Each of the foregoing assumptions represents a qualitative dimension along which the baseline of an impact assessment must be defined. A researcher who wants to estimate the costs or benefits of changing conditions must define as fully as possible the socioeconomic, political, institutional, and cultural environments within which the change will be felt. A "first-best" analysis assumes that everything works efficiently in response to changing conditions in the context of all of the right information; results of first-best analyses reflect benchmarks of "best-news" scenarios. Second-best analyses assume that distortions caused by the failure of some or all of these assumptions to hold will diminish the efficiency of the first-best world; they can produce dramatically different answers to cost and valuation questions. Indeed, baselines that are constructed to reflect the global externalities of climate change by definition reflect second-best circumstances.
It may be reasonable to assume that distortions will persist as change occurs over the short run. Making the same assumption over the long run could be a mistake, however. Will information not improve over time? If distortions are costly, they may persist over the long term if the beneficiaries have sufficient power to preserve their advantage. There is no right way to do second-best analysis; it is simply incumbent on the researcher to report precisely what assumptions define the baseline.
The discount rate allows costs and values occurring at different times to be compared by converting future economic values into their equivalent present values. Formally, the present value of some cost Ct that will come due in t years is
Ct / (1+d)t ,
where d is the appropriate discount rate. The discount rate is non-negative because resources invested today in physical and human capital usually can be transformed into more resources later on. The IPCC and others have focused an enormous amount of attention on the discount rate (for detailed discussions see Arrow et al., 1996; Portnoy and Weyant, 1999; Chapter 1 of this volume). Toth (2000b) provides a review of this and other more recent literature, with particular emphasis on the implications of discounting to issues of intergenerational equity.
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