Hyperbolic discounting in analyzing investment in groundwater irrigation in India

Hyperbolic discounting in analyzing investment in groundwater irrigation in India

2006-02

Working or Discussion Paper

https://ageconsearch.umn.edu/record/43626

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Researchers are often confronted with the choice of discount rate as well as the method of discounting for estimating the amortized cost of long-term investment in agriculture including groundwater irrigation. The obvious choice is to use the opportunity cost of capital, which is the prevailing interest rate of around 9 percent (compounded – exponential basis), charged on longterm agriculture loans. However, using the ‘exponential’ basis does not provide a realistic amortized cost of irrigation as it over estimates the value of investment due to ‘exponential’ basis as demonstrated above. In order to obtain an empirical estimate of this interest rate, using field data from farmers three dry agro-climatic zones of Karnataka (Shamsundar (1996), Sripadmini (2001), Chaitra (2002), Rajendra (2003)) nominal investment per irrigation well is considered (Table 3). The nominal investments were deflated using the index number of wholesale prices (1993-94 base year). Considering nominal and real growth in investment per irrigation well between the 1980’s and 2000’s in the three agro-climatic zones of Karnataka, using the exponential discounting, the nominal investment per well is found to be increasing between 3.7 and 5.7 percent. This shows that the amortization of groundwater investment cannot exceed say six percent. The real (exponential rate of) interest is computed by deflating the initial year investment and the terminal year investment per irrigation well using the 1993-94 as base all India wholesale price index numbers. It is found that in real terms the investment per well is falling between –2.5 percent and –0.17 percent.(Table 3). The fall in real investment is due to increased competition by rig owners in offering almost uniform rate of drilling over the years in several aquifers of Karnataka. For instance the price of drilling has been between Rs. 35 and Rs. 50 per feet between 1985 and 2005 for shallow bore wells. The phenomenon may not be very different in other states of peninsular India. A comparison of nominal investment in terminal year and the estimated cost of well in 2005 indicates that in EASTREN DRY ZONE the nominal interest rate is 3.7 percent, the real interest rate is –0.17 percent and the investment per well in 2002 (terminal year) being Rs. 53,478 and in 2005 (current year) being Rs. 59578 are comparable. But in CENTRAL DRY ZONE, while the nominal investment per well in 2000 is Rs. 45,000, the estimated investment in 2005 is Rs. 59,193, which is an unrealistically high exponential growth obtained by compounding the initial investment of Rs. 18,480 from 1984 to 2005. Similarly in EASTREN DRY ZONE, while the actual investment per well in 2000 is Rs. 75,095, the estimated investment per well in 2005 works to Rs. 97,702, which is again unrealistic. As the real interest rate is negative in irrigation wells, this could be one of the reasons for mushrooming of irrigation wells in Karnataka, since this makes investment affordable across different classes of farmers. Thus this analysis has two messages. One, that the nominal interest rate which has to be considered for amortizing investment on irrigation well can be around 3 to 6 percent, and that the real investment per well is falling.

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