Implied discount rate used in the purchase of energy efficient durables:
past studies, explanations, and potential solutions
Past studies have indicated consumers employ usually large discount rates when analysing the
purchase of energy efficient durables. Evidence from the purchase of air conditioners,
refrigerators, and light bulbs indicate consumers require a substantial return on their
investment to purchase a more energy efficient model. Complex calculations, uncertainty of
future savings, and income are all suggested explanations for this phenomenon. Many feel
this irrational behaviour can be offset with increased education and additional purchase
incentives. Interestingly, hybrid vehicles may be exempt from such high consumer discount
Economics 366 – A1
Professor Robin Lindsay
December 3, 2008
Our need to stay warm, keep food fresh, light our homes (etc…) create a need for
energy-utilizing durable goods like furnaces, refrigerators, and light bulbs. When it comes to
the purchase of these durables, consumers are often faced with an energy-based trade-off: a
good with a high cost and high efficiency, or a low cost and low efficiency. Holding all else
constant and assuming rational decision making, we would expect consumers to make their
purchase based on the incremental capital outlay (difference in price) and incremental future
savings1. For an accurate comparison, consumers must discount all future savings by an
appropriate rate to view if the present value of the savings is greater than the incremental
Any discount rate should be reflective of an individual’s risk tolerance and uncertainty
regarding future energy savings. It should also be commensurate with a user’s opportunity
cost, reflective of other investment opportunities with a similar risk-return parameter. Many
economists have found the implied discount rates of energy efficient purchases to be
substantially higher than expected. In this paper I will examine the results of studies focusing
on the implied discount rates for the purchase of air conditioners, refrigerators, light bulbs,
and hybrid automobiles. I will extend the finding and discuss the potential reasons why
consumers are behaving in this way. Lastly, I will consider actions to help decrease these
rates and increase the purchase of efficient durables.
Jerry Hausman was the first to analyze the implied discount rates of home appliance
purchases in his 1979 study Individual discount rates and the purchase and utilization of
energy-using durables. Since consumers are bound by specific constraints for the purchase
(mainly room size and climate), Hausman assumes many variables (especially capacity) are
exogenous. He finds only the purchase price and electricity consumptions are endogenous
variables –that is to say they are within scope of decision making for the consumer.
Incramental outlay = High efficiency appliance price – Low efficiency appliance price
Given Hausman’s model we would expect a rational consumer to select an air
conditioner (ac) that possesses the minimum total cost, where total cost is equal to the capital
cost (purchase price) and the present value of the operating costs (energy cost). Since
Hausman determined a mean finite life of ten years, I express a simplified model below:
Tc = C0 + Oc * [1 – 1/ (1+r)10)] / r
C0 is equal to the capital cost, Oc is the annual operating cost, and r is the discount rate or “the
required rate of return of a similar economic asset”. The annual operating cost is a function of
the price of electricity ($/KWH), capacity of the ac (BTU/hr) and its efficiency (BTU/KWH).
Since both the capacity and the efficiency are known at purchase, the consumer can derive a
cost/hour (and year) based on their assumption regarding the future price of electricity.
Hausman solves for r in the model above and determines the average discount rate to
be 26.4%. He extrapolates his findings to showcase how the discount rate varies across
different economic demographics. Accordingly, the sample data is classified into six groups
based on total household income ($6,000, $10,000, $15,000, $25,000, $35,000, $50,000)2.
The results are staggering: household income levels under $6,000 have an implied discount
rate of 89% while those with greater than $50,000 only discount the savings by 5.1%.
Potential explanations for the differences in discount rates are focused on the riskiness of the
purchase and its size relative to the family income level. This will be expanded upon later in
Hausman faced two issues with his economic model. First, the marginal cost of
electricity is often represented by a stepwise function: as the quantity consumed increases, the
household can move into a different (likely lower) marginal price bracket. Second, electricity
does not behave in a discrete fashion and is subject price fluctuations. Both issues make it
difficult for consumers to incorporate future energy costs into their pre-purchase analysis.
Expressed in 1979 dollars.
Therefore, uncertainty in future energy costs may serve as an explanation to why consumers
employ larger discount rates. This will be elaborated upon late in this paper.
Dermot Gately extends Hausman’s study to consider the purchase of three different
type of refrigerators in Individual discount rates and the purchase and utilization of energy-
using durables: comment. Gately considers six fridges (three brands each with a high
efficiency and low efficiency model). If electricity costs remain low ($0.038/KWH), discount
rates vary between 45% and 130%. Should the higher price prevail ($0.10/ KWH), Gately
observes discount rates between 120%-300%.
At first glance this might provide evidence that consumers continue to discount the
purchase of energy efficient durables at too high a rate. However, one must remember the
implied discount rate is a function of the difference in capital outlay between the high and low
efficiency models: the smaller the difference, the greater the discount rate (ceteris paribus). In
Gately’s study these large discount rates can likely be attributed to the pricing scheme of the
respective models. Out of the three models the greatest difference in price was $43 (9%) and
the smallest difference was $12 (2.5%). It appears the manufacturer is trying to influence the
consumer to purchase the more efficient model and is happy to cannibalize sales of the less
efficient model. In other words, they are setting the price of the less efficient model
artificially high. Therefore, it may be the case that the implied discount rates in Gately’s study
are skewed upwards.
Consumers face similar tradeoffs when confronted with the purchase of new light
fixtures. Peter Kooreman conducts a related study in his work Individual discounting, energy
conservation, and household demand for lighting. Kooreman argues that lighting is one of the
most applicable durables to consider in this type of analysis because it accounts for roughly
one quarter of all household electricity consumption. Furthermore, he states energy efficient
light bulbs like compact fluorescent lamp (CFL) use roughly 80% less electricity compared to
conventional incandescent light bulbs and last roughly eight times as long. Despite these
savings, many consumers may not purchase CFLs as their price is thirty times greater than
Compared to Hausman’s model, the economic model for lighting is more complicated
because CFL bulbs have a different lifespan than traditional light bulbs. We can adjust for the
different life spans by modeling the equation under the equivalent annual cost method:3
Ac = (r * C0 ) / [1 – (1 + r)t] + Oc
C0 represents the initial capital outlay, which is amortized over the assumed lifetime of the
light bulb (this calculation accounts for the need to constantly replace low efficiency bulbs).
Oc represents the annual operating costs, r represents the discount rate expressed annually,
and t represents the assumed lifespan of the bulb in years.
Kooreman finds the mean discount rate to be 19.1%. It is interesting to note this rate is
smaller than those reported in both the Hausman and Gately study. It could be the case that
although the high efficiency bulb is thirty times more expensive on a relative scale, it is still
an inexpensive purchase on an absolute scale. That is to say, consumers have less of an issue
with the absolute difference in price in dollars, compared to the difference in price in
percentage terms. This finding is consistent with Hausman’s conclusion regarding the impact
of a consumer’s income on their implied discount rate.
Although Hausman’s model could be applied to the purchase of a hybrid, difficulty
arises with the estimations of the variables that influence a consumer purchase decision.
Hausman assumed that there were only two endogenous variables (price and energy
consumption). It is clear that should a similar study be executed for hybrids, the endogenous
variables must be expanded to include such factors as comfort, handling, acceleration, noise,
This model differs from the previous model in so far as it focuses on the lowest annual cost instead of the
lowest present value of total costs (Hausman’s model). The Hausman model could be extrapolated by rolling
over continuous purchases of the low efficiency light bulb upon expiry, however re-arranging the variables is
both easier to implement and interpret.
and durability. In addition, the purchase of automobiles cannot be modeled without including
non-financial benefits4 such as status, as these tend to be important attributes in the purchase
decision. The aforementioned issues are likely reasons why a study analyzing the implied
discount rate of hybrids has yet to be published5.
The main argument for hybrids is their cost savings. According to Hybrid Cars –Pros
and Cons, a 2006 publication on Physorg.com, hybrids may not deliver the savings
consumers are anticipating. Although hybrid owners can expect to save 20%-35% on fuel
consumption (compared to a standard model), they cost an additional 35%-47% ($5,000-
$8,000)6. In the case of the Honda Civic (traditional) versus the Honda Insight (hybrid),
annual fuel savings are estimated at $230. That means over a ten-year life span, the
undiscounted savings is a mere $2,300! Interestingly, the article also indicates that many
owners find the actual mileage of hybrid vehicles to be roughly 10% less than what is
claimed. The article suggests this is because few vehicle operators drive in the most efficient
manor: many accelerate too quickly or drive at sub-optimal speeds. Finally, the advanced
technologies in hybrids may require added maintenance costs7.
Despite the factors mentioned above, Green Car Congress indicates that the sale of
hybrids have increased 27% year-over-year from January 2007 to 2008. It is clear that with
the recent rise in the price of fuel, consumers are looking to purchase hybrids instead of gas
guzzling vehicles like SUVs. Although it may not be an economic purchase, there is little
doubt that consumer demand for hybrids (and subsequent purchases) continues to rise. Such a
trend may be indicative that consumers discount their expect savings at lower discount rates
than other studies (Hausman, etc…) have indicated.
One such benefit would be the particular status that a particular automobile delivers.
This is an assumption as I could not find a study focusing on the implied discount rate of a hybrid purchase.
Part of these costs may have been offset by governmental rebates. In 2007 the federal government launched a
rebate program up to $2000 for fuel-efficient vehicles. This program is scheduled to end December 31, 2008.
Added computer programming is required and hybrids have an electric motor in addition to a gas motor.
I have summarized studies indicating consumers employ large discount rates when
evaluating the purchase of energy efficient durables. Now I will focus on possible
explanations why. Hausman (1979) suggests that at least part of the reason might be because
the average purchaser cannot easily compute these present value calculations. Even if they are
attempted, consumers may not have full confidence in the accuracy of their computations.
This argument holds especially true for durables like LED lights, which have a different
expected lifespan than traditional bulbs, and thus require additional analysis. If a consumer is
not confident in their ability to effectuate these calculations, we would expect this uncertainty
to be reflected in a higher discount rate.8
Another possibility is the uncertainty in cost savings. The more a consumer is
uncertain about recouping their investment, the greater the discount rate. Therefore if a
consumer is purchasing a new air conditioner and is unsure about its durability or the price of
electricity, they are likely to discount any savings by a larger rate. In addition, many US
families have short average home occupancies and might not believe they will be in the house
long enough to recoup the additional capital outlay. Such behaviour would have an impact on
the discount rates used for the purchase appliances, insulation upgrades, or any other durable
that cannot be easily transported upon moving homes.
A third explanation has to do with income levels. Hausman finds there is a substantial
correlation between income level and discount rate (the income effect). If we define the
financial impact of a purchase as the percentage of a consumer’s income that is spent,
spending an extra $500 on an energy efficient air conditioner has a greater financial impact on
a family that earns $25,000 compared to one that earns $200,000. As the incremental cost
represents a larger portion of disposable income for the less wealthy family, a greater
If a consumer is uncertain in their ability to effectuate complex computations, they will view the investment as
more risky (less likely to get back what is expected). Financial theory suggests the discount rate must rise to
reflect this added risk.
percentage of their income is at risk with this investment. Thus, the low-income family is
more worrisome that the investment will not provide the expected return. Accordingly, they
will discount the purchase by a higher rate.
In addition to investment risk, we would expect lower income families to be net
borrowers whereas higher income families would be net-savers. Since the cost of borrowing
is greater than the return on savings, families that borrow will have a higher cost of capital
and thus a higher discount rate. Furthermore, Hausman argues many consumers (especially
low income) will finance their purchases with high interest credit cards. Such a decision
would also increase the discount rate as any annual savings must cover the incremental credit
card payment9 to be economically viable.
Although consumers tend to discount the cost savings of efficient home durables by
high rates, this appears not to be the case with hybrids. Based on Hausman’s income effect,
one might expect consumers to employ a greater discount rate for the purchase of a hybrid as
the purchase is large relative to total income. However preliminary evidence suggests this is
not the case. Sales continue to climb despite indications that future economics gains are not
worth the additional capital required to purchase a hybrid. Therefore a primary motivation for
the purchase of a hybrid must be non-economic gains.
Such non-economic utility could be generated from the benefit of helping the
environment or driving the most fashionable car on the market. Perhaps consumers’ decisions
are focused on minimizing the total cost of the initial outlay, annual operating cost, and
environmental costs. In other words, they are willing to absorb a negative financial return if
the purchase has a positive environmental impact such as a reduction in greenhouse gas
emissions. Secondly, consumers may be willing to pay more for a hybrid because the owning
In other words, if the payment is now $200/year and the less efficient model would have been $150/year, the
appliance must generate $50/year in additional savings assuming the credit card payment and appliance are
amortized over the same time horizon.
one generates a certain amount of caché. This is undoubtedly the case with some high-end
luxury vehicles, so such a conclusion may not be out of the realm of possibility.
Another argument regarding why consumers employ lower discount rates in the
purchase of hybrids is an overreaction to the rise in the price of fuel. In a 2004 working paper
by Poteshman and Mahani titled Overreaction to stock market news and misevaluation of
stock prices by unsophisticated investors, the authors conclude many investors overreact to
past news causing them to make poor investment decisions. If such a theory holds true in the
purchase of hybrids, investors may over estimate the future price of fuel and the
corresponding savings of owning a hybrid. If this were the case, consumers may still employ
high discount rates, but overvalued the cost savings by such a drastic margin that the purchase
of a hybrid was still economical.
If purchasers are irrationally discounting cost savings, one possible solution is to
provide the consumer with more education regarding energy efficient purchases. In 1992 the
US Environmental Protection Agency introduced Energy Star as a program to help identify
products that reduce greenhouse gas. Currently, many countries (including Canada) have
expanded the program to help consumers identify energy efficient goods. On their website,
Energy Star provides a calculator (energystar.org) so individuals can determine the economic
impact of an energy efficient appliance. Before any purchase is made, consumers can use the
calculator to determine the total savings and the payback period of the investment. If this tool
were properly utilized, it would remove much of the difficulty in computing the present value
analysis and possibly lower the utilized discount rate.
In addition to education, many are trying to entice consumers with rebates and
financing arrangements. Atherton and Train discuss these impacts in their 1995 study
Rebates, loans, and customer’s choice of appliance efficiency level, where they conclude
rebates on energy efficient purchases have a greater impact than financing arrangements. The
authors suggest that for every $1 in rebates, consumers would require $3 in financing to be
equally satisfied. This makes sense as the rebate lowers the incremental outlay required for
purchase, while financing only make the purchase more accessible10. Although rebates are
effective in promoting the purchase of energy efficient durables, they are often not
implemented because they are susceptible to freeloading and may cause a consumption
rebound11. Despite the findings of Atherton and Train, financing may be a more useful
incentive to individuals with lower incomes. If the consumer is otherwise not able get credit
and is forced to pay in cash, the incremental outlay will likely be a substantial portion of their
disposable income. As such, we would expect them employ a very large discount rate
(Hausman 1979). If credit is extended, the income effect should be somewhat offset and the
discount rate lowered12.
Many academic studies have concluded consumers use large discount rates in the
purchase of energy efficient durables. Inability to effectuate complex net present value
calculations, uncertainty about performance variables, and volatile energy prices are all
factors that influence a consumer’s discount rate. Furthermore, income appears to have a high
correlation with the implied discount rates: less wealthy families are required to part with a
greater percentage of their annual income. These findings are consistent throughout various
studies on air conditioners, refrigerators, and light bulbs. When it comes to hybrid cars,
consumers appear to highly value the utility created by their aesthetic or environmental gains.
Also, purchasers may over-extend the projected cost savings of hybrid ownership. Currently
programs such as Energy Star help inform the customer of the economic gains from
This assumes that the interest rate of financing is not significantly different from what the consumer could
obtain on their own.
Freeloading: Giving a consumer a discount for a purchase that they would have made without any incentive.
Consumption rebound: The rebate causes the consumer to spend less on the appliance. The savings is then put
towards consuming more energy, thereby somewhat defeating the purpose of a energy efficient purchase.
This strategy may help reduce excessively large discount rates (greater than 50%), but likely would not have
much of an effect on consumers who already have access to credit.
purchasing more energy efficient durables. Also, rebates and financing arrangements have
been shown to entice consumers into purchasing more efficient appliances. If these programs
are successful, we should observe downward pressure on discount rates. Such a change would
be positive, as consumers will be more likely to purchase energy efficient durables.
Atherton, Terry and K.E. Train, (1995) “Rebates, loans, and consumer’s choice of
appliance efficiency level”. Energy Journal, 16(1), 55-69
Dunn, Philip (2006), “Hybrid Cars – Pros and Cons” (2006). Accessed November 29,
Energy Star, “Purchasing & Procurement” (No Date). Accessed November 29, 2008.
Gately, D (1980) “Individual discount rates and the purchase and utilization of
energy-using durables: Comment”. Bell Journal of Econimics, 11(1), Spring,
Green Car Congress (2008), “Reported US Sales of Hybrids Up 27.3% In
January 2008”. Accessed November 29, 2008.
Hausman, J.A. (1979) “Individual discount rates and the purchase and utilization of
energy-using durables”. Bell Journal of Econimics, 10(1), Spring, 33-54
Kooreman, Peter (1996) “Individual discounting, energy conservation, and household
demand for lighting”. Resource and Energy Economics, 18(1), 103-114
Poteshman, A.M. and R.S. Mahani, (2004) “Overreaction to stock market news and
misevaluation of stock prices by unsophisticated investors”. Working Paper
Wikipedia (2008), “Equivalent annual cost”. Accessed November 29, 2008