DP16007 The welfare cost of ignoring the beta
|Publication Date:||April 2021|
|Keyword(s):||Arrow-Lind theorem, Asset Pricing, Capital budgeting, Carbon Pricing, discounting, investment theory, Rare Disasters, WACC fallacy|
|JEL(s):||G12, H43, Q54|
|Programme Areas:||Public Economics, Occasional Paper|
|Link to this Page:||cepr.org/active/publications/discussion_papers/dp.php?dpno=16007|
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.