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The Welfare Cost of Ignoring the Beta

Christian Gollier ()

No 309916, FEEM Working Papers from Fondazione Eni Enrico Mattei (FEEM)

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.

Keywords: Risk; and; Uncertainty (search for similar items in EconPapers)
Pages: 28
Date: 2021-03-16
New Economics Papers: this item is included in nep-fmk
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (4)

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https://ageconsearch.umn.edu/record/309916/files/ndl2021-003.pdf (application/pdf)

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Working Paper: The welfare cost of ignoring the beta (2021) Downloads
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Persistent link: https://EconPapers.repec.org/RePEc:ags:feemwp:309916

DOI: 10.22004/ag.econ.309916

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