Rehabilitating the Opportunity Cost of Capital in Cost–Benefit Analysis

The opportunity cost of capital describes how invested resources would appreciate in value over time. Yet, currently, no consensus exists among economists as to how to account for this issue in a cost–benefit analysis, because disagreements are wrapped up in a broader, seemingly intractable, controversy surrounding the social discount rate. The social discount rate debate, in turn, forms part of a larger debate about what the normative aims of public policy should be. This paper provides background on these debates, explains how adherents of the two mainstream social discounting approaches each deal with the opportunity cost of capital, and describes limitations of both approaches, which are substantial. The paper argues that absent special circumstances, the conceptually sound approach to accounting for the opportunity cost of capital is using a shadow price, not a social discount rate. The paper reviews various methods of calculating this shadow price and discusses the policy implications of changing various parameters in the shadow price equation. The policy implications of cost–benefit analysis change dramatically depending on the social rate of time preference parameter selected in the shadow price equation, because at low rates, the convergence condition underlying cost–benefit analysis is violated. When this occurs, attention in analysis turns away from nonpecuniary benefits and costs and toward those benefits and costs exchanged in markets