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Chapter 16: Problem 4

In the 1960s Yale University began offering students an alternative to taking out student loans. Instead, students could attend Yale in exchange for a specified percentage of their earnings over a significant length of time. Yale used historical data to determine the percentage so that the program would pay for itself-large payments from high earners would offset the smaller payments from low earners. a. If you were planning on becoming a Wall Street financier, would you be more likely to take out loans or enroll in the Yale program? Why? b. If you were planning on becoming a missionary, would you be more likely to take out loans or enroll in the Yale program? Why? c. The tuition program turned out to be a financial disaster for Yale. Do your answers to (a) and (b) shed light on why? Explain. d. What kind of information problem did the Yale program suffer from?

Short Answer

Expert verified
High earners should opt for traditional loans, while low earners benefit from the Yale program. The program failed due to adverse selection, attracting low earners.

Step by step solution

01

Analyzing the Wall Street Financier Scenario

If you plan to become a Wall Street financier, your expected earnings are likely to be high. Paying a fixed percentage of your potentially high earnings may result in a larger payment than what you would have paid if you took out a traditional loan, which typically involves fixed interest rates. Therefore, as a high earner, it may be more beneficial to take out traditional loans rather than paying a percentage of your income.
02

Assessing the Missionary Scenario

As a missionary, expected earnings are typically lower compared to high-earning roles. Paying a percentage of lower income to Yale could be economically advantageous compared to fixed loan repayments which might not decrease relative to your earnings level. Thus, enrolling in the Yale program could be more beneficial for someone with lower expected future earnings.
03

Explaining the Financial Disaster for Yale

The Yale program likely attracted students who expected lower future earnings, such as those entering less lucrative fields, while students expecting higher earnings chose traditional loans. This created a selection bias, resulting in mostly lower payments over time, as higher earners avoided the program, contributing to its financial failure.
04

Identifying the Information Problem in the Yale Program

The Yale program suffered from adverse selection, an information problem where individuals with higher expected costs (lower earners) enroll in the program, while those with lower expected costs (higher earners) opt for different financial solutions. This imbalance leads to financial instability within the program.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Understanding Student Loans
Student loans are a form of financial aid designed to help students cover the costs of their education. They can originate from the government or private institutions.
  • Government student loans usually have lower interest rates and more flexible repayment options.
  • Private student loans often come with higher interest rates and require a credit check, possibly needing a co-signer.
Student loans typically involve borrowing a fixed amount of money, which is repaid over time, with interest. This interest on student loans, particularly federal ones, is typically lower than that of other types of loans.
Many students rely on these loans to fund their education as not everyone can afford the full tuition fees upfront.
Repayment terms can be quite varied but usually begin after graduation, thus giving students time to settle into their careers before starting to pay back their debts.
Explaining Income-Based Repayment
Income-Based Repayment (IBR) is designed to assist borrowers in managing their student loan payments by adjusting them according to their income.
  • Typically, payments are capped at a percentage of the borrower's discretionary income.
  • IBR provides relief to those whose student loans might otherwise consume a substantial portion of their earnings.
This repayment plan is crucial for individuals in lower-paying jobs as it ensures that their loan payments do not overshadow their living expenses.
It offers flexibility and financial breathing room, preventing borrower delinquency and default. As income increases, so too can the repayments, aligning the monthly payment more closely with the borrower's ability to pay.
Ultimately, IBR reflects a more personalized approach to loan repayment and can sometimes lead to loan forgiveness if certain conditions are met over time.
The Concept of Information Asymmetry
Information asymmetry occurs when one party in a transaction has more or better information than the other. This can lead to an imbalance in decision-making processes.
  • It often results in adverse selection, where the more informed party takes advantage of the situation.
  • For example, in the Yale tuition program, students with expected lower earnings capitalized on the program advantages.
This means individuals expected to earn less were more likely to join Yale's income-sharing program while high earners avoided it, opting for traditional loans.
Information asymmetry challenges the fairness and efficiency of markets.
In education finance, understanding this concept can help stakeholders design better tuition programs that consider likely behaviors based on income forecasts.
Insights into Education Finance
Education finance involves strategies and solutions designed to fund educational activities. This can encompass everything from student loans to government grants and scholarships.
  • Effective education finance models consider both immediate costs and long-term financial implications for students.
  • Programs need to be sustainable and fair to all parties involved, including students, institutions, and lenders.
Education finance aims to make obtaining a degree more accessible, regardless of a student's personal financial situation.
A well-designed financial aid program ensures that both the provider's and receiver's interests are balanced and that long-term repayment is feasible.
When designing such programs, careful consideration of salary expectations based on career paths is essential to avoid issues like adverse selection.

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Most popular questions from this chapter

In an isolated town, there are two distinct markets for cars. Buyers will pay up to \(\$ 12,000\) for a highquality car or \(\$ 8,000\) for a low-quality car. There are 100 high-quality cars for sale, and the sellers have a minimum acceptable price of \(\$ 11,000\). There are also 100 low-quality cars for sale at a minimum acceptable price of \(\$ 5,000\). The supply of automobiles is perfectly inelastic above the reservation price. a. If there is perfect information, how many high quality and how many low- quality cars will be sold? b. Suppose that the quality of a car is known to the seller, but not to the buyer. What price will prevail in the marketplace if buyers correctly estimate the chance of acquiring a low-quality car at \(50 \% ?\) What happens to the number of high-quality cars for sale at that price? c. After sellers make all adjustments, what will the equilibrium price of cars be? What proportion of those cars will be high-quality cars? d. What happens to your answers to (a), \((\mathrm{b})\), and (c) if sellers of high-quality cars have a reservation price of \(\$ 9,500\) instead of \(\$ 11,000 ?\)

Suppose that, to deal with adverse selection problems, a new federal lemons law requires all used car dealerships to provide a one-year warranty for each car they sell. Explain how this new law, designed to reduce adverse selection, might increase the problem of moral hazard.

Suppose that there are two types of workers in the world: Charlie Hustles, who are highproductivity workers, and Lazy Susans, who are low-productivity workers. The market would pay \(\$ 70,000\) (this and all numbers in this question are in present value terms) to hire a Charlie Hustle, but only \(\$ 20,000\) to hire a Lazy Susan. The problem, of course, is that a firm cannot tell on sight whether a job applicant is a Charlie or a Susan. One way to attempt to separate the Chucks and the Suzies is to require a college degree. It is easy for a Charlie Hustle to obtain a degree (the degree takes four years to complete and costs \(\$ 40,000\) in total). It is harder for a Lazy Susan to obtain a degree (six years and a cost of \(\$ 60,000\) ). Assume that a college education adds nothing to either worker's productivity. a. If the company, operating blindly with no degree requirements, were to pay an average wage of \(\$ 45,000,\) what would most of its applicants look like? b. Suppose that the company announces that it will pay \(\$ 70,000\) to those with college degrees, and \(\$ 20,000\) to those without. What is the net benefit of a college education to a Charlie? To a Susan? Does the degree requirement allow the firm to filter out low-quality applicants? c. Suppose that a new federal subsidy to assist lowproductivity workers reduces the cost of obtaining a degree to \(\$ 46,000\). What is the net benefit of a college education to a Charlie? To a Susan? Does the degree requirement allow the firm to filter out low-quality applicants? d. In light of your answers to (b) and (c), discuss the following assertion: To be effective, a signal must be costly, but it must be more costly for a low-productivity applicant. e. Colleges and universities have been accused of practicing grade inflation. In fact, some colleges have actually outlawed awarding a grade of "F." Given your answer to (d), discuss the impact of this practice on the signaling value of a college diploma. Is this practice good for students? Does your answer depend on the quality of the student? Explain.

Many health and casualty insurance policies require policyholders to pay a certain amount (called a deductible) for claims before the insurer itself will begin to pay. a. Explain how the existence of a deductible reduces the problems of moral hazard. b. Often, insurers will let policyholders choose a low deductible, or will offer them a larger deductible in exchange for a substantial reduction in the premium. Explain how this two-tiered system helps insurers deal with the problem of adverse selection.

To assist in ensuring adequate and affordable health care for all, the federal government has mandated that health insurers provide health insurance to all, regardless of their physical condition. Insurers may not reject coverage for preexisting health problems. a. Explain why this mandate, standing alone, creates tremendous potential for adverse selection problems. b. A second part of recent health-care reforms is a mandate that every person must either obtain insurance through his employer or through the private market. Explain how this mandate reduces (i) adverse selection problems in general and (ii) the adverse selection problems discussed in part (a) in particular.
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