Chapter 9 Notes
I. ANALYZING THE INVESTMENT DECISION
A. Comparison of Costs and Benefits
1. In order to determine if an investment should be undertaken, the following steps should be
followed.
a. Step one: estimate all of the costs you expect to pay and all the benefits you expect to
receive.
1. The times at which these costs will paid out and benefits will be received should be
estimated as well.
b. Step two: adjust the estimates of costs and benefits by discounting them for the number
of years before making a payment and the number of years before receiving a benefit.
c. Step three: compare the adjusted (present value of) costs and benefits.
2. There are two investment decision rules.
a. The present value decision rule says an investment is worthwhile if the sum of the present
value of benefits (PVB) exceeds the sum of the present value of costs (PVC).
1. Present value is equal to a future value divided by a discount factor or PV 0=FVt/(1+i)t
b. The rate of return decision rule says an investment is worthwhile if the ROR on the
investment is greater than the ROR on your best alternative.
1. The rate of return is the discount rate (the interest rate in the discount factor) at which
the sum of the present value of benefits is equal to the sum of the present value of
costs.
II. INVESTING IN A COLLEGE EDUCATION: MONETARY BENEFITS AND COSTS
A. Monetary versus Nonmonetary Benefits and Costs
1. Monetary benefits and costs can be valued in dollars.
a. Monetary costs accrue to the student and to society.
1. The primary costs to the student and his or her family are tuition, books and supplies,
and income foregone.
2. External monetary costs include grants and appropriations by state and federal
governments.
3. Social monetary costs equal students costs plus external costs.
b. Monetary benefits accrue to the student and to society.
1. The principal student monetary benefit is increased lifetime earnings.
2. Monetary external benefits include increased tax revenue.
3. Social monetary benefits equal student benefits plus external benefits.
2. Nonmonetary benefits and costs cannot be valued in dollars.
B. Student PVNB and ROR
1. Estimates of student present value of net benefits (PVNB) indicate that benefits by far
outweigh costs.
2. The real student ROR to a college education is estimated to be 14.27%.
C. Social PVNB and ROR
1. Social costs are the dollar value of student costs plus non-students costs.
2. Social benefits are the sum of:
a. Student benefits.
b. The benefits produced by the government expenditures financed by the increase in
income and Social Security taxes paid by college graduates.
c. The benefits produced by funds provided by private non-student sources.
3. The real social ROR is 14.5%, or just 0.23% higher than the real student ROR.
III. INVESTING IN A COLLEGE EDUCATION: NONMONETARY BENEFITS AND COSTS
A. Nonmonetary Student Benefits
1. Studies, such as one by Haveman and Wolfe, indicate significant nonmonetary student
benefits such as improved health, increased rates of return from savings, increased life
satisfaction, and better decision-making abilities.
2. Such benefits are not easily valued.
B. Nonmonetary Student Costs
1. A major student cost is overeducation, which tends to lead to dissatisfaction and lower
productivity.
C. Nonmonetary External Benefits
1. Research spillovers are by-products of advanced degrees.
2. Knowledge spillovers add to the stock of knowledge in the economy. This appears to play a
major role in economic growth.
3. Community benefit spillovers include the value of sports and artistic events.
D. Nonmonetary External Costs
1. These include the extra demands placed by a college on the community’s schools, police and
fire department, traffic congestion, etc.
IV. INTERNATIONAL PERSPECTIVE
A. Rates of Return Around the World
1. Studies show that investment in education is almost universally accepted as worthwhile. It is
shown that the social rates of return are sufficiently high to justify this investment, especially
in primary and secondary education in the developing countries.
V. GOVERNMENT SUPPORT: IS IT NECESSARY?
A. Three Rationales Advanced for Government Support of College Education
1. Government support of college education is necessary to realize all socially justified
investment in college education.
a. To ensure that society invests enough in college education.
b. To ensure that student borrowing reflects the social risk of default.
c. To increase enrollment of lower-income students.
B. Ensuring that Society Invests Enough in College Education
1. A reduction in taxes to finance public education would increase the student ROR, while an
increase in tuition and fees would reduce the student ROR.
2. The student rate of return to an investment in college without government support is 11.36%.
Students would under-invest in college education under these circumstances and government
subsidy is necessary to achieve the desired level of investment (See figure 9.3)
C. Ensuring that Student Borrowing Reflects the Social Risk of Default
1. In 1999-2000, more than 60% of bachelor’s degree recipients graduated with some debt,
typically over $17,000.
2. Loan finance has three effects:
a. Proceeds from the loan reduce costs while in college.
b. These costs, plus interest on the loan, are shifted to the future.
c. The loan changes the student rate of return.
3. In the college student loan market; group risk of default is small, but individual risk of default
is high. Lacking a government supply of funds (or government guarantee against default),
financial terms for student loans (interest rate, payment deferral period, repayment period,
etc.) would reflect the relatively high individual risk of default. Thus, under these terms,
students would borrow less than they would from a government source offering loan terms
that reflect the relatively low social risk of default.
4.
Government support of college education is necessary to achieve the socially optimal amount
of student borrowing.
D. Increasing the Enrollment of Lower-Income Students
1. Government support of college education increases college enrollment by students from
lower-income households.
a. Pell Grants
1. The largest federal government subsidy to college is the Pell Grant, which awards
financial aid on the basis of need as determined by the income and assets of students
and their parents.
b. Appropriations
1. The largest source of subsidies is the money appropriated by state legislatures for
higher education.
c. Both Pell grants and tuition subsidies are inefficient methods of increasing access by
lower-income students.