Poverty Reduction

Public intervention to reduce poverty may be justified on ethical and political grounds. Even in the idealized Arrow-Debreu world, Pareto-efficient solutions achieved by the decentralized market system depend on the initial allocation of resources among all the actors in society. A Pareto-efficient solution could be glaringly inequitable, leaving some with too much and others with too little. A case can be made for public provision of goods that the poor consume relatively more than the nonpoor— for goods with low-income elasticity—on grounds of redistribution. Some types of health care may qualify. However, low income elasticity is not the only grounds for government intervention in the provision of goods and services for the poor. Governments provide many types of health and education services that have high income elasticity to the poor on grounds of redistribution. Although targeting project benefits toward the poor is always a good idea, sometimes leakage is either technically inescapable or is the political price of poverty reduction. To benefit the poor it may be necessary to benefit some of the nonpoor.

Discounting and Compounding Techniques

The decision on a project’s acceptability hinges on whether the benefits exceed the costs. If all benefits and costs occurred in the same year, the decision would be a simple one of comparing benefits and costs. Usually, however, benefits and costs occur at different times, with costs usually exceeding benefits during the first years of the project. This issue arises in both economic and financial analysis. The techniques used to compare costs and benefits occurring in different years are the same in both types of analysis. We call these discounting techniques.

Discounting enables us to compare the value of dollars in different time periods. A dollar received today enables us to increase our present consumption whereas a dollar received in the future can increase only future consumption. Therefore, a dollar received now is more valuable than a dollar received in the future. Postponing consumption makes tomorrow’s dollar less valuable than today’s, even if tomorrow’s dollar has as much purchasing power as today’s. The declining value of money over time has nothing to do with inflation, only with the postponement of consumption.

The declining value of money over time explains, in large measure, why we require interest whenever we lend money. Lending money entails postponing consumption. To compensate for this, we demand an amount that enables us to increase our consumption in the future for every dollar we lend. Thus, whenever we open a savings account and place our money at 5 percent interest per year, we implicitly state that US$1.05 one year from today

is worth at least as much as US$1 today. If we buy a five-year certificate of deposit paying 5 percent per year of compound interest, we will receive US$1.28 in five years for every dollar we give up today. We implicitly state that US$1.28, five years hence, is worth at least as much as US$1 today. Discounting involves the reverse procedure. It answers the question: How much is US$1.28, received in five years, worth today? The answer depends on the interest rate we are willing to accept. If we accept an interest rate of 5 percent per year, then US$1.28 in five years is worth US$1 today, which is equivalent to saying that US$0.78 today is worth US$1.00 in the future.