How to choose a discount rate--and justify it

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In general there are three possible justifications for choosing a discount rate for your cost benefit analysis. The three justifications are used to explain how people perceive costs and benefits affecting them in different time periods. Because there are a lot of mechanisms within an economy that account for valuing money in different time periods (the most obvious is the interest rate on loans, but inflation and other factors can play a role) they tend to be the predominate choice when choosing a discount rate. The three most common justifications for discount rates are:

1) Cost of borrowing funds. The first and most appropriate justification for choosing a discount rate would be the cost of borrowing the money or capital to run a project. This justification makes the most sense if you are actually going to borrow funds to complete your project. In this scenario you would want your benefits to grow at a rate faster than the interest rate on the loan you made to make the project possible.
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What is a discount rate in cost benefit analysis

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In economics we try to choose the optimal way to allocate resources. This includes considering many different types of resources and individuals. The classic way to consider this problem in principle level economics courses is to use the supply and demand graph. This is a good visual way to see how demanders and suppliers consider the quantity and price that they are willing to pay and accept respectively. However, this class problem ignores the question of time and how people and firms include time in their decision making process. In order for economists to consider both current and future benefits and costs, their needs to be a mechanism available that allows the analyst to compare these values over different time periods. In order to do this, we use what is called a discount rate.

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What is present value?

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The present value is the value in today's dollars of an asset, benefit, or cost that will occur in the future. Perhaps the easiest way to think of a present value is to ask yourself how much you would be willing to accept to sell your rights to a future asset.

For example, is you were to plant an orange tree today you make expect to get $50 worth of oranges in the future. Since you have to wait for the oranges (and their $50 value), the value in today's dollars will be less. If someone is patient and the time they have to wait for the oranges is small, then their willingness to accept amount (the present value) may be $45 or $40. If the person is impatient or has to wait a long period of time, then the willingness to accept amount (the present value) may be much lower approaching $5 or so.

The present value of a future payoff should never be larger than the face value of the payoff. This is a result of the idea of "discounting" which means that people tend to prefer having resources now rather than in the future. For example, imagine you were given the choice between:
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What is a price function?

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Sometimes you will be asked to define a price function. When you receive such a question, it is probably in regards to a supply and demand graph, and you will be asked to graph said price function. The three components of a price function include: price (as you probably expected), an intercept, and quantity. It is also possible for a price function to include many other variables such as preferences, prices of related goods, income, number of buyers, etc. but this is for more complicated price functions (and upper division style classes).

A price function generally looks like:

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Economics of a gift economy

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The gift economy seems like a pretty straightforward concept, people giving gifts to each other. However, there are a bunch of subtleties involved in the gift giving culture. In its purest form, we look at gift giving as a transfer of property rights over objects. For example, if person A gives an apple to person B, we can assume that is the end of the story. No money changed hands, and person A has no expectation of reciprocation from person B. Person A is also assumed to gain no influence or other non-tangible benefits from their gift, other than perhaps a "warm glow" or happy feeling. In reality though, a gift giving economy cannot thrive without other ulterior motives attached to this giving.

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Games for learning economics

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Freeeconhelp.com is proud to present the following games to help you learn economics:


Economics island is a short "choose your own adventure" or "point and click adventure" type game that begins with you being stranded on an island. As you progress through time, you gather resources ultimately planning your escape. Along the way you learn about opportunity cost, PPFs, and other introductory vocabulary (typically good for the first 2 or 3 chapters in a standard text book). The game allows you to experience the economic principles firsthand, generally before you are introduced to the terminology. It is recommended as study guide, or perhaps for those who REALLY need to learn the material but are having a hard time with dry textbooks. There is also a bit of challenge to the game, in trying to leverage your economic knowledge into completing the game faster. The quicker you pick up the principles and use them, the higher the score you can attain. This game is available for play at Newgrounds.com at the above link, and available via google play: Economics Island App. Amazon users can download the game on Amazon at: Economics Island Amazon App.

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The effect of taxes on supply and demand

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One form of government intervention is the introduction of taxes. Taxes are typically introduced to increase government revenue, but they also have the effect of raising the cost of goods and services to the consumer. Because of the increased cost, we generally see a reduction in the quantity of goods and services produced and consumed after the introduction of taxes. A common form of tax is a sales tax, which is added on to the price of a product and paid by the consumer. Another common type of tax is a VAT (value added tax) which is paid by the producer along their production chain.

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