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The Welfare Cost of Ignoring the Beta

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  • Christian Gollier

    (Toulouse School of Economics, University of Toulouse-Capitole)

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.

Suggested Citation

  • Christian Gollier, 2021. "The Welfare Cost of Ignoring the Beta," Working Papers 2021.03, Fondazione Eni Enrico Mattei.
    • Handle: RePEc:fem:femwpa:2021.03
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    References listed on IDEAS

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    Cited by:

    1. Sophie Zhou & Frederick van der Ploeg & Rick van der Ploeg, 2023. "Structural Change and the Climate Risk Premium during the Green Transition," CESifo Working Paper Series 10840, CESifo.
    2. 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.
    3. 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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