1
00:00:00,040 --> 00:00:02,460
The following content is
provided under a Creative

2
00:00:02,460 --> 00:00:03,870
Commons license.

3
00:00:03,870 --> 00:00:06,910
Your support will help MIT
OpenCourseWare continue to

4
00:00:06,910 --> 00:00:10,560
offer high quality educational
resources for free.

5
00:00:10,560 --> 00:00:13,460
To make a donation or view
additional materials from

6
00:00:13,460 --> 00:00:16,180
hundreds of MIT courses, visit
mitopencourseware@ocw.mit.edu.

7
00:00:22,180 --> 00:00:28,560
PROFESSOR: So today we're
going to continue our

8
00:00:28,560 --> 00:00:30,050
discussion of capital markets.

9
00:00:30,050 --> 00:00:32,650
If you remember the introduction
from last time,

10
00:00:32,650 --> 00:00:38,350
what we talked about was we
talked about labor as an input

11
00:00:38,350 --> 00:00:39,790
and where it came from.

12
00:00:39,790 --> 00:00:42,240
And these lectures are about
capitals and input, where it

13
00:00:42,240 --> 00:00:42,760
comes from.

14
00:00:42,760 --> 00:00:44,820
We talked about the fact that
while capital, ultimately, is

15
00:00:44,820 --> 00:00:47,880
machines, and buildings, and
things like that, what we

16
00:00:47,880 --> 00:00:49,140
think about in this course,
we're going to think about

17
00:00:49,140 --> 00:00:53,280
financial capital and what's
behind all the different kinds

18
00:00:53,280 --> 00:00:56,160
of capital that businesses
use.

19
00:00:56,160 --> 00:00:58,940
We talked about peoples' savings
decisions as creating

20
00:00:58,940 --> 00:01:01,810
a pool of capital from which
businesses draw.

21
00:01:01,810 --> 00:01:04,410
And then we talked about present
value and the notion

22
00:01:04,410 --> 00:01:08,140
of considering the fact that
dollars in the future are

23
00:01:08,140 --> 00:01:09,940
worth less than dollars today.

24
00:01:09,940 --> 00:01:13,130
So with that as background, what
we want to do now is talk

25
00:01:13,130 --> 00:01:15,750
about how firms and individuals
should make

26
00:01:15,750 --> 00:01:17,240
choices over time.

27
00:01:17,240 --> 00:01:19,040
We talked a couple of lectures
ago about how firms and

28
00:01:19,040 --> 00:01:21,720
individuals make choices when
faced with uncertainty.

29
00:01:21,720 --> 00:01:23,790
So that was sort of a choice
across two different

30
00:01:23,790 --> 00:01:24,740
states of the world.

31
00:01:24,740 --> 00:01:25,700
You could get hit by a car.

32
00:01:25,700 --> 00:01:27,460
You could not get
hit by a car.

33
00:01:27,460 --> 00:01:29,540
Now we'll talk about choices
across two different time

34
00:01:29,540 --> 00:01:32,020
periods, today versus tomorrow,
and how people make

35
00:01:32,020 --> 00:01:34,170
those choices.

36
00:01:34,170 --> 00:01:36,040
And the answer is going to be
pretty simple following what

37
00:01:36,040 --> 00:01:38,250
we did last time, which is
whenever you're faced with two

38
00:01:38,250 --> 00:01:41,560
choices that pay off at
different times, you just want

39
00:01:41,560 --> 00:01:44,620
to choose the choice with the
highest present value.

40
00:01:44,620 --> 00:01:49,560
So if you're faced with two
streams of payments, you know

41
00:01:49,560 --> 00:01:50,750
that you can't just
add them up.

42
00:01:50,750 --> 00:01:52,880
What you need to do is you need
to add them up in a way

43
00:01:52,880 --> 00:01:54,500
that gets present value.

44
00:01:54,500 --> 00:01:57,620
So, for example, consider the
example of a professional

45
00:01:57,620 --> 00:02:02,370
athlete who's considering
two contracts.

46
00:02:02,370 --> 00:02:09,335
One contract pays $1 million
today, and one contract pays

47
00:02:09,335 --> 00:02:15,650
$500,000 today and $2
million in deferred

48
00:02:15,650 --> 00:02:20,350
payments in 10 years.

49
00:02:20,350 --> 00:02:23,525
So that's the two contract
options facing the player.

50
00:02:27,010 --> 00:02:30,580
If you read it in the newspaper,
they would describe

51
00:02:30,580 --> 00:02:32,630
this is a $2.5 million contract
and this as a $1

52
00:02:32,630 --> 00:02:35,470
million contract.

53
00:02:35,470 --> 00:02:37,340
However, the newspaper is wrong,
because they haven't

54
00:02:37,340 --> 00:02:39,560
accounted for the fact
that some of those

55
00:02:39,560 --> 00:02:40,330
payments are deferred.

56
00:02:40,330 --> 00:02:42,730
So they're worth less.

57
00:02:42,730 --> 00:02:43,690
So how do we compare them?

58
00:02:43,690 --> 00:02:45,580
Well, to compare them, we have
to take the present value of

59
00:02:45,580 --> 00:02:50,100
these two streams. So the
present value of the first

60
00:02:50,100 --> 00:02:52,810
stream is just $1 million,
because it's paid today.

61
00:02:52,810 --> 00:02:53,815
So putting it in today's
dollars,

62
00:02:53,815 --> 00:02:55,260
it's worth $1 million.

63
00:02:55,260 --> 00:03:01,860
The second stream is worth, the
present value is $500,000

64
00:03:01,860 --> 00:03:10,750
plus $2 million over 1 plus i
to the 10th, because it's

65
00:03:10,750 --> 00:03:12,770
being paid in 10 years.

66
00:03:12,770 --> 00:03:14,510
And actually here, I'm
going to not use i.

67
00:03:14,510 --> 00:03:16,330
I'm going to use r for the
real interest rate.

68
00:03:16,330 --> 00:03:18,420
Remember last time we talked
about how what really matters

69
00:03:18,420 --> 00:03:21,550
is the real interest rate, the
interest rate you get minus

70
00:03:21,550 --> 00:03:24,080
inflation, minus the costs of
price increases for goods you

71
00:03:24,080 --> 00:03:26,450
have to buy with that interest.
So remember we want

72
00:03:26,450 --> 00:03:27,450
to use the real interest
rate here.

73
00:03:27,450 --> 00:03:30,150
So I'll use r now.

74
00:03:30,150 --> 00:03:34,600
So, basically, whether this
second contract is a better

75
00:03:34,600 --> 00:03:40,920
deal or not depends on what
the real interest rate is.

76
00:03:40,920 --> 00:03:46,340
So if r equals 5%, then the
present value of this second

77
00:03:46,340 --> 00:03:49,230
contract is $1.73 million.

78
00:03:49,230 --> 00:03:52,220
So that is a good deal.

79
00:03:52,220 --> 00:03:56,500
On the other hand, if r equalled
20%, if there's a 20%

80
00:03:56,500 --> 00:03:59,760
interest rate as there was back
in the late '70s, early

81
00:03:59,760 --> 00:04:06,030
'80s, then the present value
is $0.82 million.

82
00:04:06,030 --> 00:04:07,280
So it's not a good deal.

83
00:04:09,660 --> 00:04:12,940
So the key is if you want to
ever compare two streams of

84
00:04:12,940 --> 00:04:16,260
payments that pay off in
different times, you have to

85
00:04:16,260 --> 00:04:17,339
bring them back to a comparable

86
00:04:17,339 --> 00:04:18,940
unit, to today's dollars.

87
00:04:18,940 --> 00:04:20,380
And the way we do that
is by calculating

88
00:04:20,380 --> 00:04:21,630
their present value.

89
00:04:25,570 --> 00:04:27,900
And this is a problem people
have. A common mistake that's

90
00:04:27,900 --> 00:04:29,970
made is people don't
consider this in

91
00:04:29,970 --> 00:04:31,680
evaluating streams of payments.

92
00:04:31,680 --> 00:04:35,550
So a classic example is when
you hear someone wins $100

93
00:04:35,550 --> 00:04:37,540
million in the lottery.

94
00:04:37,540 --> 00:04:39,340
It's actually a lot
less than that.

95
00:04:39,340 --> 00:04:42,500
Because $100 million lottery
win, what it really is is $5

96
00:04:42,500 --> 00:04:45,640
million a year for 20 years.

97
00:04:45,640 --> 00:04:47,480
And you have a choice.

98
00:04:47,480 --> 00:04:50,760
You could take a lump sum now,
or you take the $5 million a

99
00:04:50,760 --> 00:04:53,130
year over 20 years.

100
00:04:53,130 --> 00:04:57,010
So basically, the $5 million
a year over 20 years is, of

101
00:04:57,010 --> 00:04:59,500
course, worth a lot less
than $100 million.

102
00:04:59,500 --> 00:05:00,340
What's it worth?

103
00:05:00,340 --> 00:05:04,810
Well, it's worth $5 million plus
$5 million over 1 plus

104
00:05:04,810 --> 00:05:09,100
the real interest rate plus $5
million over 1 plus the real

105
00:05:09,100 --> 00:05:12,380
interest rates squared plus
dot dot dot dot plus $5

106
00:05:12,380 --> 00:05:18,400
million over 1 plus the real
interest rate to the 20th.

107
00:05:18,400 --> 00:05:22,920
So, for example, for an interest
rate of 5%, if r

108
00:05:22,920 --> 00:05:28,290
equals 5%, this lottery is
really worth $65 million.

109
00:05:28,290 --> 00:05:30,320
Now, that's still pretty good.

110
00:05:30,320 --> 00:05:34,910
But it's a lot less
than $100 million.

111
00:05:34,910 --> 00:05:38,430
When you hear a number about a
player's contract or a lottery

112
00:05:38,430 --> 00:05:42,420
winning, you need to always
recognize that the effective

113
00:05:42,420 --> 00:05:45,210
value is going to be lower than
what you hear on the news

114
00:05:45,210 --> 00:05:49,010
because of the time payment
that takes place.

115
00:05:49,010 --> 00:05:50,675
Now whether that's a big
deal or not depends on

116
00:05:50,675 --> 00:05:52,300
the interest rate.

117
00:05:52,300 --> 00:05:54,740
So Victor Martinez just signed
with the Detroit Tigers for

118
00:05:54,740 --> 00:06:00,410
four years and $50 million.

119
00:06:00,410 --> 00:06:03,560
Now, he could have signed with
the Chicago White Sox for

120
00:06:03,560 --> 00:06:05,170
three years and $42 million.

121
00:06:05,170 --> 00:06:08,550
Or the Boston Red Sox
were offering.

122
00:06:08,550 --> 00:06:09,925
So the Chicago White Sox
were offering three

123
00:06:09,925 --> 00:06:11,180
years and $42 million.

124
00:06:11,180 --> 00:06:13,290
Now, you might say that you
can't really compare those

125
00:06:13,290 --> 00:06:15,610
two, because one is out
three years, and

126
00:06:15,610 --> 00:06:16,330
one is out four years.

127
00:06:16,330 --> 00:06:19,240
But the truth is the interest
rate right now is so low that

128
00:06:19,240 --> 00:06:20,940
you can pretty much
compare them.

129
00:06:20,940 --> 00:06:22,690
Right now, the interest
rate you can get in a

130
00:06:22,690 --> 00:06:24,670
bank is close to 0.

131
00:06:24,670 --> 00:06:27,180
So, basically, if the interest
rate is 0, the present value

132
00:06:27,180 --> 00:06:29,050
is the nominal value.

133
00:06:29,050 --> 00:06:31,060
So right now, you can sort
of compare players'

134
00:06:31,060 --> 00:06:33,150
contracts like that.

135
00:06:33,150 --> 00:06:35,710
On the other hand, when the
interest rate is higher, you

136
00:06:35,710 --> 00:06:37,940
can't do that comparison.

137
00:06:37,940 --> 00:06:39,870
And, in particular, what you'll
hear a lot of times is

138
00:06:39,870 --> 00:06:41,800
these contracts have very
deferred payments.

139
00:06:41,800 --> 00:06:43,630
So even for a low interest rate,
it's still worth a lot

140
00:06:43,630 --> 00:06:45,750
less in the end.

141
00:06:45,750 --> 00:06:49,900
So that's the key point to
remember when you hear values.

142
00:06:49,900 --> 00:06:51,660
It's to know that you have
to discount them

143
00:06:51,660 --> 00:06:52,830
by when they happen.

144
00:06:52,830 --> 00:06:57,060
And that's going to depend on
how high the interest rate is.

145
00:06:57,060 --> 00:07:01,900
Now, this leads us directly to
the important implication of

146
00:07:01,900 --> 00:07:05,330
present value which is how firms
and individuals make

147
00:07:05,330 --> 00:07:06,580
investment decisions.

148
00:07:13,070 --> 00:07:15,750
So we've talked about firms
choosing a level of capital

149
00:07:15,750 --> 00:07:16,910
and a level of labor.

150
00:07:16,910 --> 00:07:17,880
And we talked about in a simple

151
00:07:17,880 --> 00:07:19,960
isoquant-isocost framework.

152
00:07:19,960 --> 00:07:21,580
But, in reality, firms
don't really deal

153
00:07:21,580 --> 00:07:22,430
with that simple framework.

154
00:07:22,430 --> 00:07:26,860
In reality, for any given
investment decision, they

155
00:07:26,860 --> 00:07:29,920
essentially want to compare the
cost of that investment to

156
00:07:29,920 --> 00:07:31,810
the benefits of that
investment.

157
00:07:31,810 --> 00:07:33,460
And that depends on
things like the

158
00:07:33,460 --> 00:07:34,440
isoquants and the isocosts.

159
00:07:34,440 --> 00:07:36,710
But it also depends critically
on the time frame over which

160
00:07:36,710 --> 00:07:39,780
that investment will pay out.

161
00:07:39,780 --> 00:07:41,760
And what firms consider when
they make an investment

162
00:07:41,760 --> 00:07:45,410
decision is the net present
value of that decision.

163
00:07:45,410 --> 00:07:47,690
On net, what's the
present value?

164
00:07:47,690 --> 00:07:49,870
Because often, for the
investment decisions, you have

165
00:07:49,870 --> 00:07:54,830
to lay out money up front to
recoup that money later on.

166
00:07:54,830 --> 00:07:56,940
So this adds an extra
dimension.

167
00:07:56,940 --> 00:07:58,040
Which is not just you're
adding up a

168
00:07:58,040 --> 00:07:59,350
stream of future payments.

169
00:07:59,350 --> 00:08:03,360
You're actually contrasting a
debit now versus credits in

170
00:08:03,360 --> 00:08:05,100
the future.

171
00:08:05,100 --> 00:08:08,140
And the math is the same, but
it's a little bit more

172
00:08:08,140 --> 00:08:09,380
complicated.

173
00:08:09,380 --> 00:08:13,460
So the net present value of any
investment is going to be

174
00:08:13,460 --> 00:08:17,160
the revenues from that
investment in period 0 minus

175
00:08:17,160 --> 00:08:21,610
the cost of that investment in
period 0 plus the revenues

176
00:08:21,610 --> 00:08:24,440
from that investment in the
period 1 minus the cost of

177
00:08:24,440 --> 00:08:30,970
that investment in period 1 over
1 plus r plus dot dot dot

178
00:08:30,970 --> 00:08:35,440
dot dot plus the revenues in
year t minus the costs in year

179
00:08:35,440 --> 00:08:40,700
t over 1 plus r to the t.

180
00:08:40,700 --> 00:08:45,430
So the net present value is
going to be a function of at

181
00:08:45,430 --> 00:08:49,130
every year is the investment
making or losing money and

182
00:08:49,130 --> 00:08:53,100
then adding those future gains
or losses up discounting by

183
00:08:53,100 --> 00:08:55,210
when they occur.

184
00:08:55,210 --> 00:08:57,260
And the bottom line
is firm investment

185
00:08:57,260 --> 00:08:58,440
decisions are very simple.

186
00:08:58,440 --> 00:09:02,510
If this is greater than 0, then
it's a good investment.

187
00:09:02,510 --> 00:09:03,760
If it's less than 0, it's not.

188
00:09:06,940 --> 00:09:10,140
And this matters a lot, because
you'll often see

189
00:09:10,140 --> 00:09:13,315
investments that have
cash losses up

190
00:09:13,315 --> 00:09:14,490
front and gains later.

191
00:09:14,490 --> 00:09:16,770
In fact, that's sort of the
definition of investment.

192
00:09:16,770 --> 00:09:19,335
It's that you're investing some
money up front to yield

193
00:09:19,335 --> 00:09:21,960
returns later on.

194
00:09:21,960 --> 00:09:24,260
So, for example, if you have an
investment with an upfront

195
00:09:24,260 --> 00:09:29,620
cost of $100 in year 1, it's
going to cost you $100 in year

196
00:09:29,620 --> 00:09:35,120
1 to buy some machine, and
you get no revenues.

197
00:09:35,120 --> 00:09:39,600
So it's minus $100 in year 1.

198
00:09:39,600 --> 00:09:50,440
But in year 2, you're going to
earn $200 from that machine

199
00:09:50,440 --> 00:09:53,280
minus you're going to have
a $50 maintenance on the

200
00:09:53,280 --> 00:09:57,710
machine, so $150 in year 2.

201
00:09:57,710 --> 00:10:00,920
So in year 1, you buy the
machine for $100.

202
00:10:00,920 --> 00:10:04,480
In year 2, the machine produces
some widgets which

203
00:10:04,480 --> 00:10:05,915
you can sell for $200.

204
00:10:05,915 --> 00:10:08,010
But, along the way, you have
to maintain that machine.

205
00:10:08,010 --> 00:10:11,650
And that costs you
$50 in year 2.

206
00:10:11,650 --> 00:10:20,980
The net present value is minus
$100 plus $150 over 1 plus r.

207
00:10:20,980 --> 00:10:23,650
That's the net present value.

208
00:10:23,650 --> 00:10:27,470
Whether that's positive or not
is going to depend critically

209
00:10:27,470 --> 00:10:31,340
on what the interest rate is.

210
00:10:31,340 --> 00:10:34,170
So the key thing is we want to
take that stream of payments,

211
00:10:34,170 --> 00:10:37,850
positive or negative, and put
them in today's terms. Are

212
00:10:37,850 --> 00:10:40,280
there questions about that?

213
00:10:40,280 --> 00:10:42,620
But this raises the question of
well, what interest rates

214
00:10:42,620 --> 00:10:45,040
should a firm use?

215
00:10:45,040 --> 00:10:47,440
So the firm has got to
make this decision.

216
00:10:47,440 --> 00:10:49,925
Should all firms just walk by
BayBank, or Fleet Bank, or

217
00:10:49,925 --> 00:10:51,300
whatever the hell
it's called now?

218
00:10:51,300 --> 00:10:53,050
What is the big bank called?

219
00:10:53,050 --> 00:10:54,780
Fleet, I guess.

220
00:10:54,780 --> 00:10:59,060
Should they walk by now and look
in the window and say the

221
00:10:59,060 --> 00:11:02,820
interest rate is 1%, or
2%, 3% and use that?

222
00:11:02,820 --> 00:11:05,420
What should firms do?

223
00:11:05,420 --> 00:11:08,250
Basically, the key issue is that
different firms will have

224
00:11:08,250 --> 00:11:10,680
different interest rates
that they want to use.

225
00:11:10,680 --> 00:11:16,230
Or firms will have different,
what we call, discount rates.

226
00:11:16,230 --> 00:11:18,550
You can have a firm-specific
discount rate.

227
00:11:22,830 --> 00:11:25,680
You can have a firm-specific
discount rate that firms might

228
00:11:25,680 --> 00:11:26,580
want to use.

229
00:11:26,580 --> 00:11:30,290
And what's going to determine
that is going to be the

230
00:11:30,290 --> 00:11:32,960
opportunity cost of
money to the firm.

231
00:11:39,390 --> 00:11:42,570
What is the firm's next
best use of that

232
00:11:42,570 --> 00:11:43,820
money they're investing.

233
00:11:45,850 --> 00:11:50,090
So, for example, let's say a
firm has a bunch of cash

234
00:11:50,090 --> 00:11:51,340
sitting around.

235
00:11:54,210 --> 00:11:57,550
Let's say the firm has $100 in
cash sitting around, and it's

236
00:11:57,550 --> 00:12:01,120
trying to decide whether or not
to make this investment.

237
00:12:01,120 --> 00:12:05,100
How do we decide on what the
opportunity cost on that

238
00:12:05,100 --> 00:12:07,700
investment is, what the right
discount rate is to use?

239
00:12:07,700 --> 00:12:11,455
How should the firm
think about that?

240
00:12:11,455 --> 00:12:14,260
If it's got the cash sitting
around, how should the firm

241
00:12:14,260 --> 00:12:15,540
think about whether it
should invest $100?

242
00:12:15,540 --> 00:12:15,720
Yeah.

243
00:12:15,720 --> 00:12:18,671
AUDIENCE: Well, whether or not
it has some other place that

244
00:12:18,671 --> 00:12:19,448
it can invest it.

245
00:12:19,448 --> 00:12:21,340
Or it's just going to rot
in a safe somewhere.

246
00:12:21,340 --> 00:12:24,290
PROFESSOR: Well, at a minimum,
we can put it in the bank.

247
00:12:24,290 --> 00:12:27,560
So at a minimum, it can always
earn 1% or 2% of whatever

248
00:12:27,560 --> 00:12:29,910
banks are paying now.

249
00:12:29,910 --> 00:12:32,530
But what you're saying
is right.

250
00:12:32,530 --> 00:12:37,210
It may also have other
investment opportunities.

251
00:12:37,210 --> 00:12:39,270
So, in some sense, the
discount rate for any

252
00:12:39,270 --> 00:12:42,350
investment opportunity is what
you could earn on the next

253
00:12:42,350 --> 00:12:44,480
best investment opportunity.

254
00:12:44,480 --> 00:12:46,290
So if I've got $100 sitting
around, and I've got a

255
00:12:46,290 --> 00:12:50,570
guaranteed 10% I can make
somewhere, then if I decide

256
00:12:50,570 --> 00:12:52,260
whether or not I should take
this investment, I should use

257
00:12:52,260 --> 00:12:54,100
a discount rate of 10%.

258
00:12:54,100 --> 00:12:57,400
If I can make 20% somewhere,
I should use 20%.

259
00:12:57,400 --> 00:12:58,690
So, in some sense, what you
want to do is you want to

260
00:12:58,690 --> 00:13:01,660
stack up your investment
opportunities from worst to

261
00:13:01,660 --> 00:13:04,030
best in terms of
rate of return.

262
00:13:04,030 --> 00:13:08,780
And then you start at the top
of the list and ask, OK,

263
00:13:08,780 --> 00:13:12,170
discounting at the best
alternative opportunity, is

264
00:13:12,170 --> 00:13:13,830
this one worth it given
the steam of payments?

265
00:13:13,830 --> 00:13:16,650
And then work your way down the
list. So, basically, the

266
00:13:16,650 --> 00:13:20,560
key thing is that for any firm,
their opportunity cost,

267
00:13:20,560 --> 00:13:23,030
their discount rate is the next
best thing they could

268
00:13:23,030 --> 00:13:25,080
have done with the money.

269
00:13:25,080 --> 00:13:30,770
Similarly, if a firm doesn't
have the money and is deciding

270
00:13:30,770 --> 00:13:35,130
whether or not to borrow the
money to do this investment,

271
00:13:35,130 --> 00:13:38,620
then the discount will be the
cost of borrowing the money.

272
00:13:38,620 --> 00:13:40,720
Right now the bank only
pays 1% on your money.

273
00:13:40,720 --> 00:13:44,990
But if you want a loan, you
still have to pay 4% for it.

274
00:13:44,990 --> 00:13:49,520
So it may be that you could end
up in a situation where

275
00:13:49,520 --> 00:13:55,550
your $100 doesn't really do
you that much good saved.

276
00:13:55,550 --> 00:13:59,610
And it would cost so much to
borrow the $100, that it's

277
00:13:59,610 --> 00:14:01,510
better to use the $100 that's
sitting around.

278
00:14:01,510 --> 00:14:03,526
So, basically, let's say you
have $100 sitting around, and

279
00:14:03,526 --> 00:14:05,700
you're trying to decide how
to finance its investment.

280
00:14:05,700 --> 00:14:08,650
Well let's say you have an
alternative investment that

281
00:14:08,650 --> 00:14:10,590
yields 10%.

282
00:14:10,590 --> 00:14:13,890
What you do is you put the
$100 on the alternative.

283
00:14:13,890 --> 00:14:16,550
And then you say, well, should
I then borrow to finance this

284
00:14:16,550 --> 00:14:19,040
investment?

285
00:14:19,040 --> 00:14:22,000
Well, I have to ask, is the
borrowing rate low enough that

286
00:14:22,000 --> 00:14:24,350
this net present value
is positive?

287
00:14:24,350 --> 00:14:26,780
So the firm wants to consider
all of its options it can do

288
00:14:26,780 --> 00:14:28,730
with its money that it's
borrowing and consider a

289
00:14:28,730 --> 00:14:31,470
discount rate for each, which
is the alternative next best

290
00:14:31,470 --> 00:14:32,720
use of the money.

291
00:14:34,830 --> 00:14:36,090
Now it's not just
firms that make

292
00:14:36,090 --> 00:14:37,700
these investment decisions.

293
00:14:37,700 --> 00:14:39,120
People have to make these
decisions too.

294
00:14:39,120 --> 00:14:41,650
In fact, I faced one, a number
of years ago, when I was first

295
00:14:41,650 --> 00:14:43,220
teaching this course.

296
00:14:43,220 --> 00:14:45,450
So it's good for me to work
it out in the context.

297
00:14:45,450 --> 00:14:46,850
I was decided this just
about the time I was

298
00:14:46,850 --> 00:14:48,210
delivering this lecture.

299
00:14:48,210 --> 00:14:50,020
And here was my choice.

300
00:14:50,020 --> 00:14:52,000
Basically, I had to decide
on whether to invest in

301
00:14:52,000 --> 00:14:54,860
insulation for my 100-year-old
house.

302
00:14:54,860 --> 00:14:58,110
I've got this old house, windy,
crappy, whatever, and I

303
00:14:58,110 --> 00:15:00,650
had to decide whether to
invest in insulation.

304
00:15:00,650 --> 00:15:03,790
And the math was that my heating
bills were costing me

305
00:15:03,790 --> 00:15:06,920
$2,000 a year.

306
00:15:06,920 --> 00:15:08,230
I was spending $2,000
a year in heat.

307
00:15:08,230 --> 00:15:09,000
It's a lot more now.

308
00:15:09,000 --> 00:15:13,440
Back then it was
$2,000 a year.

309
00:15:13,440 --> 00:15:19,050
My best estimate was that if I
insulated my house, I could

310
00:15:19,050 --> 00:15:21,970
lower my heating costs by
about 25%, or about

311
00:15:21,970 --> 00:15:31,000
minus $500 per year.

312
00:15:31,000 --> 00:15:38,970
But to do that insulation
would cost $4,000.

313
00:15:38,970 --> 00:15:43,890
So my question was, do I make
a $4,000 investment to lower

314
00:15:43,890 --> 00:15:47,200
my heating costs
by $500 a year?

315
00:15:47,200 --> 00:15:49,860
Well, I know how to do that.

316
00:15:49,860 --> 00:15:54,602
I say, I take my $4,000, that's
a negative in year 1.

317
00:15:54,602 --> 00:15:56,450
So let's say there's no effect
in year 1 of the heating

318
00:15:56,450 --> 00:15:57,590
costs, because they're
putting it in.

319
00:15:57,590 --> 00:15:59,890
So the heating savings
start in year 2.

320
00:15:59,890 --> 00:16:03,330
So then in year 2 I'm
going to save $500.

321
00:16:03,330 --> 00:16:04,530
But that I'm going to
have to discount at

322
00:16:04,530 --> 00:16:06,010
some interest rate.

323
00:16:06,010 --> 00:16:08,460
In year 3, I'm going to
save another $500.

324
00:16:08,460 --> 00:16:13,730
I'll discount that at some
interest rate, and so on.

325
00:16:13,730 --> 00:16:18,140
Now, the tricky thing about this
calculation is twofold.

326
00:16:18,140 --> 00:16:20,170
What are the two things I still
have to figure out to do

327
00:16:20,170 --> 00:16:21,880
this calculation?

328
00:16:21,880 --> 00:16:22,160
Yeah.

329
00:16:22,160 --> 00:16:23,658
AUDIENCE: The time frame that
you're going to spend in the

330
00:16:23,658 --> 00:16:25,080
house and the interest rate.

331
00:16:25,080 --> 00:16:26,940
PROFESSOR: One is the
interest rate.

332
00:16:26,940 --> 00:16:29,030
Now, for that one, I have to
think well, if I had money

333
00:16:29,030 --> 00:16:31,790
sitting around, what was the
next best investment

334
00:16:31,790 --> 00:16:33,040
opportunity.

335
00:16:35,130 --> 00:16:37,390
This was the early 2000s when
the stock market didn't look

336
00:16:37,390 --> 00:16:39,880
like a very good investment
opportunity.

337
00:16:39,880 --> 00:16:41,830
The next best was the interest
rates were probably on the

338
00:16:41,830 --> 00:16:43,810
order of about 5% back then.

339
00:16:43,810 --> 00:16:46,770
So let's say I could have put
it in the bank at 5%.

340
00:16:46,770 --> 00:16:48,500
But the other tricky thing
is how long will I

341
00:16:48,500 --> 00:16:50,920
have the house for?

342
00:16:50,920 --> 00:16:55,150
If I'm going to own the house
forever, or for long enough

343
00:16:55,150 --> 00:16:58,450
that it's equivalent to forever,
then I know I can

344
00:16:58,450 --> 00:17:05,930
just rewrite this as minus
$4,000 plus $500 over r.

345
00:17:05,930 --> 00:17:15,660
So if the interest rate was 5%,
then that's minus $4,000

346
00:17:15,660 --> 00:17:22,359
plus $500 over 5% or plus
$10,000 which is well above 0.

347
00:17:22,359 --> 00:17:24,440
So at a 5% interest rate, if I
was going to own the house

348
00:17:24,440 --> 00:17:27,810
forever, this is a
great investment.

349
00:17:27,810 --> 00:17:28,220
Yeah.

350
00:17:28,220 --> 00:17:30,575
AUDIENCE: Wouldn't you also have
to consider how much it

351
00:17:30,575 --> 00:17:32,302
would add to the value of
your house when you

352
00:17:32,302 --> 00:17:32,930
attempt to sell it?

353
00:17:32,930 --> 00:17:34,080
PROFESSOR: Excellent point.

354
00:17:34,080 --> 00:17:36,570
Even if I'm not going own the
house forever, it still might

355
00:17:36,570 --> 00:17:38,160
be a good investment.

356
00:17:38,160 --> 00:17:42,040
Let's say I was going to sell
the house in two years, then

357
00:17:42,040 --> 00:17:49,590
it would be minus $4,000
plus $500 over 1.05--

358
00:17:49,590 --> 00:17:50,995
Well, let's say I was going to
sell it after two years.

359
00:17:50,995 --> 00:17:52,130
So this is the first year
and the second year.

360
00:17:52,130 --> 00:17:55,650
So you might say, well, this
is clearly a bad deal.

361
00:17:55,650 --> 00:17:58,270
I'm spending $4,000, and
all I'm saving is $500.

362
00:17:58,270 --> 00:18:00,740
And that's in this future
where it's worth less.

363
00:18:00,740 --> 00:18:03,020
But then the question is, how
much does it raise the value

364
00:18:03,020 --> 00:18:04,410
of my house?

365
00:18:04,410 --> 00:18:09,230
In a perfect world, given that
my house will live on forever,

366
00:18:09,230 --> 00:18:14,330
it should raise the value
of my house by $10,000.

367
00:18:14,330 --> 00:18:17,460
Because what I've done is
I've saved $500 forever.

368
00:18:17,460 --> 00:18:21,810
So whoever buys it after me
should be willing to pay

369
00:18:21,810 --> 00:18:24,400
$10,000 more for it.

370
00:18:24,400 --> 00:18:26,820
But the question is that
information, will that

371
00:18:26,820 --> 00:18:27,860
percolate down?

372
00:18:27,860 --> 00:18:30,260
Will people actually include
that in the value?

373
00:18:30,260 --> 00:18:33,390
So in some sense, the decision I
had to make was, will I live

374
00:18:33,390 --> 00:18:36,670
there long enough that even if
the next people don't value

375
00:18:36,670 --> 00:18:37,890
it, I'll still end
up having the

376
00:18:37,890 --> 00:18:39,280
positive net present value.

377
00:18:39,280 --> 00:18:41,830
If I lived there for more than
about 10 or 12 years, that

378
00:18:41,830 --> 00:18:43,850
would be true.

379
00:18:43,850 --> 00:18:45,630
And the second thing is if I'm
going to live there less than

380
00:18:45,630 --> 00:18:49,610
that, will the price go up
enough that the net present

381
00:18:49,610 --> 00:18:51,250
value will be positive?

382
00:18:51,250 --> 00:18:51,970
I decided to do it.

383
00:18:51,970 --> 00:18:53,630
I've been there at least
10 years since.

384
00:18:53,630 --> 00:18:54,720
So it was a good decision.

385
00:18:54,720 --> 00:18:58,230
But this is exactly how
consumers face these kinds of

386
00:18:58,230 --> 00:18:59,350
decisions every day.

387
00:18:59,350 --> 00:19:03,620
Just as uncertainty affects
decision making of people

388
00:19:03,620 --> 00:19:06,690
every day, so does thinking
about streams of

389
00:19:06,690 --> 00:19:09,370
payments over time.

390
00:19:09,370 --> 00:19:10,690
Yeah.

391
00:19:10,690 --> 00:19:12,106
AUDIENCE: Did you leave
out the square on

392
00:19:12,106 --> 00:19:14,310
the $500 over 1+r?

393
00:19:14,310 --> 00:19:15,060
PROFESSOR: Yeah.

394
00:19:15,060 --> 00:19:16,016
You're right.

395
00:19:16,016 --> 00:19:18,890
Good point.

396
00:19:18,890 --> 00:19:19,650
OK.

397
00:19:19,650 --> 00:19:24,230
so now another very interesting
application of

398
00:19:24,230 --> 00:19:25,580
this that may be more
relevant to you.

399
00:19:25,580 --> 00:19:26,600
You guys aren't thinking
about insulating your

400
00:19:26,600 --> 00:19:28,210
houses right now.

401
00:19:28,210 --> 00:19:31,440
But your family has recently
thought about a

402
00:19:31,440 --> 00:19:32,830
very important decision.

403
00:19:32,830 --> 00:19:36,000
It's not about investing in
physical capital, like

404
00:19:36,000 --> 00:19:38,130
investing a machine,
but investing

405
00:19:38,130 --> 00:19:40,540
in your human capital.

406
00:19:40,540 --> 00:19:43,110
An important theory due to
Gary Becker, Nobel Prize

407
00:19:43,110 --> 00:19:46,850
winning economist at Chicago,
was that just as we can think

408
00:19:46,850 --> 00:19:50,940
of firms buying machines as
investing in physical capital,

409
00:19:50,940 --> 00:19:54,530
we think of people investing in
education as like building

410
00:19:54,530 --> 00:19:56,620
your human capital.

411
00:19:56,620 --> 00:19:59,260
You're spending money to
improve your long run

412
00:19:59,260 --> 00:20:01,696
productivity just like buying a
machine improves the firm's

413
00:20:01,696 --> 00:20:02,205
long run opportunity.

414
00:20:02,205 --> 00:20:04,210
So it's exactly the
same thing.

415
00:20:04,210 --> 00:20:06,280
It's just instead of investing
in a building or a machine, we

416
00:20:06,280 --> 00:20:07,730
invest in you.

417
00:20:07,730 --> 00:20:10,800
And, likewise, human capital
investment decisions are

418
00:20:10,800 --> 00:20:13,600
subject to the same net present
value considerations

419
00:20:13,600 --> 00:20:15,630
that physical capital production
decisions are

420
00:20:15,630 --> 00:20:18,040
subject to.

421
00:20:18,040 --> 00:20:21,210
Let's think about this with
an example from the book.

422
00:20:21,210 --> 00:20:26,790
So imagine that if you don't go
to college, you're going to

423
00:20:26,790 --> 00:20:28,980
work for age 18 to age 70.

424
00:20:28,980 --> 00:20:30,200
And if you do go to college,
you work from

425
00:20:30,200 --> 00:20:31,725
age 22 to age 70.

426
00:20:31,725 --> 00:20:33,985
You get the extra year dinking
around Europe or whatever.

427
00:20:33,985 --> 00:20:36,750
No, that's right, 18
to 22, four years.

428
00:20:36,750 --> 00:20:40,270
So you either work from 18 to 70
if you don't go to college

429
00:20:40,270 --> 00:20:44,090
or 22 to 70 if you
do go to college.

430
00:20:44,090 --> 00:20:47,330
Imagine, moreover, that college
costs $10,000 a year,

431
00:20:47,330 --> 00:20:49,590
obviously not MIT.

432
00:20:49,590 --> 00:20:53,410
Some state school, $10,000 a
year is what college is going

433
00:20:53,410 --> 00:21:02,460
to cost. And the cost of going
to college is twofold.

434
00:21:02,460 --> 00:21:05,080
One is you pay the
$10,000 a year.

435
00:21:05,080 --> 00:21:09,620
Second, you forgo earning
while you're in college.

436
00:21:09,620 --> 00:21:11,500
The benefit of going to college
is you learn a lot

437
00:21:11,500 --> 00:21:13,540
more once you graduate.

438
00:21:13,540 --> 00:21:19,700
On average, at age 22, the
typical college educated

439
00:21:19,700 --> 00:21:21,510
person-- once again, not MIT--
but the typical college

440
00:21:21,510 --> 00:21:25,750
educated person earned about
$30,000 while someone with a

441
00:21:25,750 --> 00:21:28,690
high school diploma only
earned about $20,000.

442
00:21:28,690 --> 00:21:32,540
So you earn a lot
more thereafter.

443
00:21:32,540 --> 00:21:37,210
So, basically, the trade-off is
you pay tuition up front,

444
00:21:37,210 --> 00:21:40,220
and you lose earnings up front,
but you earn a lot more

445
00:21:40,220 --> 00:21:41,620
starting at age 22.

446
00:21:41,620 --> 00:21:43,240
Well, how do we think about
whether that's a good

447
00:21:43,240 --> 00:21:44,520
investment or not.

448
00:21:44,520 --> 00:21:47,590
Well, let's look at
Figure 22-1, the

449
00:21:47,590 --> 00:21:49,620
present value of education.

450
00:21:49,620 --> 00:21:53,640
What you see is a diagram
of the net present value

451
00:21:53,640 --> 00:21:54,210
calculation.

452
00:21:54,210 --> 00:22:00,860
So from age 18 to 22 there's
a huge cost, which is your

453
00:22:00,860 --> 00:22:03,360
forgone earnings plus
the amount that you

454
00:22:03,360 --> 00:22:05,950
had to pay to go.

455
00:22:05,950 --> 00:22:09,290
Then starting at age 22, there's
a net benefit, which

456
00:22:09,290 --> 00:22:10,950
is you earn more.

457
00:22:10,950 --> 00:22:13,040
Basically, whether the net
present value is positive

458
00:22:13,040 --> 00:22:18,160
depends on comparing the shape
of these and discounting the

459
00:22:18,160 --> 00:22:20,530
fact that the earnings you make
from going to college are

460
00:22:20,530 --> 00:22:22,110
worth a lot less.

461
00:22:22,110 --> 00:22:27,940
So what's striking here is that
basically if the discount

462
00:22:27,940 --> 00:22:32,720
rate is more than 5.1%, it turns
out not to make sense to

463
00:22:32,720 --> 00:22:33,910
go to college.

464
00:22:33,910 --> 00:22:36,040
It's pretty amazing, if
you think about it.

465
00:22:36,040 --> 00:22:40,110
You earn 50% more if you go
to college, 50% more.

466
00:22:40,110 --> 00:22:43,540
And yet if the discount rate is
more than 5.1%, which it's

467
00:22:43,540 --> 00:22:47,203
been, typically, in many years
in our society, it's going to

468
00:22:47,203 --> 00:22:50,870
end up not making sense
to go to college.

469
00:22:50,870 --> 00:22:51,570
Why?

470
00:22:51,570 --> 00:22:54,150
Because the upfront costs
are worth so much more.

471
00:22:54,150 --> 00:22:57,380
The upfront benefits of
excluding college are now.

472
00:22:57,380 --> 00:23:01,820
And the benefits of your
education are distant.

473
00:23:01,820 --> 00:23:03,310
So, as a result, because
of net present value

474
00:23:03,310 --> 00:23:07,680
considerations, unless the
discount rate is very low,

475
00:23:07,680 --> 00:23:10,230
it's not going to make sense
to go to college.

476
00:23:13,000 --> 00:23:19,410
It turns out now, of course, the
discount rate is very low.

477
00:23:19,410 --> 00:23:23,650
Now we ask ourselves, OK, what
is the discount rate your

478
00:23:23,650 --> 00:23:25,260
parents face when they
decide whether

479
00:23:25,260 --> 00:23:26,090
to send you to college?

480
00:23:26,090 --> 00:23:27,010
Or maybe you faced it?

481
00:23:27,010 --> 00:23:28,590
Maybe you're paying for
your own college.

482
00:23:28,590 --> 00:23:30,260
What's the discount
rate you face?

483
00:23:30,260 --> 00:23:34,500
Well, once again, it's the
opportunity cost of the money

484
00:23:34,500 --> 00:23:37,710
you use to go to college and the
opportunity cost of what

485
00:23:37,710 --> 00:23:39,410
you could have done with the
money you made if you were

486
00:23:39,410 --> 00:23:40,660
working now at gap.

487
00:23:43,390 --> 00:23:45,180
The opportunity cost of the
money you could have made, is

488
00:23:45,180 --> 00:23:49,040
you could have saved that
at some interest rate.

489
00:23:49,040 --> 00:23:50,760
But the truth is whatever you
could have saved it at,

490
00:23:50,760 --> 00:23:53,230
nothing is yielding much
more than 0 right now.

491
00:23:53,230 --> 00:23:55,170
There's no investment that
yields anything.

492
00:23:55,170 --> 00:23:58,650
So the interest rate is very
low on that savings.

493
00:23:58,650 --> 00:24:01,900
Moreover, you had to borrow
the $10,000 a year and, in

494
00:24:01,900 --> 00:24:05,040
your case, the $50,000 a year,
to come to college.

495
00:24:05,040 --> 00:24:11,710
And that's at the borrowing rate
which is still above 5%

496
00:24:11,710 --> 00:24:12,600
even in this economy.

497
00:24:12,600 --> 00:24:13,060
Yeah.

498
00:24:13,060 --> 00:24:16,860
AUDIENCE: Can you explain to me
what the discount rate is.

499
00:24:16,860 --> 00:24:20,143
PROFESSOR: Oh, the discount rate
is the interest rate in

500
00:24:20,143 --> 00:24:21,910
this net present value
calculation.

501
00:24:21,910 --> 00:24:24,450
So when you're considering
whether to go to college, it's

502
00:24:24,450 --> 00:24:27,750
the rate at which you discount
those future extra earnings

503
00:24:27,750 --> 00:24:28,970
that you're going to get.

504
00:24:28,970 --> 00:24:33,690
So the discount rate is your
version of the interest rate.

505
00:24:33,690 --> 00:24:36,805
It's the opportunity cost, the
opportunity cost to you of

506
00:24:36,805 --> 00:24:38,380
what you could have done
with that money.

507
00:24:38,380 --> 00:24:41,200
What you could have done with
the savings from working is

508
00:24:41,200 --> 00:24:41,980
basically nothing.

509
00:24:41,980 --> 00:24:43,840
It would have just sat
under your mattress.

510
00:24:43,840 --> 00:24:47,540
However, the money you had to
borrow to come to college,

511
00:24:47,540 --> 00:24:49,420
that you paid 7%, 8%.

512
00:24:52,200 --> 00:24:56,000
That's money that has a pretty
high discount rate.

513
00:24:56,000 --> 00:24:58,300
That's money that's worth a
lot less in the future.

514
00:24:58,300 --> 00:25:00,520
So at the end of the day, with
today's interest rates, it

515
00:25:00,520 --> 00:25:02,850
almost certainly makes sense
to go to college.

516
00:25:02,850 --> 00:25:05,420
However, when interest rates
are high, it might not.

517
00:25:05,420 --> 00:25:07,360
And that's an argument for why
the government may want to

518
00:25:07,360 --> 00:25:10,370
subsidize student loans.

519
00:25:10,370 --> 00:25:11,980
The government is in the
business of subsidizing

520
00:25:11,980 --> 00:25:13,150
student loans and making
student loans

521
00:25:13,150 --> 00:25:14,510
artificially cheap.

522
00:25:14,510 --> 00:25:16,290
That's a pretty big government
expenditure.

523
00:25:16,290 --> 00:25:19,860
It's on the order of
$30 billion a year.

524
00:25:19,860 --> 00:25:20,860
Why is the government
doing that?

525
00:25:20,860 --> 00:25:22,620
Well, this table
tells you why.

526
00:25:22,620 --> 00:25:24,650
If the government thinks that
there's social benefits for

527
00:25:24,650 --> 00:25:27,670
having a more highly educated
population, then, essentially,

528
00:25:27,670 --> 00:25:30,250
by intervening to lower the
discount rate through

529
00:25:30,250 --> 00:25:32,900
subsidizing college loans, the
government can encourage

530
00:25:32,900 --> 00:25:37,050
people to go to college.

531
00:25:37,050 --> 00:25:37,990
OK.

532
00:25:37,990 --> 00:25:39,240
Questions about that?

533
00:25:41,840 --> 00:25:45,180
So that's how we think about
net present value in

534
00:25:45,180 --> 00:25:47,800
investment decisions which is
basically to put everything in

535
00:25:47,800 --> 00:25:50,215
today's dollars and then,
on net, ask if

536
00:25:50,215 --> 00:25:52,740
it's positive or negative.

537
00:25:52,740 --> 00:25:55,130
Now, the other thing I want
to talk about, in terms of

538
00:25:55,130 --> 00:25:57,250
government policy, and in terms
of important issues in

539
00:25:57,250 --> 00:26:00,436
this area, is about increasing
savings.

540
00:26:00,436 --> 00:26:05,530
I want to talk about increasing
savings in the US.

541
00:26:05,530 --> 00:26:07,860
Why do we care about increasing
savings in the US?

542
00:26:07,860 --> 00:26:09,150
Why do we care about
that as a goal?

543
00:26:09,150 --> 00:26:11,330
After all, I said savings
is a bad.

544
00:26:11,330 --> 00:26:13,150
Consumption is the good.

545
00:26:13,150 --> 00:26:15,140
Why do we care about savings?

546
00:26:15,140 --> 00:26:17,750
Well, the fact is the
US government does.

547
00:26:17,750 --> 00:26:20,030
The US government spends
hundreds of billions of

548
00:26:20,030 --> 00:26:23,540
dollars a year encouraging
individuals to save in ways

549
00:26:23,540 --> 00:26:25,450
I'll describe in a moment.

550
00:26:25,450 --> 00:26:26,530
Why do they do that?

551
00:26:26,530 --> 00:26:32,200
Well, the reason they do that is
because savings becomes the

552
00:26:32,200 --> 00:26:34,620
engine for growth
in our economy.

553
00:26:34,620 --> 00:26:40,140
Basically, as savings goes up,
that increases the pool of

554
00:26:40,140 --> 00:26:42,960
capital available for
firms to draw from.

555
00:26:42,960 --> 00:26:48,960
In other words, that shifts
out the capital

556
00:26:48,960 --> 00:26:50,210
market supply curve.

557
00:26:54,520 --> 00:26:55,980
In terms of the diagram that
we made last time of the

558
00:26:55,980 --> 00:26:57,980
capital market, that shifts out
the capital market supply

559
00:26:57,980 --> 00:27:01,280
curve or increases that
pool of capital.

560
00:27:01,280 --> 00:27:04,270
As the capital market supply
curve shifts out, what happens

561
00:27:04,270 --> 00:27:05,780
to the interest rate?

562
00:27:05,780 --> 00:27:07,490
It falls.

563
00:27:07,490 --> 00:27:09,450
That leads the real interest
rate to fall.

564
00:27:09,450 --> 00:27:10,940
Because there's a bigger pool.

565
00:27:10,940 --> 00:27:12,530
It's cheaper to get from it.

566
00:27:12,530 --> 00:27:15,950
As a pool grows, it's cheaper
to draw from it.

567
00:27:15,950 --> 00:27:17,150
That lowers the interest rate.

568
00:27:17,150 --> 00:27:20,940
What does a lower interest
rate mean for any given

569
00:27:20,940 --> 00:27:23,060
investment to its net
present value?

570
00:27:23,060 --> 00:27:24,430
It means it's higher.

571
00:27:24,430 --> 00:27:28,080
In means that any given
investment has a higher net

572
00:27:28,080 --> 00:27:30,240
present value now.

573
00:27:30,240 --> 00:27:32,720
Because a lower interest rate
means you might as well invest

574
00:27:32,720 --> 00:27:35,420
instead of just putting the
money off to the future.

575
00:27:35,420 --> 00:27:38,490
And a higher net present value
means more investment.

576
00:27:43,330 --> 00:27:46,360
So more savings becomes
the engine of

577
00:27:46,360 --> 00:27:48,400
growth for our economy.

578
00:27:48,400 --> 00:27:50,860
Because savings promotes
investment.

579
00:27:50,860 --> 00:27:55,220
When people save, it lowers
the price of borrowing.

580
00:27:55,220 --> 00:27:58,870
Firms are more likely to borrow,
and they invest more.

581
00:27:58,870 --> 00:28:02,300
And so that's why savings
is so important.

582
00:28:02,300 --> 00:28:05,070
And this is basically a lot
of what Bob Solow won

583
00:28:05,070 --> 00:28:06,040
his Nobel Prize for.

584
00:28:06,040 --> 00:28:08,420
A famous professor from MIT
won his Nobel Prize for

585
00:28:08,420 --> 00:28:10,770
pointing out the critical
role in savings is

586
00:28:10,770 --> 00:28:13,690
an engine of growth.

587
00:28:13,690 --> 00:28:15,490
It's that basically savings
becomes the

588
00:28:15,490 --> 00:28:17,150
key engine to growth.

589
00:28:17,150 --> 00:28:21,020
And as a result, society should
care about how much

590
00:28:21,020 --> 00:28:24,210
individuals save, not just
how much they consume.

591
00:28:24,210 --> 00:28:26,470
And that's why savings
is so important.

592
00:28:26,470 --> 00:28:30,300
The problem is we don't save
a whole lot in the US.

593
00:28:30,300 --> 00:28:33,320
In China, for example, the
savings rate, depending on how

594
00:28:33,320 --> 00:28:37,110
it's measured, is on
the order of 30%.

595
00:28:37,110 --> 00:28:39,140
So for every dollar people
earn in China,

596
00:28:39,140 --> 00:28:41,540
they save about $0.30.

597
00:28:41,540 --> 00:28:45,360
In the US, it's about 3%.

598
00:28:45,360 --> 00:28:47,630
For every dollar we earn,
we save about $0.03.

599
00:28:47,630 --> 00:28:49,020
It was negative for a while.

600
00:28:49,020 --> 00:28:49,880
Yeah.

601
00:28:49,880 --> 00:28:53,302
AUDIENCE: Are those rates
including taxes and other

602
00:28:53,302 --> 00:28:54,718
things that people
have to pay.

603
00:28:54,718 --> 00:28:57,080
So is it like revenue?

604
00:28:57,080 --> 00:29:02,110
PROFESSOR: Its a share of your
disposable income you save.

605
00:29:02,110 --> 00:29:04,605
The check you take home, how
much of it do you save, and

606
00:29:04,605 --> 00:29:05,690
how much of it do you spend?

607
00:29:05,690 --> 00:29:09,380
US citizens spend about $0.97 on
every dollar we take home.

608
00:29:09,380 --> 00:29:11,270
Chinese citizens spend
about $0.70 on every

609
00:29:11,270 --> 00:29:13,010
dollar they take home.

610
00:29:13,010 --> 00:29:14,730
You might have noticed that
China's grown a hell of a lot

611
00:29:14,730 --> 00:29:17,700
faster than the US over
the last 30 years.

612
00:29:17,700 --> 00:29:19,360
It's no coincidence.

613
00:29:19,360 --> 00:29:22,640
They're basically building up
a stock of capital that's

614
00:29:22,640 --> 00:29:25,840
allowing their firms to draw
on it at a cheap rate and

615
00:29:25,840 --> 00:29:27,910
invest. And that's why something
like 20% of all the

616
00:29:27,910 --> 00:29:30,920
world's cranes are in
Shanghai right now.

617
00:29:30,920 --> 00:29:34,410
Because they have a huge pool
of capital they can drawn to

618
00:29:34,410 --> 00:29:38,020
build all of those new
buildings and invest.

619
00:29:38,020 --> 00:29:40,730
So this is a big problem
for our place

620
00:29:40,730 --> 00:29:42,120
in the world economy.

621
00:29:42,120 --> 00:29:44,020
The US is falling behind in
the world economy, because

622
00:29:44,020 --> 00:29:45,510
we're not saving enough.

623
00:29:45,510 --> 00:29:47,190
We're not building up
that pool of capital

624
00:29:47,190 --> 00:29:48,550
that our firms need.

625
00:29:48,550 --> 00:29:51,920
As a result, there's a huge
public policy effort to

626
00:29:51,920 --> 00:29:54,620
promote savings.

627
00:29:54,620 --> 00:29:58,180
And, in particular, there's an
enormous amount of emphasis on

628
00:29:58,180 --> 00:30:01,395
tax subsidies to retirement
savings.

629
00:30:12,000 --> 00:30:18,530
The basic idea here is that when
you put money in the bank

630
00:30:18,530 --> 00:30:21,510
to save for your retirement, the
interest you earn on that

631
00:30:21,510 --> 00:30:22,760
money is taxed.

632
00:30:24,830 --> 00:30:26,330
The interest you earn on
that money is taxed.

633
00:30:26,330 --> 00:30:30,030
That lowers the rate of
return to savings.

634
00:30:30,030 --> 00:30:33,870
And, assuming substitution
effects dominate, that means

635
00:30:33,870 --> 00:30:36,530
you save less.

636
00:30:36,530 --> 00:30:39,530
So in today's system, since we
tax the interest you earn in

637
00:30:39,530 --> 00:30:43,470
the bank, you save less
people think.

638
00:30:43,470 --> 00:30:45,700
We still don't have quite
convincing evidence on that.

639
00:30:45,700 --> 00:30:49,400
But people usually presume
substitution effects dominate.

640
00:30:49,400 --> 00:30:52,610
There's less savings partly
because we're taxing savings.

641
00:30:52,610 --> 00:30:54,370
And, as a result, there's
less investment.

642
00:30:54,370 --> 00:30:54,610
Yeah.

643
00:30:54,610 --> 00:30:56,710
AUDIENCE: When we're talking
about savings here, are we

644
00:30:56,710 --> 00:30:59,308
just talking about just
private savings?

645
00:30:59,308 --> 00:31:03,740
Or are we also concerned with
what the government is doing?

646
00:31:03,740 --> 00:31:06,900
PROFESSOR: Excellent question.

647
00:31:06,900 --> 00:31:08,420
Let me actually come
back to that.

648
00:31:08,420 --> 00:31:09,690
Let me answer that, but I want
to come back to that.

649
00:31:09,690 --> 00:31:10,570
That's important.

650
00:31:10,570 --> 00:31:15,740
What we care about,
of course, is the

651
00:31:15,740 --> 00:31:16,650
total net pool of savings.

652
00:31:16,650 --> 00:31:18,650
And if the government draws from
that, that's less money

653
00:31:18,650 --> 00:31:20,120
that firms can draw from.

654
00:31:20,120 --> 00:31:21,080
So you're absolutely right.

655
00:31:21,080 --> 00:31:23,560
We about the net level of social
savings which is people

656
00:31:23,560 --> 00:31:24,260
plus government.

657
00:31:24,260 --> 00:31:26,600
If people save a lot, but the
government has a huge deficit,

658
00:31:26,600 --> 00:31:27,870
that cancels out.

659
00:31:27,870 --> 00:31:28,880
And I want to come
back to that.

660
00:31:28,880 --> 00:31:30,130
It's very important.

661
00:31:33,880 --> 00:31:36,220
This is a good point
you raise.

662
00:31:36,220 --> 00:31:37,430
We take these taxes.

663
00:31:37,430 --> 00:31:40,080
We tax your interest. That
discourages savings, but at

664
00:31:40,080 --> 00:31:42,090
least it raises money
for the government.

665
00:31:42,090 --> 00:31:43,870
So on net, it's not clear if
it's a bad thing or a good

666
00:31:43,870 --> 00:31:45,100
thing for savings.

667
00:31:45,100 --> 00:31:47,510
On the one hand, at least we get
money for the government

668
00:31:47,510 --> 00:31:49,250
which can reduce the
government's deficit.

669
00:31:49,250 --> 00:31:51,290
On the other hand, we discourage
your savings which

670
00:31:51,290 --> 00:31:52,590
may reduce your savings.

671
00:31:52,590 --> 00:31:54,110
So on net, it's not clear.

672
00:31:54,110 --> 00:31:58,160
But, generally, the assumption
is that on net, total social

673
00:31:58,160 --> 00:32:01,080
savings falls.

674
00:32:01,080 --> 00:32:05,130
But as that question points out,
that assumption relies on

675
00:32:05,130 --> 00:32:05,600
two things.

676
00:32:05,600 --> 00:32:07,540
The first one relies on the
substitution effects

677
00:32:07,540 --> 00:32:08,820
dominating income effects.

678
00:32:08,820 --> 00:32:10,870
And it relies on the
substitution effects being so

679
00:32:10,870 --> 00:32:13,850
strong that the reduced savings
because we're taxing

680
00:32:13,850 --> 00:32:18,340
it exceeds the extra revenues
we get from taxing it.

681
00:32:18,340 --> 00:32:21,700
But under those two assumptions,
the government

682
00:32:21,700 --> 00:32:25,860
might want to offer some tax
subsidies or try to offset

683
00:32:25,860 --> 00:32:29,500
this taxation of capital
income by offering tax

684
00:32:29,500 --> 00:32:31,950
subsidies to individuals.

685
00:32:31,950 --> 00:32:35,240
And the way we do that is we say
that you can save for your

686
00:32:35,240 --> 00:32:36,490
retirement tax-free.

687
00:32:39,160 --> 00:32:39,820
Actually, it's not tax-free.

688
00:32:39,820 --> 00:32:40,360
Let me say it again.

689
00:32:40,360 --> 00:32:41,420
We allow you to save for
your retirement on a

690
00:32:41,420 --> 00:32:42,670
tax-deferred basis.

691
00:32:49,340 --> 00:32:52,655
So, for example, we have
employer-provided pensions.

692
00:32:55,330 --> 00:32:57,260
Pensions are plans that
your employer sets up.

693
00:33:00,680 --> 00:33:08,350
where you take part of your
salary, and that is not taxed.

694
00:33:08,350 --> 00:33:09,830
Instead it's saved.

695
00:33:09,830 --> 00:33:12,210
And when you retire, you
get that savings,

696
00:33:12,210 --> 00:33:14,980
and then it's taxed.

697
00:33:14,980 --> 00:33:18,690
So, in other words, right now
MIT takes $2,000 from my

698
00:33:18,690 --> 00:33:21,700
salary every year and
puts it aside.

699
00:33:21,700 --> 00:33:24,600
When I report my income to the
IRS, it's $2,000 lower.

700
00:33:24,600 --> 00:33:27,450
So I'm not paying taxes on that
even though I earned it.

701
00:33:27,450 --> 00:33:29,930
That money is in an MIT
pension account that's

702
00:33:29,930 --> 00:33:30,790
building up.

703
00:33:30,790 --> 00:33:32,620
MIT has invested, and
it's building up.

704
00:33:32,620 --> 00:33:36,520
And when I retire, I'm going to
get that money and then pay

705
00:33:36,520 --> 00:33:39,270
taxes on it.

706
00:33:39,270 --> 00:33:42,960
Now, you might ask yourself,
so what?

707
00:33:42,960 --> 00:33:44,510
What the hell is the
advantage of that?

708
00:33:44,510 --> 00:33:45,970
You pay taxes now or you
pay taxes later.

709
00:33:45,970 --> 00:33:47,070
Who cares?

710
00:33:47,070 --> 00:33:51,097
Why is that a benefit to me?

711
00:33:51,097 --> 00:33:53,259
AUDIENCE: Because the present
value of the money in the

712
00:33:53,259 --> 00:33:54,590
future is less.

713
00:33:54,590 --> 00:33:58,582
The after tax amount is going to
be less assuming that taxes

714
00:33:58,582 --> 00:34:01,780
don't rise by a substantial
amount in the future.

715
00:34:01,780 --> 00:34:03,000
PROFESSOR: Exactly.

716
00:34:03,000 --> 00:34:04,740
Assuming tax rates
stay the same.

717
00:34:04,740 --> 00:34:04,860
Let's leave that.

718
00:34:04,860 --> 00:34:07,780
The point is just as money in
the future is worth less than

719
00:34:07,780 --> 00:34:11,270
money today, paying taxes in
the future is better than

720
00:34:11,270 --> 00:34:13,300
paying taxes today.

721
00:34:13,300 --> 00:34:16,340
So if MIT take the $2,000 aside
for me and saves it, and

722
00:34:16,340 --> 00:34:21,630
I pay taxes on it in 25 years
when I retire, that's 25 years

723
00:34:21,630 --> 00:34:22,710
with a 5% discount rate.

724
00:34:22,710 --> 00:34:24,719
That's nothing.

725
00:34:24,719 --> 00:34:28,580
25 years at a 5% discount rate,
those taxes are worth

726
00:34:28,580 --> 00:34:31,380
like 1/3 of what they are
if I pay them today.

727
00:34:31,380 --> 00:34:34,360
So basically by deferring
taxes, we are wealthier.

728
00:34:34,360 --> 00:34:36,090
Just like by deferring payments,
we're poorer.

729
00:34:44,230 --> 00:34:46,560
We don't have the table here.

730
00:34:46,560 --> 00:34:48,480
AUDIENCE: [INAUDIBLE PHRASE].

731
00:34:48,480 --> 00:34:49,040
PROFESSOR: What?

732
00:34:49,040 --> 00:34:50,290
No.

733
00:34:52,340 --> 00:34:54,040
That's OK.

734
00:34:54,040 --> 00:34:57,260
Let me just sort of explain
an example.

735
00:34:57,260 --> 00:34:59,980
Let me just do an example
here and explain that.

736
00:34:59,980 --> 00:35:06,100
So imagine you've got an
individual who's a

737
00:35:06,100 --> 00:35:09,500
70-year-old, so someone
about to retire.

738
00:35:09,500 --> 00:35:15,940
They are a 70-year-old, and
he earns $100 on his job.

739
00:35:15,940 --> 00:35:18,280
And he wants to save it for
1 year and then spend it.

740
00:35:22,970 --> 00:35:25,550
And he has two choices.

741
00:35:25,550 --> 00:35:29,615
He can put it in the bank or he
can have his employer hold

742
00:35:29,615 --> 00:35:33,670
it aside as a pension payment,
and he can get it next year.

743
00:35:33,670 --> 00:35:38,020
And let's say the interest
rate is 10%.

744
00:35:38,020 --> 00:35:52,930
And let's say his
tax rate is 25%.

745
00:35:52,930 --> 00:35:54,870
So the bank route,
what happens?

746
00:35:54,870 --> 00:35:58,220
First of all, $100 he gets
is going to get taxed.

747
00:35:58,220 --> 00:36:02,050
So he's going to have $75
to put in the bank.

748
00:36:02,050 --> 00:36:03,240
He's going to put that
in the bank.

749
00:36:03,240 --> 00:36:04,660
And that's going to
yield $7.50 in

750
00:36:04,660 --> 00:36:07,000
interest after one year.

751
00:36:07,000 --> 00:36:09,530
But that will also be taxed.

752
00:36:09,530 --> 00:36:11,175
That $7.50 of interest
will also be taxed.

753
00:36:14,810 --> 00:36:22,170
He has to pay $1.88 in taxes
on that $7.50 of interest.

754
00:36:22,170 --> 00:36:32,490
So on net, he's going
to end up with $75,

755
00:36:32,490 --> 00:36:35,280
$82.50 minus $1.88.

756
00:36:35,280 --> 00:36:41,765
So he's going to end
up with $80.32.

757
00:36:41,765 --> 00:36:43,180
Is that right?

758
00:36:43,180 --> 00:36:46,660
$80.22.

759
00:36:46,660 --> 00:36:51,040
So he's going to end
up with $80.22.

760
00:36:51,040 --> 00:36:53,490
Now, if instead he asks his
employer to hold it aside as a

761
00:36:53,490 --> 00:37:00,160
pension, then he gets the whole
$100, and that gets

762
00:37:00,160 --> 00:37:01,660
saved at 10%.

763
00:37:01,660 --> 00:37:06,720
So he earns $10 of interest. So
at the end of the year when

764
00:37:06,720 --> 00:37:08,090
he gets the pension
payment from the

765
00:37:08,090 --> 00:37:11,900
employer, he gets $110.

766
00:37:11,900 --> 00:37:21,490
That is then taxed at 25%, and
he ends up with $82.50.

767
00:37:21,490 --> 00:37:23,580
He ends up with more money.

768
00:37:23,580 --> 00:37:26,215
Even though it's just paying
taxes one year later, he ends

769
00:37:26,215 --> 00:37:27,230
up with more money.

770
00:37:27,230 --> 00:37:30,310
And the reason is because he
got to earn the interest on

771
00:37:30,310 --> 00:37:31,570
the taxes instead of the
government earning the

772
00:37:31,570 --> 00:37:32,860
interest on the taxes.

773
00:37:32,860 --> 00:37:34,660
Here, he pays taxes up front.

774
00:37:34,660 --> 00:37:37,990
So he has less to save. So
he ends up with less.

775
00:37:37,990 --> 00:37:40,650
Here, by paying taxes later, he
gets to earn the interest

776
00:37:40,650 --> 00:37:41,620
on that extra money.

777
00:37:41,620 --> 00:37:43,780
And he ends up with more.

778
00:37:43,780 --> 00:37:47,620
So by deferring taxes, he's
effectively richer.

779
00:37:47,620 --> 00:37:50,850
And this is a very
simple example.

780
00:37:50,850 --> 00:37:53,620
If you did the same example,
and instead of making it 1

781
00:37:53,620 --> 00:37:59,925
year, you made it 30 years, then
you'd end up with twice

782
00:37:59,925 --> 00:38:01,970
as much money if you go the
pension then if you go the

783
00:38:01,970 --> 00:38:05,730
regular savings route, twice
as much money just from

784
00:38:05,730 --> 00:38:09,985
deferring taxation
for 30 years.

785
00:38:09,985 --> 00:38:11,800
You get taxed either way.

786
00:38:11,800 --> 00:38:13,570
It's just that you get to earn
the interest instead of the

787
00:38:13,570 --> 00:38:17,155
government earning the
interest. Yeah.

788
00:38:17,155 --> 00:38:20,440
AUDIENCE: Can you earn interest
on a pension?

789
00:38:20,440 --> 00:38:20,720
PROFESSOR: OK.

790
00:38:20,720 --> 00:38:23,410
So let's come to that.

791
00:38:23,410 --> 00:38:24,995
Let me make sure people
understand the math here and

792
00:38:24,995 --> 00:38:26,890
why it's a better deal.

793
00:38:26,890 --> 00:38:27,360
OK.

794
00:38:27,360 --> 00:38:28,440
Do you earn interest
on a pension.

795
00:38:28,440 --> 00:38:29,780
It's a good question.

796
00:38:29,780 --> 00:38:32,590
There is three ways that you
can have tax subsidized

797
00:38:32,590 --> 00:38:33,680
retirement savings.

798
00:38:33,680 --> 00:38:35,230
And let me go through
them clearly now.

799
00:38:35,230 --> 00:38:36,930
One route is the pension.

800
00:38:41,730 --> 00:38:45,360
Under a pension, your employer
takes money out of your

801
00:38:45,360 --> 00:38:48,670
salary, saves it in some account
with your name on it,

802
00:38:48,670 --> 00:38:51,420
but they invest it.

803
00:38:51,420 --> 00:38:53,520
And then you get the money
when you retire.

804
00:38:53,520 --> 00:38:56,390
An alternative, which firms
are slowly moving to, is

805
00:38:56,390 --> 00:39:00,550
401(k) accounts, which you've
all heard of by now.

806
00:39:00,550 --> 00:39:03,770
401(k) accounts are just like
pensions, except you control

807
00:39:03,770 --> 00:39:06,290
the investment of the
money, not the firm.

808
00:39:06,290 --> 00:39:08,570
So under a pension account, your
employer takes money out

809
00:39:08,570 --> 00:39:12,520
of your salary, puts it aside,
and invests it as he likes,

810
00:39:12,520 --> 00:39:14,270
and you get the return
when you retire.

811
00:39:14,270 --> 00:39:17,250
A 401(k) account is the same
thing except you decide how

812
00:39:17,250 --> 00:39:19,990
much to take or the employer
decide how much to take, and

813
00:39:19,990 --> 00:39:23,330
you decide how to invest it.

814
00:39:23,330 --> 00:39:24,998
And then you get the return
at the end of the day.

815
00:39:24,998 --> 00:39:26,280
But the tax treatment
is the same.

816
00:39:26,280 --> 00:39:27,002
Yeah.

817
00:39:27,002 --> 00:39:29,362
AUDIENCE: Isn't it also one's
defined benefits and one's

818
00:39:29,362 --> 00:39:30,130
defined contribution.

819
00:39:30,130 --> 00:39:33,010
PROFESSOR: Well, within this,
within pensions, there's two

820
00:39:33,010 --> 00:39:35,250
kinds of pensions.

821
00:39:35,250 --> 00:39:39,800
There's defined benefits and
defined contributions.

822
00:39:39,800 --> 00:39:41,780
We can think of this as old
style and new style.

823
00:39:41,780 --> 00:39:43,960
Defined benefits is what the
auto companies and the steel

824
00:39:43,960 --> 00:39:45,180
companies had.

825
00:39:45,180 --> 00:39:46,490
It's dying away.

826
00:39:46,490 --> 00:39:49,600
A defined benefit pension is one
where you don't actually

827
00:39:49,600 --> 00:39:51,540
get an account from
your employer.

828
00:39:51,540 --> 00:39:53,120
They just take money
out of your salary.

829
00:39:53,120 --> 00:39:55,200
And then when you retire, they
pay you some amount which is

830
00:39:55,200 --> 00:39:56,780
unrelated to what
you put away.

831
00:39:56,780 --> 00:39:58,410
It's related to something like
how long you worked at the

832
00:39:58,410 --> 00:40:00,320
company and what your
wages were.

833
00:40:00,320 --> 00:40:02,490
So defined benefit pension is
they literally define the

834
00:40:02,490 --> 00:40:05,510
pension benefit you get.

835
00:40:05,510 --> 00:40:07,600
And it's got no direct relation
to how much money

836
00:40:07,600 --> 00:40:09,190
they took away on your behalf.

837
00:40:09,190 --> 00:40:12,070
It's related, instead, to what
you earned and how long you

838
00:40:12,070 --> 00:40:13,070
worked there.

839
00:40:13,070 --> 00:40:15,480
A defined contribution pension
is what I described.

840
00:40:15,480 --> 00:40:17,310
It's literally an account
with your name on it.

841
00:40:17,310 --> 00:40:18,940
And that's what most
pensions are now.

842
00:40:18,940 --> 00:40:21,620
Almost any firm you guys will
work for will have a defined

843
00:40:21,620 --> 00:40:24,885
contribution pension, which is
one where there's literally an

844
00:40:24,885 --> 00:40:27,300
account with your name on it.

845
00:40:27,300 --> 00:40:29,650
And most of you will have
401(k)s where you actually

846
00:40:29,650 --> 00:40:32,700
control the investment.

847
00:40:32,700 --> 00:40:37,140
And then finally, the
last option is IRAs.

848
00:40:37,140 --> 00:40:39,420
That's not the Ireland
thing, but

849
00:40:39,420 --> 00:40:42,100
individual retirement accounts.

850
00:40:42,100 --> 00:40:44,640
These are accounts which
operate outside

851
00:40:44,640 --> 00:40:46,360
the employment setting.

852
00:40:46,360 --> 00:40:50,490
You can literally set up your
own pension, effectively, by

853
00:40:50,490 --> 00:40:52,590
taking money, putting
it in the bank, and

854
00:40:52,590 --> 00:40:53,850
calling it an IRA.

855
00:40:53,850 --> 00:40:55,140
The thing about IRAs
is IRAs are not

856
00:40:55,140 --> 00:40:56,220
special investment vehicles.

857
00:40:56,220 --> 00:40:58,280
They're just a label for
savings that you do.

858
00:40:58,280 --> 00:41:00,000
Any kind of savings
can be an IRA.

859
00:41:00,000 --> 00:41:01,260
You can have gold in your IRA.

860
00:41:01,260 --> 00:41:03,090
You can have cash in your IRA.

861
00:41:03,090 --> 00:41:04,770
You can have whatever you
want in your IRA.

862
00:41:04,770 --> 00:41:06,420
Any kind of investment
is an IRA.

863
00:41:06,420 --> 00:41:10,370
What an IRA means is you say to
the government, this money,

864
00:41:10,370 --> 00:41:15,280
up to $5,000 a year, don't
tax me on now.

865
00:41:15,280 --> 00:41:16,720
I'm going to put it in a
specially labelled bank

866
00:41:16,720 --> 00:41:20,370
account, and you'll tax me
on it when I retire.

867
00:41:20,370 --> 00:41:22,570
So it's just like a pension, but
you set it up on your own.

868
00:41:22,570 --> 00:41:23,820
And the firm is not involved.

869
00:41:32,210 --> 00:41:34,340
Let me just say something
on the IRA.

870
00:41:34,340 --> 00:41:38,100
If you're not wealthy, if your
income is below about $75,000

871
00:41:38,100 --> 00:41:40,470
a year, it operates just
like I described.

872
00:41:40,470 --> 00:41:42,990
If you are wealthy, if your
income is above about $75,000

873
00:41:42,990 --> 00:41:46,230
a year, then you can't get
the tax break on the IRA.

874
00:41:46,230 --> 00:41:48,410
So the IRAs are really more
focused towards lower income

875
00:41:48,410 --> 00:41:50,490
populations.

876
00:41:50,490 --> 00:41:54,540
Now, here's an interesting
question that you all face.

877
00:41:54,540 --> 00:41:57,550
You're going to get jobs
in a couple of years.

878
00:41:57,550 --> 00:42:00,100
And your employers are going
to offer you pensions, or a

879
00:42:00,100 --> 00:42:02,020
401(k), and you can
set up an IRA.

880
00:42:02,020 --> 00:42:03,450
And you're going to have
to decide, do I want

881
00:42:03,450 --> 00:42:05,740
to do that or not?

882
00:42:05,740 --> 00:42:07,380
Now, what are the
considerations?

883
00:42:07,380 --> 00:42:09,450
Well one consideration is what
I mentioned last time, which

884
00:42:09,450 --> 00:42:11,860
is that savings earlier in
your career is a lot more

885
00:42:11,860 --> 00:42:14,550
beneficial than savings
later in your career.

886
00:42:14,550 --> 00:42:17,060
The second advantage, of course,
is that there's the

887
00:42:17,060 --> 00:42:19,770
tax break which, of course,
the earlier you do it, the

888
00:42:19,770 --> 00:42:21,060
more valuable it is than
the later you do

889
00:42:21,060 --> 00:42:23,100
it by the same logic.

890
00:42:23,100 --> 00:42:25,380
On the other hand, there's a
huge disadvantage to these

891
00:42:25,380 --> 00:42:26,970
forms of savings.

892
00:42:26,970 --> 00:42:30,400
You can't get them
until you retire.

893
00:42:30,400 --> 00:42:32,170
If you take them out before
you retire, you pay a tax

894
00:42:32,170 --> 00:42:34,710
penalty on them.

895
00:42:34,710 --> 00:42:37,120
So this trade-off when you think
about setting these up

896
00:42:37,120 --> 00:42:40,380
is you only want to put in money
you're sure you're not

897
00:42:40,380 --> 00:42:42,930
going to need until
you retire.

898
00:42:42,930 --> 00:42:44,300
So it's a good idea
to set these up.

899
00:42:44,300 --> 00:42:47,270
It's a good idea to take
advantage of this tax breaks.

900
00:42:47,270 --> 00:42:50,810
But, in doing so, you have
to remember that there's

901
00:42:50,810 --> 00:42:52,460
different kinds of savings, and
there's different needs

902
00:42:52,460 --> 00:42:53,760
for savings.

903
00:42:53,760 --> 00:42:55,995
You can't put savings for
a house in these.

904
00:42:55,995 --> 00:42:58,750
You don't put savings in case
you lose your job in these.

905
00:42:58,750 --> 00:43:00,980
These are for savings which you
can honestly say I won't

906
00:43:00,980 --> 00:43:02,350
need for 30 years.

907
00:43:02,350 --> 00:43:04,160
And that's the trade-off.

908
00:43:04,160 --> 00:43:06,420
You should do it early and
as much as you can.

909
00:43:06,420 --> 00:43:07,990
But you should also recognize
that you don't want to leave

910
00:43:07,990 --> 00:43:10,050
yourself with no money in
the bank to do this.

911
00:43:10,050 --> 00:43:11,890
Because then, if you lose
your job, there's

912
00:43:11,890 --> 00:43:14,500
nothing to draw on.

913
00:43:14,500 --> 00:43:19,130
And that's how one sort of
thinks about these things.

914
00:43:19,130 --> 00:43:19,410
Yeah.

915
00:43:19,410 --> 00:43:23,370
AUDIENCE: So you said there
was a tax penalty if you

916
00:43:23,370 --> 00:43:24,360
[INTERPOSING VOICES] early.

917
00:43:24,360 --> 00:43:26,835
Is that greater than the tax
rate that you would normally

918
00:43:26,835 --> 00:43:27,330
pay on them?

919
00:43:27,330 --> 00:43:29,820
Because then, even with
that penalty--

920
00:43:29,820 --> 00:43:31,440
PROFESSOR: It depends on how
long you have the money in.

921
00:43:31,440 --> 00:43:33,660
If you have it in for 20 plus
years, even with the tax

922
00:43:33,660 --> 00:43:34,960
penalty, it's a good
idea to do it.

923
00:43:34,960 --> 00:43:35,790
But if you're going to have
it for five years,

924
00:43:35,790 --> 00:43:36,828
it's not worth it.

925
00:43:36,828 --> 00:43:38,920
AUDIENCE: So it's bigger than
a tax [INAUDIBLE PHRASE].

926
00:43:38,920 --> 00:43:39,850
PROFESSOR: Yes.

927
00:43:39,850 --> 00:43:42,190
It's 10% of the balance.

928
00:43:42,190 --> 00:43:44,430
You pay 10% of the balance
for the tax.

929
00:43:44,430 --> 00:43:47,220
So, basically, whether that's a
good thing or not depends on

930
00:43:47,220 --> 00:43:48,970
how long the money's been in
there and what the forgone

931
00:43:48,970 --> 00:43:49,520
interest rate is.

932
00:43:49,520 --> 00:43:51,630
But for a short investment, it's
going to be a bad idea.

933
00:43:51,630 --> 00:43:53,375
If you have an IRA for 20 years
and then have to take it

934
00:43:53,375 --> 00:43:54,350
out, it's still a better
deal then having

935
00:43:54,350 --> 00:43:55,600
not put it in there.

936
00:43:57,990 --> 00:44:01,620
One last point about a 401(k)
that's very interesting.

937
00:44:01,620 --> 00:44:04,750
Basically, in the theory I've
taught you in the last two

938
00:44:04,750 --> 00:44:09,245
lectures, what determines your
savings is the interest rate.

939
00:44:09,245 --> 00:44:11,470
If the interest goes up and
substitution effects dominate,

940
00:44:11,470 --> 00:44:12,570
you save more.

941
00:44:12,570 --> 00:44:14,280
If it goes down,
you save less.

942
00:44:14,280 --> 00:44:16,880
But, in fact, in the real world,
savings is determined

943
00:44:16,880 --> 00:44:19,620
by lots of other factors that
economists are just starting

944
00:44:19,620 --> 00:44:21,040
to think about and model.

945
00:44:21,040 --> 00:44:22,650
One which you've know for a
long time, of course, is

946
00:44:22,650 --> 00:44:23,860
precaution.

947
00:44:23,860 --> 00:44:26,250
The bigger risk you face in
your life, the more you'll

948
00:44:26,250 --> 00:44:29,100
want to save. So, for a given
interest rate, we've found

949
00:44:29,100 --> 00:44:31,080
that individuals who face
greater risk in

950
00:44:31,080 --> 00:44:33,670
their lives save more.

951
00:44:33,670 --> 00:44:36,960
Likewise, we found that
government programs which

952
00:44:36,960 --> 00:44:40,190
protect you from risk cause
you to save less.

953
00:44:40,190 --> 00:44:41,720
So this is another tricky
thing with government

954
00:44:41,720 --> 00:44:44,060
programs. On the one hand, we
like government programs like

955
00:44:44,060 --> 00:44:47,870
unemployment insurance or social
health insurance that

956
00:44:47,870 --> 00:44:50,330
protect us in case we lose
our job or get sick.

957
00:44:50,330 --> 00:44:52,490
We have to recognize the social
costs of those programs

958
00:44:52,490 --> 00:44:54,000
is people save less.

959
00:44:54,000 --> 00:44:56,930
And that's less savings equals
less investment.

960
00:44:56,930 --> 00:44:59,290
So precaution is one reason
why people save.

961
00:44:59,290 --> 00:45:01,410
But there's other factors which
fall in the realm of

962
00:45:01,410 --> 00:45:03,500
behavioral economics, which I've
mentioned earlier in this

963
00:45:03,500 --> 00:45:06,010
course, which drive why people
save. And this is one of the

964
00:45:06,010 --> 00:45:07,320
most important economic
findings in the

965
00:45:07,320 --> 00:45:09,280
last couple of decades.

966
00:45:09,280 --> 00:45:13,250
Studies of firms that change the
structure of their 401(k)s

967
00:45:13,250 --> 00:45:15,040
in a particular way
that shouldn't

968
00:45:15,040 --> 00:45:17,370
matter but does a lot.

969
00:45:17,370 --> 00:45:20,900
So for most firms, when you go
decide to join the firm,

970
00:45:20,900 --> 00:45:22,220
they'll say, here's a
benefits package.

971
00:45:22,220 --> 00:45:22,840
You can sign up.

972
00:45:22,840 --> 00:45:23,880
You can sign up for
health insurance.

973
00:45:23,880 --> 00:45:26,870
You can sign up for
life insurance.

974
00:45:26,870 --> 00:45:29,780
You can sign up for a 401(k).

975
00:45:29,780 --> 00:45:30,940
And that's the way
it usually goes.

976
00:45:30,940 --> 00:45:34,245
And we typically see, as a
typical large firm, is with

977
00:45:34,245 --> 00:45:38,350
new employees there's about a
25% sign-up rate for 401(k)s.

978
00:45:38,350 --> 00:45:42,380
And over the next 10 years,
that grows to about 70%.

979
00:45:42,380 --> 00:45:43,350
So people don't join
right away.

980
00:45:43,350 --> 00:45:46,200
They join slowly.

981
00:45:46,200 --> 00:45:48,850
Some firms experimented with
changing the contract in a

982
00:45:48,850 --> 00:45:52,500
very small way that should not
matter in this course.

983
00:45:52,500 --> 00:45:54,720
They've instead said,
welcome to our firm.

984
00:45:54,720 --> 00:45:57,690
You are now signed up for the
401k unless you tell us you

985
00:45:57,690 --> 00:45:59,440
don't want that.

986
00:45:59,440 --> 00:46:01,050
Now, that's the same thing.

987
00:46:01,050 --> 00:46:04,510
I can sign up or I can tell them
I don't want to be in.

988
00:46:04,510 --> 00:46:06,300
Those are identical things.

989
00:46:06,300 --> 00:46:07,660
It's just a question
of the default.

990
00:46:07,660 --> 00:46:09,210
It's just a question of the
default that I have to say

991
00:46:09,210 --> 00:46:12,680
affirmatively yes or I have
to say affirmatively no.

992
00:46:12,680 --> 00:46:15,250
What they found when they
switched, is the initial

993
00:46:15,250 --> 00:46:21,890
sign-up rate from 401(k)s went
from 25% to 75% simply by this

994
00:46:21,890 --> 00:46:22,890
relabeling.

995
00:46:22,890 --> 00:46:25,060
Simply by shifting the default,
you've got an

996
00:46:25,060 --> 00:46:27,800
incredible change in
people's behavior.

997
00:46:27,800 --> 00:46:30,440
And what this says is that
economics is about more than

998
00:46:30,440 --> 00:46:31,340
things like interest rates.

999
00:46:31,340 --> 00:46:33,520
It's about more than prices.

1000
00:46:33,520 --> 00:46:35,240
In this course, economics
is all about prices.

1001
00:46:35,240 --> 00:46:37,350
I talked about it in
the first lecture.

1002
00:46:37,350 --> 00:46:40,360
But in the real world, we bring
psychology into it.

1003
00:46:40,360 --> 00:46:41,980
Economics is about more
than just price.

1004
00:46:41,980 --> 00:46:44,140
It's about important
behavioral factors.

1005
00:46:44,140 --> 00:46:46,880
And this says that important
policies that there may be a

1006
00:46:46,880 --> 00:46:49,120
much more significant policy
than spending all this money

1007
00:46:49,120 --> 00:46:52,330
on tax subsidies and raising
the government deficit.

1008
00:46:52,330 --> 00:46:55,070
These tax subsidies, by the way,
add up to on the order of

1009
00:46:55,070 --> 00:46:57,940
$200 billion a year that
we spend on these.

1010
00:46:57,940 --> 00:47:00,040
So that's $200 billiion a year
that we're increasing the

1011
00:47:00,040 --> 00:47:03,100
deficit by to have these
tax subsidies.

1012
00:47:03,100 --> 00:47:04,680
What if, instead, we got rid of
them all and just defaulted

1013
00:47:04,680 --> 00:47:06,330
everyone to 401(k)s.

1014
00:47:06,330 --> 00:47:11,660
We'd probably raise savings more
and potentially save the

1015
00:47:11,660 --> 00:47:13,000
government a lot of money.

1016
00:47:13,000 --> 00:47:16,780
So, basically, the point is that
we have a lot of tools at

1017
00:47:16,780 --> 00:47:18,370
our disposal besides prices.

1018
00:47:18,370 --> 00:47:20,160
And our government policy makers
have to be thinking

1019
00:47:20,160 --> 00:47:21,250
about those.

1020
00:47:21,250 --> 00:47:23,480
OK so let me stop there.

1021
00:47:23,480 --> 00:47:24,270
Thank you all for coming.

1022
00:47:24,270 --> 00:47:25,640
Have a great Thanksgiving.

1023
00:47:25,640 --> 00:47:28,820
And we'll come back after
Thanksgiving and talk about

1024
00:47:28,820 --> 00:47:30,070
equity and efficiency.