Thursday, December 12, 2013

To discount or not to discount?

In Economics, it is standard practice to discount future periods and generations. This is done throughout economics fields, even in the valuation of future benefits from nature, despite objections from biologists. Besides, we would not know how to solve our intertemporal models without discounting, unless one assumes a finite number of generations.

But this was not always so. As Pedro Garcia Duarte points out, Cambridge (UK) in the 1930s was lobbying against discounting. Surprisingly, Frank Ramsey (of the Ramsey model) was part of this faction, following his mentor Pigou. Their reasoning is purely ethical: future generations should be valued the same as the current one. But Ramsey pioneered an intertemporal model with infinite horizon, how did he solve it, you might say. Here is the trick. He assumed there is a finite maximum utility and a finite maximum production, called bliss, and minimized the deviation from it. A cheap trick, as this is essentially looking at infinity minus infinity. Garcia Duarte also explains the first intertemporal models and how discounting was either ignored or not viewed as a technical necessity. It is only in the mid-thirties that arguments about risk and impatience start appearing, and in the 1960s that work on the neo-classical growth model established discounting as an essential ingredient of any intertemporal theory.

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