Economics 3220 Lecture Notes - Social Discount Rate, Net Present Value, Opportunity Cost

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2 Mar 2013
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Chapter 6-2
CBA Framework
Step 4: Compare social costs and benefits of the program and calculate net
benefits as the difference between total benefits and total costs (NB= TB-TC)
o Total benefits are the total damage costs avoided (area under the MD
curve for the quantity reduced)
o Total costs are the total abatement costs incurred by polluting firms
(area under MAC curve for the quantity reduced)
o Decision rule: If MB>0 then project is viable, except the projection on
economic grounds
Class exercise
Suppose the government of Alberta proposed to reduce SOx emissions from
265 to 265 kilotonnes over a 20 year period
Estimates of costs and benefits of the proposed program are in the table.
Calculate the Net benefits to see if the program is economically viable
Not a good method
Compounding and Discounting
For many projects, benefits and costs occur in the future:
o Usually, costs occur in the near future
o Benefits occur in the distant future
However, decisions to accept or reject a project are made in the current time
(t=0) period
Since future benefits and costs are worthless in the current time period, we
need to find a way to calculate how much they are worth in the current time
this is called present value (PV) calculations
Discounting future benefits and costs is a way to calculate their present
values (PV)
It is the opposite of compounding or calculating future values (FV) of current
investments
Discounting
Suppose we have $100 today that we can invest in an interest bearing
account at an interest rate of r=5% per year
FV is received after 1 year=
o $100 (1+0.05)1 = $105 this is compounding
After 2 years = 105 (1+1.05)1 = 100(1+0.05)2
After 3 years = 100(1+0.05)3
If we used V0 to indicate value at present time (t=0_, then its
future value Vt received after t years is Vt=V0(1+r)t
Present Value of $105 received one year from now = $105/(1+0.05)1= $100
This is discounting
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Document Summary

Suppose the government of alberta proposed to reduce sox emissions from. 265 to 265 kilotonnes over a 20 year period. Estimates of costs and benefits of the proposed program are in the table. Calculate the net benefits to see if the program is economically viable. For many projects, benefits and costs occur in the future: usually, costs occur in the near future, benefits occur in the distant future. However, decisions to accept or reject a project are made in the current time (t=0) period. Since future benefits and costs are worthless in the current time period, we need to find a way to calculate how much they are worth in the current time this is called present value (pv) calculations. Discounting future benefits and costs is a way to calculate their present values (pv) It is the opposite of compounding or calculating future values (fv) of current investments.

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