The Rate of Discount for Benefit-Cost Analysis and Theory of the Second Best

Abstract

In this paper I wish to present a way of thinking about what the rate of discount ought to be for evaluating projects within the public sector. The conclusion of my analysis is that there is not a convincing case that the social rate of time preference ought to be used. Nor is there a convincing case that the marginal rate of transformation in the private sector ought to be used. Neither of these rates is, in general, appropriate; indeed, the appropriate rate of discount may not even lie between the two.

Interest in the problems of benefit-cost analysis arises from the belief that in a variety of circumstances one does not want to use market prices for evaluating a project; implicitly, there is some market failure, which leads market prices not to reflect social evaluations. Thus, intrinsically, benefit-cost analysis is concerned with second-best situations. We assume, for one reason or the other, that the failure giving rise to a discrepancy between market prices and social evaluations cannot be attacked directly.