Suppose that Butch faces 3 schooling choices. He can stop at a high-school diplo
ID: 2721128 • Letter: S
Question
Suppose that Butch faces 3 schooling choices. He can stop at a high-school diploma, in which case his earnings for the rest of his life will be $20,000 per year. He can get a 2-year college degree, in winch case his earning? will be $35,000 for the rest of his life, or he can get a 4-year college degree, in which case his earnings will be $45,000 for the rest of his life. A good approximation for the present discounted value of an annuity (which we discussed in class) is: PV = B/r, where B is the annual benefit from the annuity and r is the annual discount rate Assume that tuition for both 2 and 4-year college is zero. The only cost of schooling is the opportunity cost of not being able to work dining those years. You do not need to discount these costs when comparing the benefits and costs of different schooling choices. 1. Assume that 2-year and 4-year degrees are totally separate. For example, if Butch does a 4-year degree, he gives up earnings of $20,000 for each year he is a school. Suppose Batch's discount rate is 20%. What schooling level will he choose? 2 Now assume that if Butch gets a 4-year degree he must get a 2-year degree first (that is, his first 2 years of the 4-year degree are spent getting a 2-year degree). Suppose Butch s discount rate is 20%. What schooling level will he choose?Explanation / Answer
Q.1
2 years and 4 years degrees are totally separate.
If he chooses 2 year degrees = Total opportunity cost will be $40000($20000*2)
Benefits will be $35000 for the rest of life.
PV of the annuity using formula provided= 35000/20%= $175000
Net Benefit from 2 year schooling= PV of the annuity- opportunity cost
=175000-40000
Net Benefit from 2 year schooling=$135000
If he chooses 4 year degrees = Total opportunity cost will be $80000($20000*4)
Benefits will be $45000 for the rest of life.
PV of the annuity using formula provided= 45000/20%= $225000
Net Benefit from 2 year schooling= PV of the annuity- opportunity cost
=225000-80000
Net Benefit from 2 year schooling=$145000
Thus He must choose 4 year of schooling as net benefit is higher.
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