Solutions3[1] - Associate Level Material Appendix C The...

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EC 151 Homework III Solutions Inequality & Poverty Due October 7th in class 1) Inequality & Human Capital Investment There two people, A & B, who each own their own investment bank. Each has two investment options in this period of financial turmoil. The time horizon is only two periods. So they make the investment today and then get the return tomorrow. Investment strategies can mean investing in either i, ii or a mix of both. i) Invest in physical capital in the form of new leather chairs for the top management. Doing this costs $2000 per chair. Leather chairs will boost the morale of the management, increasing productivity and each increases the return by an additional 1.5%. ii) Invest in human capital in the form of sending the CFO to finance classes teaching him about managing risk. Each class costs $2000. The first three classes are extremely useful and each class increases return by an additional 5% next period. Then the CFO starts getting progressively bored and zoning out, so the return declines by 2% for every class after the third. a. Make a graph with investment amount on X-axis and return on Y-axis for both the options. Returns to Physical & Human Capital 0 2 4 6 8 10 12 14 16 18 0 2000 4000 6000 8000 10000 12000 14000 16000 18000 20000 Dollars Invested Return Physical Capital Human Capital b. A $20,000 to invest. What would her investment strategy be? She will invest $10K in human capital because till this point the return to HC is higher. Then, she will invest the remaining $10K in physical capital. c. B has $4000 to invest. What would her investment strategy be? She will invest it all in HC. d. The government implements a program to “help” B by taking $2000 from A and giving it to B. What are the strategies of each now after this redistribution? Is the economy better or worse off now? After the redistribution, A has $18K and B has $6K. A will invest this additional amount in HC because it has a higher return for this amount. A will still invest $10K in HC and the remaining $8K in PC. The economy is better off in this situation because essentially, more money ($2000) is being invested at a higher return rate. That is, the $2000 earns an additional 2% if invested in HC (which it is now) but only an extra 1.5% when invested in PC (where it was before). What we see is that at low levels of investment, it is usually more beneficial to invest in human capital, but as the amount available to invest increases; at some point the incentive to invest in physical capital will become higher. What is driving all this? Human capital will usually have diminishing returns after
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a point, because when you increase human capital, you are just adding it to the same person. However,
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Solutions3[1] - Associate Level Material Appendix C The...

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