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The welfare cost of ignoring the beta

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  • Gollier, Christian

Abstract

Because of risk aversion, any sensible investment valuation system should value less projects that contribute more to the aggregate risk, i.e., that have a larger income-elasticity of net benefits. In theory, this is done by adjusting discount rates to consumption betas. But in reality, for various reasons (Arrow-Lind and WACC fallacies, market failures), most public and private institutions and people use a discount rate that is rather insensitive to the risk profile of their investment projects. I show in this paper that the economic consequences of the implied misallocation of capital are dire. To do this, I calibrate a Lucas model in which the investment opportunity set contains a myriad of projects with different expected returns and risk profiles. The welfare loss of using a single discount rate is equivalent to a permanent reduction in consumption that lies somewhere between 15% and 45%, depending upon which familiar discounting system is used. Economists should devote more energy to support a reform of public discounting systems in favor of what has been advocated by the normative interpretation of modern asset pricing theories over the last four decades.

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  • Gollier, Christian, 2021. "The welfare cost of ignoring the beta," CEPR Discussion Papers 16007, C.E.P.R. Discussion Papers.
    • Handle: RePEc:cpr:ceprdp:16007
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    Cited by:

    1. Spackman, Michael, 2021. "Social discounting and the equity premium," LSE Research Online Documents on Economics 111488, London School of Economics and Political Science, LSE Library.
    2. Gollier, Christian & van der Ploeg, Frederick & Zheng, Jiakun, 2023. "The discounting premium puzzle: Survey evidence from professional economists," Journal of Environmental Economics and Management, Elsevier, vol. 122(C).

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    More about this item

    Keywords

    Discounting; Investment theory; Asset pricing; Carbon pricing; Arrow-lind theorem; Wacc fallacy; Rare disasters; Capital budgeting;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • H43 - Public Economics - - Publicly Provided Goods - - - Project Evaluation; Social Discount Rate
    • Q54 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Environmental Economics - - - Climate; Natural Disasters and their Management; Global Warming

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