The Isolation Paradox and the Discount Rate for Benefit-Cost Analysis

Abstract

One argument used to justify a rate of discount for benefit-cost analysis below the market rate is based on a divergence of private and collective behavior known as the "isolation paradox." In this paper we reexamine this argument using a three-period general equilibrium model incorporating the intergenerational structure of benevolence assumed by earlier writers. We show that in this model the appropriate rate of discount is the market rate, regardless of the existence of the isolation paradox. In the absence of other market distortions, no shadow pricing of capital inputs is necessary in the calculation of net present value.