Discount Rates for Public Investment Under Uncertainty

Abstract

The problem of efficient allocation of capital in a world of uncertainty has played a major role in the debate on the social rate of discount. One view, which has been advanced by Hirshleifer [7, 8] and supported by Diamond [6], is that differences in rates of return on capital in the private sector of the economy reflect differences in riskiness among alternative lines of investment, and that these differences are of normative significance for the allocation of capital in the public sector. Thus, when discounting costs and benefits of a particular type of public investment, the government should take as its discount rate the rate of return on capital in a private industry of similar riskiness. Another view, which counts Samuelson [17] and Vickrey [22] among its supporters, is that because of the extremely large and diversified investment portfolio held by the public sector, the marginal return from public investment as a whole is practically risk free and should be equated to the market rate on riskless bonds. In an important recent contribution Arrow and Lind [2] come to the same conclusion for a somewhat different reason; the total risk carried by the public sector is shared among so many that each individual’s risk burden becomes negligible.

A preliminary version of this article was presented at the Workshop. I am indebted to the participants in the workshop for many interesting discussions. Special thanks are due to Jaques H. Drèze, earlier work with whom resulted in [20], and to Louis Gevers, Maurice Marchand and James Mirrlees. The paper has previously been published in the June 1972 issue of the International Economic Review where two referees provided constructive and interesting criticisms. The present version is identical to the one published in the IER except for a minor reformulation of the model in section III; this is described in note 1, p. 198 below.