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Uncertainty and the Evaluation of Public Investment Decisions

The implications of uncertainty for public investment decisions remain controversial. The essence of the controversy is as follows. It is widely accepted that individuals are not indifferent to uncertainty and will not, in general, value assets with uncertain returns at their expected values. Depending upon an individual's initial asset holdings and utility function, he will value an asset at more or less than its expected value. Therefore, in private capital markets, investors do not choose investments to maximize the present value of expected returns, but to maximize the present value of returns properly adjusted for risk. The issue is whether it is appropriate to discount public investments in the same way as private investments. There are several positions on this issue. The first is that risk should be discounted in the same way for public investments as it is for private investments. It is argued that to treat risk differently in the public sector will result in overinvestment in this sector at the expense of private investments yielding higher returns. The leading proponent of this point of view is Jack Hirshleifer. He argues that in perfect capital markets, investments are discounted with respect to both time and risk and that the discount rates obtaining in these markets should be used to evaluate public investment opportunities. A second position is that the government can better cope with uncertainty than private investors and, therefore, government investments should not be evaluated by the same criterion used in private markets.