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The discount rate is usually taken to be equal to the real rate of return you can get from investments. And this is based on three parts: growth of the economy, how quickly more stuff satisfies our desire for still more stuff, and our preference for having stuff now rather than later. For a slightly more technical discussion, see the ENRICHMENT.
Enrichment
Want to learn more?
Read the Enrichment titled Discount Rate.
Economists know that sometimes recessions or depressions happen, the Dark Ages really did engulf Europe, and civilizations have fallen in many places. But, with a sufficiently broad view, the economy has always regrown even stronger from these setbacks, as people produced more and more goods and services. Some of this growth is linked to population growth—we have more workers—but some of the growth is the increase in economic productivity per person.
Video: World GDP Per Capita (1:17)
PRESENTER: This figure from Qwfp at Wikipedia.org-- the source is down here on the lower left-- shows the history of the size of the world economy per person. So more dollars or more economic activity goes up against time starting in the year 1500 on the left and running up to 2,000. And then growth has continued.
And what you'll notice is that the economy per person as grown fairly steadily even with all the wars. Even with all the plagues and everything else, we've seen growth. This growth looks like what we call an exponential. Except, what we know is that an exponential goes to infinity and we are confident that you can't make something infinite.
The really interesting questions are whether the future eventually flattens out or whether the future might flatten out and then come down gradually, or whether the future might go way up and then crash into something horrible. And this is a subject that has to interest a lot of people in a lot of ways
In mainstream economics, the assumption is often made that this growth per person will continue for a long time, so that we are so far from any limits on growth that they do not have a meaningful effect on economic activity now. If you expect the economy to grow rapidly, then the discount rate is high—your grandchildren will have the resources to address problems from climate change even if you don’t invest much to help them. (Some economists have explored alternatives to this; we’ll visit such issues soon.)
Next, a single apple is more valuable to a starving person than to an overfed billionaire; the apple may be as valuable to the poor person as a yacht is to the billionaire. If you believe that economic growth per person can continue for a long time, then investing now to help future generations means that you’re taking apples from you, a poor person, and giving apples or yachts or dollars to your incredibly wealthy grandchildren. If this transfer of money to wealthier future generations doesn’t bother us very much, then the discount rate is low and we try to help them; if we object to giving money to rich people, then the discount rate is high and we tend to spend more on us now.
Finally, we tend to behave as if now is more valuable than later, and our generation is more valuable than future generations. We won’t give the bank a dollar unless they promise to give us more than a dollar back, and we demand a greater extra payment than can be explained by the expected growth of the economy and our objections to giving money to the wealthy, even if the “wealthy” person is just us getting our money back from the bank a year later. This extra demand is just us saying that we matter most. The more we are focused on us, the higher the discount rate, and the less we invest to help the future. This is sometimes called the “pure rate of time preference”. For a person, preferring a reward now to the same reward sometime in the future is well-known. But when we choose the reward rather than giving it to future generations, some people harrumph and refer to it as “selfishness”.
Economists do NOT tell us that this is good or bad; they tell us that they have watched people buying and saving in the real world, and this is how we behave. Rather clearly, this raises large ethical issues, which we will consider later in the course—regardless of whether you call it “pure rate of time preference” or “selfishness”, some people don’t like it. For now, please don’t worry about the ethics, or the limits to growth. Because, perhaps surprisingly, even if we assume that the economy can grow forever, and we don’t want to help the future generations very much because they will be so wealthy, and we are more important than they are anyway, we still should be spending money to head off global warming if we wish to be economically efficient!