Suppose that you, after studying economics in college, quickly became rich— so rich that you have nothing better to do than worry about your 16-year old niece who can’t seemto focus on her future. Your niece currently already has a trust fund that will pay her a nice yearly income of $50,000 starting when she is 18, and she has no other means of support.
A:
You are concerned that your niece will not see the wisdom of spending a good portion of her trust fund on a college education, and you would therefore like to use $100,000 of your wealth to change her choice set in ways that will give her greater incentives to go to college.
(a) One option is for you to place $100,000 in a second trust fund but to restrict your niece to be able to draw on this trust fund only for college expenses of up to $25,000 per year for four years.
On a graph with “yearly dollars spent on college education” on the horizontal axis and “yearly dollars spent on other consumption” on the vertical, illustrate how this affects her choice set.
(b) A second option is for you to simply tell your niece that you will give her $25,000 per year for
4 years and you will trust her to “do what’s right”. How does this impact her choice set?
(c) Suppose you are wrong about your niece’s short-sightedness and she was planning on spending more than $25,000 per year from her other trust fund on college education. Do you think she will care whether you do as described in part (a) or as described in part (b)?
(d) Suppose you were right about her—she never was going to spend very much on college. Will she care now?
(e) A friend of yours gives you some advice: be careful—your niece will not value her education if she does not have to put up some of her own money for it. Sobered by this advice, you decide to set up a different trust fund that will release 50 cents to your niece (to be spent on whatever she wants) for every dollar that she spends on college expenses. How will this affect her choice set?
(f) If your niece spends $25,000 per year on college under the trust fund in part (e), can you identify a vertical distance that represents how much you paid to achieve this outcome?
B: How would you write the budget equation for each of the three alternatives discussed above?