Discounting and relative prices

Environmentalists are often upset at the effect of discounting costs of future environmental damage, e.g., due to climate change. An often-overlooked message is that we should discount costs but also take into account the increase in the relative price of the ecosystem service endangered.

The effect of discounting would thus be counteracted, and if the rate of price rise of the item was fast enough, it might even be reversed. The scarcity that leads to rising relative prices for the environmental good will also have direct effects on the discount rate itself. The magnitude of these effects depends on properties of the economy’s technology and on social preferences. We develop a simple model of the economy that illustrates how changes in crucial technology and preference parameters may affect both the discount rate and the rate of change of values of environmental goods. The combined effect of discounting and the change of values of environmental goods is more likely to be low – or even negative – the lower the growth rate of environmental quality (or the larger its decline rate), and the lower the elasticity of substitution between environmental quality and produced goods.

Co-author:

Michael Hoel