The Welfare Cost of Ignoring the Beta

Christian Gollier ()

No 2021.03, Working Papers from Fondazione Eni Enrico Mattei

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: Discounting; Investment Theory; Asset Pricing; Carbon Pricing; Arrow-Lind Theorem; WACC Fallacy; Rare Disasters; Capital Budgeting (search for similar items in EconPapers)
JEL-codes: G12 H43 Q54 (search for similar items in EconPapers)
Date: 2021-03
New Economics Papers: this item is included in nep-dem and nep-ene
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (3)

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Related works:
Working Paper: The Welfare Cost of Ignoring the Beta (2021)
Working Paper: The welfare cost of ignoring the beta (2021)
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