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Economic Problem

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

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  1. Economic Problem

  2. 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

  3. 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

  4. 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

  5. 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

  6. 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

  7. 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

  8. 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

  9. 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

  10. 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

  11. Benefits Indirect costs Synthetic Cohort Prof. Leighton

  12. 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

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