Economic Problem

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# Economic Problem - PowerPoint PPT Presentation

Economic Problem. Evaluating Future Benefits. Income or earnings accrue in the future What are those benefits worth to us today Investing in a college or a master’s degree Situation of wrongful termination Discrimination case Value of lost future earnings. A Dollar Today or Tomorrow?.

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### Economic Problem

Evaluating Future Benefits
• Income or earnings accrue in the future
• What are those benefits worth to us today
• Investing in a college or a master’s degree
• Situation of wrongful termination
• Discrimination case
• Value of lost future earnings

Prof. Leighton

A Dollar Today or Tomorrow?
• A dollar received in the future is worth less to us than a dollar received in the present

Prof. Leighton

A Dollar Today or Tomorrow?
• A dollar held today can be invested at some market rate of interest so that by the next period it will be worth more than a dollar
• \$1.00(1.05) = \$1.05

Today’s dollar invested at 5% grows to \$1.05 tomorrow

Prof. Leighton

Investing at a Rate of r
• How much money will you have in the next period if you invest B0 today at a rate of interest r ? B0 + r B0 = B0(1+r ) = B1
• B1 next period and B0 now are equivalent values
• Assuming you are neither present nor future oriented

Prof. Leighton

Discounted Value of B1: What Is B1 Worth Today?
• Work the simple problem backwards B0(1 + r ) = B1
• B1 received in the future is worth B0 today; solve for B0 B0= B1/(1 + r )
• B0is the discounted value of B1

Prof. Leighton

Present Value
• Value now of an entire stream of future benefits or costs
• Receive benefits of B0, B1, B2,…,Bn over the current and next n periods
• Face the same interest rate, r, in each period
• The present value of benefits is given by:PVB = B0 + B1/(1 + r) + B2/(1 + r)2 + B3/(1 + r)3 +…..+ Bn/(1 + r)n

Prof. Leighton

Is a Master’s Degree a Sound Financial Investment?
• If the PVB > PVC, invest in master’s degree
• If the PVB < = PVC, do not invest

Prof. Leighton

Planning the Worksheet
• Need information on
• The direct costs of graduate school
• The earnings foregone while in graduate school
• The earnings stream of workers with a college education
• The earnings stream of workers with a master’s degree
• The appropriate rate of interest

Prof. Leighton

Ideal vs. Available Data
• Longitudinal data collected each year
• Same individuals are surveyed each year
• Some have college degree; some have master’s degree
• Follow worker over his/her work life
• Data sets tend to be small
• Synthetic Cohort
• Look at a cross-section, say 1991
• Look at the average earnings for each age level
• Assume hypothetical student will follow same earnings path as the different workers in the sample did at each age

Prof. Leighton

Benefits

Indirect costs

Synthetic Cohort

Prof. Leighton

Needed Formulas
• Difference between earnings of college graduate and master’s graduate at each age
• Discounted value of that difference at each age
• Sum of the discounted values = PVB
• IF function to decide whether or not to invest

Prof. Leighton