Original Post by Andrew Garcia:
2.) Suppose we are comparing two ways of protecting ourselves against mobile-source air pollution: putting additional controls on the internal combustion engine or developing an entirely different type of engine that is cleaner. How would changes in the discount rate be likely to affect the comparison among these two options? (Field and Field 2015, 140)
Discounting is a technique used to compare costs and benefits that happen during different points in time (Field and Field 2017, 117). It can be described as the rate society as a whole is willing to sacrifice present benefits to obtain future benefits. The discount rate plays a role in determining the outcome of analyzing whether or not to pursue any long-term projects versus short term projects. Environmentalists criticize discounting, claiming it downgrades future damages resulting from current economic activity. This can be compared to anyone preferring to have a dollar today versus a dollar ten years from now (Field and Field 2017, 120-121).
Net present value needs to be calculated by subtracting present value costs from present value benefits. Choosing a discount rate can be compared to estimating the value a dollar will have in the future. A low discount rate implies a dollar’s value wont change much in the upcoming years, a high discount rate implies a dollar will decrease in value over time.
The comparison here is establishing controls immediately on the internal combustion engine versus the development of an entirely new engine type that is cleaner and more efficient. After reviewing how discount rates impact value over time, choosing to implement additional controls on internal combustion engines over developing a new type of engine implies the discount rate was low; potentially worth the long-term investment for waiting for the development of a new engine. The value of investments could either increase over time or stay relatively the same. This can also be viewed as people viewing the value of future returns offsetting the value of current investment costs (Field and Field 2017, 120). If the discount rate is high, then waiting many years for the development of the new cleaner engine would not worth the present cost, since the value invested would decrease over time.
Field, Barry C. and Martha K. Field. 2017. Environmental Economics: An Introduction. 7th ed. New York: McGraw Hill/Irwin.
Reply by Ashley Xu:
Discounting can help compare costs and benefits that occur at different points in time. It has two facets, which are the mechanics of doing it and the reasoning behind the choice of discount rates that are to be used (Field and Field 2015, 117). It is in simpler terms, the present value of benefits and costs that will show up in the future at some point. Changes in discount rate will affect the comparison among these two option, depending on what is accounted for. The air pollution has to account for the benefit-cost analysis of both programs.
Air quality is a fairly important aspect of the environment and can cost a lot to have improvements in air quality. Discount rates can vary over time. We have to look at the different outcomes depending on which discount rates are used to determine what the affects would be on the two options. If the rate is low, the value would be similar in any other year. If the rate is high, the dollar in the near term is more valuable than a term later on, therefore it would be encouraged to put resources into programs that have high payoffs in the short run. If there was a lower discount rate, then there would be programs that have high net benefits in the future that are chosen (Field and Field 2015, 119). If there was a higher discount rate, it would be more rewarding but the value would deplete over time. So if we were to choose between the two, we would choose the option that we can have a lower discount rate on because the present dollar has less value, but over time, the benefits would be a lot larger.
Field, Barry C. and Martha K. Field. 2015. Environmental Economics: An Introduction. 7th ed. New York: McGraw Hill/Irwin.
Reply by Andrew Garcia:
Discount rates are a very challenging topic to discuss and fully understand. I also answered question 2 from Ed’s post, and it took me a while to grasp the concept of discount rates which I still do not feel too confident in them. From another article I found there seems to a lot of uncertainty still surrounding the assessment of effective discount rates on solutions to climate change. Potential consequences in the future tend to have little value currently when discounted using conventional rates (Newell and Pizer 2004, 519). The challenges also stem from analyzing trade offs from short term costs and long term benefits, where benefits are linked to greenhouse gases which can stay in the atmosphere for centuries. This leads to trying to determine discount rates which are highly uncertain (Newell and Pizer 2004, 519). Overall, I feel like my struggles with this question were justified since this topic appears to be a challenging endeavor for most policy makers and environmentalists.
Reply by Professor Scott Thomas:
Yes, discount rates are tricky.
In general , I think of it this way. The most conservative thing to do over the long term is the use low discount rates. My mnemonic device: if you use large discount rates, it “discounts the future;” if you use low, conservative discount rates, it conserves the future.”
High discount rates show short term solutions in a favorable light. Low discount rates make every solution prove its worth.
So if you are comparing a new, disruptive technology that may provide long term benefits against an incumbent technology that might be risky over the long term, using high discount rates may favor the incumbent and using low (conservative) discount rates may favor the new technology…. if the future benefits are large.
But it is not a simple analysis because the high discount rates might help you justify the substantial capital investment needed to get the new technology off the ground! When you need to start something from scratch, and you’re comparing that to the “sunk cost” of an existing technology, you might need to show a higher discount rate to justify the initial capital expenditure…
You can see why this topic is controversial.
In general, I advise using a low, conservative discount rate unless there is a compelling reason not to. And this is a battle with many decision makers because high discount rates may be necessary to make their pet ideas look good.
For the students with some finance experience, I’d like to read your perspectives on this topic…
After reading all the posts about discount rates, I concur the most conservative, long-term decision is to use low discount rates. The simplest way for me to understand the reasoning is by imagining society as a whole sacrificing present benefits to obtain future ones (Field and Field 2017, 120-121). However, there are certain cases policymakers already implement conditions manifesting a high discount rate. The 2018-2019 residential solar panel system federal tax credit was a key policy change. Essentially the federal government incentivized people to buy a new technology now. My story depicts the idea, “high discount rates may be necessary to make pet ideas look good”, presented by Professor Thomas. In the face of a high discount rate, product pricing was a controversial topic during my time as a residential solar panel system consultant as I sold financing payment programs provided by nothing beyond a start-up company. Though, first, I acknowledge the strength of using other techniques, along with high discount rates, in order to get new technology off the ground.
The solar company’s executive team urged the sales division to never offer discounted pricing in addition to the tax credit, because they insisted staying true to a high price is a method of communicating a product’s value. Research from the International Journal of Research in Marketing shows three specific strategies– customer ratings, benefit communication, and revenue model – to be effective in combating low initial trust perceptions and increasing adoption of innovations (Konya-Baumbach et al. 2019). Further, emphasizing the cost of not buying the product was a crucial strategy. However, consumer risk analysis supports me offering a price guaranteeing the client is going to be additionally rewarded for the early buy into innovation.
In the case of there being multiple alternative options, such as various solar companies or a collection of new competing sustainable technologies, people need to feel reassured. As Zoe mentioned, “most of the public are risk averse, meaning they will choose the option that comes with the least amount of long term risk, even if the probability of that risk is very low” (Field and Field 2017, 139). With a new technology and the potential for it to increase in efficiency, consumer trust is a significant factor. So, I offered additional price reduction.
As a solo door-to-door renewable energy ambassador, I was essentially operating my own business in terms of building a client base. Summarizing the product at the door involved telling a homeowner installing a personal solar system cuts the electric bill by 30 percent through a financing program which does not require any money out of pocket. My pitch simply explained the product allows a homeowner to replace the utility’s electric bill with a lower monthly payment.
The first impression of me at the door is similar to the first impression of a new technology’s release. At the door, I expressed myself as the informant of a new, clean energy program and focused on logically communicating. Since there is a multitude of start-ups, it is essential to show why a particular one cannot fail. For example, “high failure rates of digital innovations by start-ups indicate that consumers’ initial trust perceptions are make-or-break for their survival” (Konya-Baumbach et al. 2019). That being said, it is risky for a business to jeopardize anything potentially interfering with first impression.
After our interaction at the door, a client received a complimentary roof survey to measure their house’s sun exposure. The sun exposure determines how many panels were needed to cover a homeowner’s energy demands. Further, the number of panels determines the total system cost which then is broken down into monthly payments. So, after the roof survey was completed, I received a proposal from the backend team and scheduled a meeting with the client.
In the case I would receive a proposal with a monthly payment cutting a homeowner’s original electric bill down by less than 30 percent, I would request a new, lower-priced proposal. At the time, I was not even taking environmental economics into consideration and had no idea “start-ups have to design adequate business models to manage consumers’ initial trust perceptions of digital innovations” (Konya-Baumbach et al. 2019). I was simply valuing ethics above all else which is necessary to do with a new technology. The practice resulted in propelling my business as I grew a referral base and was able to offer a standard-priced proposal to people who had substantial sun exposure. Building trust in client relationships was crucial for my personal business selling the new technology to lift off the ground. I concur with the statement by Professor Thomas stating, “high discount rates might help you justify the substantial capital investment needed to get the new technology off the ground”. Since we appropriately understand the public’s perception of risk, we need to reward those who decide to be open to a new technology offered at a high discount rate. With a new product, people need to be reassured they are making a smart financial decision. At the start, the only way I knew how to effectively do it was stay true to my word about price.
Offering a price reduction and sticking by it was the only way I initially could completely control my ability to make it through the first impression stage. It is particularly true considering, “start-ups seldom get a second chance to make first impression” (Konya-Baumbach et al. 2019). I recognized solar buyers were already making a risky decision relative terms of society as a whole. Since discounting is a technique used to compare costs and benefits that happen during different points in time, installing now sacrifices potential greater benefits in the long-run (Field and Field 2017, 117). Since they did not wait for solar technology to potentially improve in the long-run, I compensated them for taking climate change action now.
In terms of general financing, a consumer who finances a product is able to take out a loan and make monthly payments. However, the person providing the loan charges the consumer interest. The total amount a consumer pays if the person just waits until he/she can independently afford it is cheaper than the total amount a consumer pays if the person takes out a loan which includes interest. That being said, in the case of making the decision to take out the loan and benefit now as opposed to later, the salesperson must decrease the product’s price. It is a strategic way for a start-up to get off the ground.
Konya-Baumbach, Elisa, Monika Schuhmacher, Sabine Kuester, Victoria Kuharev. 2019. “Making a First Impression as a Start-Up: Strategies to Overcome Adoption” International Journal of Research in Marketing. 36 (2019): 385-399. http://dx.doi.org/10.1016/j.jenvman.2017.08.008
Comment by Professor Scott Thomas:
Good explanation and use of your personal experience to reinforce your points.
When you write “by imagining society as a whole sacrificing present benefits to obtain future ones,” I think that is a very good way to look at discounting. If we use high discount rates, and it justifies a short term benefit, then we usually step back and think about the long term ramifications of that short term thinking. Intuitively, we know that we need to be careful with such rationalization.
In your example, you used discounting to make the case for installing solar panels, and I imagine most of us would think that is a good thing. But you could also have been using the same approach for selling any significant capital investment (an in-ground pool, hot tub, and pool house, for example, with impressive hardscaping and a BBQ thrown in). Whether that would be a wise investment for the homeowner depends on a lot of factors. But it is clear that if the homeowner greatly discounts the future to pursue the short-term gratification of the new pool, future financial position could be compromised. If the homeowner is comparing the pool this year versus the toddler’s college fund to be manifested in 17-18 years, a high discount rate can enable some short-sighted and arguably unwise decisions. The choice of discount rate to be used is key to a fair comparison of the two alternative investments.