
the qualitative conclusions do not.
Stern view of discount rates
II
Figure 13.8 showed a 1000-year history of temperatures on the planet. Suppose we could all
agree on the science of global warming. This would allow statements of the form, 'if we continue
producing emissions at the current rate, global temperatures will rise according to the following profile, with
the following consequences in terms of flooding, volatile weather, drought, and so on:
Suppose too that there was only one country in the world, so we did not have to worry about whether the US
or India participated in trying to slow down climate change. The central issue then would be, 'how much pain
should we inflict on today's generation in order to mitigate the problem for future generations?'
The lower the discount rate we use in this calculation, the greater the present value of the benefits of helping
future generations; the lower the discount rate we use, the less today we care about helping future generations.
The Stern Review's recommendation that we should take urgent action to reduce emissions substantially
follows inexorably from its analysis provided we agree with its assumption that we should not discount the
welfare of future generations in making this policy decision today.
Others, such as Professor William Nordhaus of Yale University, have argued that today's decision makers
should discount the welfare of future generations - not least because they are still likely to be richer than us
and have better options than we face - in which case, the optimal policy response to climate change is a
slower mitigation of emissions today, albeit then requiring that future generations will have to take much
more drastic action.
The discount rate is not an academic abstraction. It affects key valuations and decisions, whether in the stock
market or in the politics of controlling global warming.
Questions
(a)
If we wish to weight equally the utility of current and future generations, what discount rate should we
apply to future utility?
(b) Still weighting utility equally, suppose future generations are richer than us and we believe in the
principle of diminishing marginal utility of consumption. Will a unit of consumption be worth more
today when we are poor, or tomorrow when we are rich?
(c)
Suppose, by sacrificing consumption today, we invest in physical capital that would make future
generations richer. Say, on average, this investment has a rate of return of 5 per cent a year in real terms.
What return would an environmental investment (e.g. preventing climate change) have to yield in order
for future generations to be pleased with the decisions we made today?
To check your answers to these questions, go to page 684.
Other missing markets: time and risk
The previous two sections were devoted to a single idea. When externalities exist, free market equilibrium
is inefficient because the externality itself does not have a market or a price. People take no account of the
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