Sunday, January 17, 2010

Airplane Reading

I have taken the blog on the road today to warm and (hopefully) soon to be sunny Phoenix, Arizona. On the flight, I had time to read a few new articles that have been sitting on my desk for a bit. Two of them worth recommending highly:

Sheila M. Olmstead, "The Economics of Water Quality," Review of Environmental Economics and Policy 4(1):44-62 (2010), is an excellent literature survey on cost-benefit analyses and more general social welfare effects of water pollution control. According to the literature, "provision of piped drinking water has very high net economic benefits, due to is potential to reduce acute illness and death, particularly among young children.... Improved sanitation also has high economic benefits through its impact on reducing exposure to waterborne contaminants." No real surprise there. Among industrialized countries, the stringency of water pollution regulations has been increasing to a point where the costs of further national regulation may in many cases outweigh the benefits. Olmstead hypothesizes that national minimum water quality standards make sense economically only up to a certain point beyond which local or regional regulations may be more efficient.

Martin L. Weitzman, "Risk-Adjusted Gamma Discounting," NBER Working Paper 15588 (Dec. 2009). This paper strikes me, like just about all of Marty's work, as an extremely important contribution to the literature on cost-benefit analysis (CBA) of long-term social problems and policies, such as climate change. In the paper, Marty does something with a very simple model that is highly counterintuitive but potentially game-changing:
[T]he standard normative interpretation of the Ramsey formula [r = p + ng, where r is the social discount rate, p is the pure rate of time preference, n  is the measure of relative risk aversion, and g is the expected rate of growth in consumption] is that the future growth rate g ismore or less exogenously given and, for postulated n, it determines the appropriate r for CBA.... In this paper the causality is reversed. For any exogenously given productivity r, CRRA [Constant Relative Risk Aversion] coefficient n implies a corresponding endogenously chosen value of the growth rate g = r/n and initial consumption level.... [U]nder uncertainty it turns out that the direction of causality between r and g matters.
* * *
[T]he ultimate goal of this paper ... will be to show that under uncertainty, even with expected discount rates [values of r] as high as 6%, the "effective" discount rate, which "ought" to be used, can be much lower than 6%.
The take away point is that fear over even small possibilities of great reductions in future productivity, combined with a fairly realistic degree of risk aversion, should transfer some amount of present consumption to the future as a matter of insurance against future losses to productivity. This really does not seem so different from the conclusion other economists have reached when hypothesizing about the potential for negative real growth rates as a result of potential climate catastrophes. See, e.g., Dasgupta, P., K.-G. Maler, and S. Barrett (1999), "Intergenerational Equity, Social Discount Rates, and Global Warming", in P.R. Portney and J.P. Weyant, eds. (1999). However, it is Marty's way of getting to the same place that is so interesting and, perhaps, groundbreaking.

By the way, it is interesting that Marty adopts a pure rate of time preference of 0, in accordance with Ramsey's preference. But unlike Lord Stern, this does not lead Marty to conclude that the social discount rate is 0 or nearly 0. Marty shows that even with a 0 value of pure time preference, a social discount rate of around 6% can make sense. Meanwhile, he shows that such a social discount rate might itself have to be discounted because of uncertainties over future discount rates!!!! So, observing a current discount rate of 6% might imply the use of a lower discount rate for long-run policies to ameliorate social-cost problems. Fascinating stuff.

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