Chapter 15 5_16_07 - 15 The Time Factor Discounting Often...

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1 15. The Time Factor: Discounting Often, people face decisions about present activities that will have effects well into the future For instance, energy conservation often requires a major immediate purchase (of insulation or more expensive light bulbs) that will reduce energy costs (of heating or electricity) in the future. How do we decide whether to undertake those purchases? As a general principle, how do we view benefits and costs that occur at different times than the present? This chapter highl ights how economists model people’s decision-making for future events. In particular, you will learn about The relationship between money in the present and money in the future: interest rates The way that interest rates affect the values of goods in the future Why there are many different interest rates in the economy The appropriate discount rate for analyzing public projects involving the future. Investing in Energy Conservation How do people decide how much to invest in energy conservation? Energy conservation is a very environmentally favorable activity: any energy conserved is energy that does not have to be produced, and energy production (from coal-burning plants, with their air pollutants, nuclear plants with radioactive waste, and dams that bury rivers under lakes) causes a great deal of environmental damage. If people invest too little in conserving energy, then society will invest too much in producing energy. Every attic insulation and every thermally efficient window replacement serves as a substitute for burning fossil fuels or producing nuclear power.
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2 The ―Home Energy Saver‖ website ( ) allows you to calculate ways of conserving energy in your own home. Some very simple actions could both save you money and reduce production of greenhouse gases and other pollutants. A programmable thermostat (that reduces the temperature in the house when people are out or in bed) costs about $70. Buying one and using it saves about $45 per year in Ann Arbor, Michigan. Is this a good deal? Major home renovations are an excellent opportunity for making investments in energy efficiency. Energy efficient replacement decisions for items such as the thermostat, energy efficient windows, wall insulation, and efficient appliances (such as the refrigerator and clothes dryer) might cost an additional $4,047. In exchange, utility bills would drop about $744 per year, and releases of carbon dioxide (a major greenhouse gas) would be about 11,803 pounds lower every year. Is this a good deal? Determining whether spending money now to save money in the future involves comparing values in the present and values in the future. Economists model this process using discounting , the subject of this chapter. The Time Value of Money How do we decide whether to invest in energy efficiency when there are large up- front costs and benefits only over time in the future? If we gain the benefits from burning fossil fuels now but must face the costs due to warming of the planet in the future, how do we balance current benefits with the future costs?
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