Sunday, February 28, 2010

Saving Green by Going Green

A recent article in the Daily Illini reported on a proposed increase in the "student sustainability fee," a fund which will provide funding for energy-saving initiatives. As an example:

He pointed out that their recent project of replacing Krannert Center’s fluorescent lights with LED’S will pay for itself in three years and save the University roughly $70,000 per year. The committee funded half of the project with a $225,000 grant.

First of all, observe that this statement is mathematically incorrect. If half of the project cost $225,000, then the total cost of the project was $450,000, so it will take about 6.5 years to pay it back at $70,000 per year.

Second of all, observe the economic puzzle. Effectively, the project is an investment with a guaranteed annual rate of return of $70k/$450k = 15.5 percent. So as long as the market rate of interest is less than 15.5 percent, which I assume it is, the optimal strategy of the university is to borrow money to finance this project, and even after paying back the interest they will actually have more money - so they should do that even in the absence of any additional funding from a "sustainability fee."

(Here is an economics article discussing similar anomalies, mostly in the context of individual purchasing decisions like whether to buy a new refrigerator.)


Dan Mont said...

When I was a professor at Cornell, Dick Thaler was teaching in the business school. I went to several of his talks.

This line of research is not only compelling but it feels right, intuitively. And there are many empirical examples. And yet, most economists ignore it. I wonder what THAT says about THEIR rationality?

Dan Mont said...

Ijust looked at your profile. It still says you are a Marland student.

Nanette Goodman said...

You should send this post to the Daily Illini