Question

Imagine that you are considering going to graduate school for economics. The program under consideration lasts for one year. The program is costly, and the value to you of its credentials is greater if you are not all that skilled and would have struggled to get a good job without the extra degree. On the other hand, if you do turn out to be very skilled in economics, you would get a good job without the degree in addition to saving on the cost of tuition. Unfortunately, you don’t know for sure yet whether or not you’re especially skilled in economics. More concretely, if you enter the program and you aren’t all that skilled, you get a total payoff of $40,000. If you enter the program and you are quite skilled, you get a total payoff of $80,000. If you don’t enter the program and you aren’t all that skilled, you get a total payoff of $5,000. If you don’t enter the program and you are quite skilled, you get a total payoff of $150,000. “Total payoff” means returns in the labor market and, when applicable, this is net of tuition costs.

(a) Give two additional pieces of information someone who had taken ECON400 would likely need in order to advise you on your course of action. Now suppose that you know, from your strong undergraduate performance, that the true probability you are skilled is 0.7. You can take an assessment before the graduate program that will determine, with complete certainty, whether or not you are skilled.

(b) What is the most that you would pay to take the assessment described above? Why?

Answer 1

a. Two additional pieces of information that would help understand whether or not to take the program would be

i) Past performance of economics to decide whether I am skilled or not skilled

ii) The scenario of the job market today compared with what might happen 1 year later.

b. Putting up the decision tree for the scenario above,

If I know with certainty that I am skilled, I will not enter the program and get a payout of 150,000

If I know with certainty that I am not skilled, I will enter the program and get a payoff of 40,000

If I enter the program, my expected payout = 80,000 * 0.7 + 40,000 * 0.3 = 68,000

If I do not enter the program, my expected payout = 150,000 * 0.7 + 5000 * 0.3 = 120,000

So the value of the assessment will be maximum of (68,000 - 40,000) and (150,000 - 120,000)

So the maximum of 28,000 or 30,000

So the maximum that I will be willing to pay to know the skill level is 30,000

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