How cost of living varies by where you live (Ch 2)

We talked of how $ does not buy the same amount today as it did in the past. So we learnt how to adjust for this when comparing prices, income across time.

Does a $ buy the same here as it does, say in Mississippi? How about New York City? LA?

Obviously not. Why not? Cost of living varies across states, even across cities within a state.

Where you live matters

It is nice to live in California: the weather, the people etc.

But, there is a price to be paid for living here, higher cost of living (average compared to other states)

Let’s assume you make $30 000 now.You are offered a job in Arizona for $27 000.

If you are indifferent between living in CA and AZ, do you take the job?

Where you live…

Depends on what $27 000 will buy in AZ.The purchasing power also varies across

states different cost of livingGenerally speaking, cost of living (COL)

is higher in more densely populated areas compared to rural areas; higher in areas with faster growth vs. those with slower growth or no growth at all.

Cost of living indices, 2003State Index State Index

Arizona 93.80 Nevada 98.60

Alaska 107.60 New York 126.6

California 125.10 Pennsylvania 100.7

Connecticut 102.90 Arkansas 89.20

Georgia 91.30 Utah 96.6

Illinois 96.50 Vermont 111.7

Mass. 100.1 Washington 102.2

US Average = 100

Calculating COL

Index value of 107.6 indicates that the cost of living in Alaska is 7.6% higher than the national average.

Index value of 89.2 indicates that cost of living in Arkansas is 10.8% less than the national average.

Calculating Cost of Living:1. AZ index was 93.80, CA was 125.1.2. Find the ratio (where you live on bottom):

89.20/125.1 = 0.7498 so what costs $1 in CA costs $0.75 in AZ.

Calculating COL

3. So if you are making $30 000 in CA, it’s the same as making:

$30 000 x 0.75 = $22 500 in AZ

4. If you are offered $27 000 in AZ, would you take it?

Another example: What about the reverse? Say you were in AZ making $30 000 and were offered $40 000 in CA, would you take it?

Another example

Living in AZ, going to CA: Ratio = 125.1/ 89.2 = 1.402

$30 000 x 1.402 = $42 060Would you take it?Think of these as “CA dollars” and “AZ

dollars”. Each buys different amounts. Although the currency is the same and $1 in CA is also equal to $1 in AZ, but buys different amounts.

Now You try it!

I am offered a job in Pennsylvania making $50 000. I currently live in Illinois and make $50 000. If I don’t particularly care where I live and am only concerned about $$$, should I take the job?

About Cost of living

Cost of living varies across states, but also within each state.

COL different here in Bakersfield (lower) compared to LA (higher).

So when moving, need to consider the COL between cities rather than between states.

Salary Calculator

Time value of money (Ch 3)

Cost of living rises over time: $ in earlier years have greater purchasing power than $ today

What about future dollars? Same true: $ today worth more than $ in future

Why?1. Rising cost-of-living2. Can invest $ today and have more in future

Comparing $ now and then (Ch 3)

So how do you account for this?Based on interest rate that could have been

earned by investing (opportunity cost of $)Should at least cover the expected ↑ in COL

Table 3: Present value converters (PVC) for future years and different interest rates ($ future worth less than $ today, so values <1)

Future value x PVC = Present Value (in today’s $)

Example

Lucky Von’s aunt passed away leaving him $100,000 (FV). But he can’t get it until he is 30. He is currently 20. Getting that lump sum in ten years is the same as getting how much today? (Assume interest rate (r) =5%)

PVC 10 yrs = 0.614 Present Value (PV) = PVC x FV PV = 0.614 x 100 000 = $ 61 400 Lucky is indifferent b/w receiving $100,000 in 10

years or $61,400 today.

Another example

Miss Moneypenny just won $10 million. But the prize will be paid over 20 years, $500,000 per year.

Even though $500,000 x 20 = $10 M, not the same as having $10 M today.

How much is it really worth in today’s $?Let’s assume r = 7%. PVC20 = 0.258, PVC19 = 0.277 …PVC1 =0..935

Another example cont…

Year 20 PV = 500,000 x 0.258 = $ 129,000 Year 19 PV = 500,000 x 0.277 =$ 138,500

׃ Year 1 PV = 500,000 x 0.935 = $ 467,500

$ 5,297,007

Now you try it!

You have a choice b/w receiving $10,000 in 4 years or $20,000 in 8 years. Which would you choose if r = 3%?

PVC8 = 0.789; PVC4 = 0.888

Is a second job worthwhile? (Ch 4)

Often when the standard of living is lower, people want/ need to take a second job.

Is it always beneficial?Depends, on what needs to be given up

(opportunity cost).Often 2 incomes in a household needed!Question: Should the second adult in a

household take a job?

Second job? (Ch 4)

Taking into account taxes and other related expenses, is the second job really worthwhile?

Points to consider:1. Taxes: SS (7.65%)

- Fed income tax additional salary taxed at higher rate - State income tax same second job: taxes can take 22% - 50% of pay

Second job?

2. Other expenses (measurable) Clothes Commute second car? Child care?

3. Other costs (not measurable) Less time for:

Housework cleaning, cooking maid? Family time

Second job?

Benefits:1. Extra income (after all expenses)2. Away from household3. Psychological advantage4. Future benefits: SS, retirement5. Present benefits: Healthcare?

Need to consider both benefits and costs marginal analysis

Second job?Marginal Analysis: Compare the cost and the

benefits of an action. Choose action if benefits > costs.

Jack and Jill are married and live with their 3 year old Amy. Jack earns $40,000. Jill is a stay at home mom. Through a friend, she is offered a job at CSUB which would pay $30,000 plus benefits. When she adds up the value of the benefits, they come out to about $6,000 a year. But, if she accepts she will have to place Amy in a daycare which costs $3,500 per year. Taking into account all extra costs, she wonders if the job is really worth it?

Jill’s Dilemma Benefits;

Salary $30 000 Fringe benefits $ 6 000 Total $36 000

Costs: SS Tax: 0.0765 x 30000 = $2 295 Fed income tax:(Need to calculate the difference between taxes when Jill

works and when she does not work.)

Federal Taxes: Jill works

1. Family income = $40 000+30 000 = $70 000

2. Standard deduction (family) = $ 9 700

3. Exemptions (3 x 3100) = $ 9 300

4. Taxable Income (1-2-3) = $ 51 000

5. Calculate tax: $14,300 10% = $ 1 430

($51,000 - 14,300 =) $36,700 15%= $ 5 505 Federal Taxes = $ 6 935

Federal taxes: Jill does not work

1. Family income = $40 0002. Standard deduction (family) = $ 9 7003. Exemptions (3 x 3100) = $ 9 3004. Taxable Income (1-2-3) = $21 0005. Calculate tax: $14 300 10% = $ 1 430 ($21,000 – 14,300=) $6700 15% = $ 1 005 Federal Taxes = $ 2 435

Federal Taxes: the difference $4500

If Jill Works: $ 6 935If Jill does not work: $ 2 435

Difference $ 4 500

State Taxes $ 1,500

These vary across states.To make things easier, we assume

the difference is simply the tax on the extra income.

Assume average rate of 5%, so extra tax:$30 000 x .05 = $1500

Child care $ 3,500

Need to spend extra on child care $3500

Commute $ 1,500

Actual costs vary depending on how Jill would get to work.

She could share a ride with her friend, or Jack could give her a ride.

She may have to purchase a new car or take the bus

We estimate that this will cost her an extra $1500 per year

Clothing and food $ 1,000

Again we will need to estimate this part as well. She may not have to purchase any new

clothes, or she may have to purchase a whole new wardrobe.

She may take lunch from home, or she may eat at the university cafeteria

We estimate these costs to be $1 000 per year

Total Extra Costs

SS $2 295 Federal tax $4 500 State tax $1 500 Child care $3 500 Commute $1 500 Clothes/ food$1 000

$14 295Net Benefits ($30 000 – 14 295) = $15 705Approximately: $7.85/hr

Is it worth it?

Essentially the net gain to them financially is roughly half of Jill’s pay.

Question: Is it worth it? Depends.What does it depend on?

Non measurable costs: family time, child in day care, housework

Non measurable benefits: feeling of contribution, time away from home

What did we learn?

Part of second job pay taxed at higher rate (27% vs 15%).

Higher the salary of second job, higher will be net benefits. Why?Many of the costs are fixed, regardless of the

salary: child care, commute, food, clothingSome depend on salary: income tax, ss tax

Generally speaking maybe better off?

TANSTAFL (Ch 5)

There Ain’t No Such Thing As a Free Lunch Scenario: Have $7 000 in the bank. See a car for $7 000.

How many would use the savings to buy the car? How many would borrow money (and pay interest) to buy the car?

Depends on OC. Opportunity cost of savings: interest it could have earned. Win free tickets to a concert in a radio contest. Are the tickets really free? No. Their value to you is the opportunity you give up instead. You

give up the time that could have been spent on studying, gardening etc.

TANSTAFL

This is true since time and money, similar to other resources, are limited.

Given limited resources, choices must be made. If use the resource in one way, then need to give up the use in another way.

Eg. If spend 3 hrs watching TV, and need to get some work done, perhaps need to sacrifice some sleep time. So cost of watching TV is ‘what else’ you could have done with the time the opportunity cost (value of the next best alternative).

How much do kids cost? (Ch 6)

In the past, we have looked at family composition. Many reasons for the make up of the average family,

mostly to do with choice. Why do some choose to have large families while others

choose smaller? One reason (measurable): cost After surveying the population, average costs of raising

kids were calculated. Not a measure of what parents ‘should’ spend (normative),

but rather what they actually do spend on average, given different income levels (positive).

Estimated cost of raising a child born in 2003 (3.1% inflation)

Child’s Age

Family Income

Low($) Middle ($) High ($)

0 - 2 21000 29420 43750

3 – 5 23640 33160 49070

6 – 8 26170 36160 52910

9 –11 28470 39100 57170

12 – 14 34990 46190 66270

15 – 17 38000 51640 75080

Total 172270 235670 344250pg 32

My kid and my money go to…

What is included? Housing, food, clothing, health care, child care and education.

Major categories: Housing (33%), food (19%), transportation (17%)

Why do the expenses rise over time? Inflation (partially) Spend more on older kids: entertainment, education,

clothes, toys etc. Not much difference between single-parent or two-parent

households. Both types of families of similar income spend approximately

the same per child.

Kid Cost

Child costs are per child, based on two-children household.

Families with more children: 3rd child – 15% less than 1st child; 4th child – 21% less; 5th child – 24% less.

Why? Economies of scale: as produce more, average cost falls. As applied here, more kids, more sharing (hand me downs, toys), lower average cost (buy in bulk)

What’s not included in the previous table? Time spent with children.

Estimates indicate 18 000 hrs for 2 kids up to 18 yrs – some kind of child care or attention

Kids Cost and Benefits

Marginal Analysis People deciding whether or not to have kids… What to consider?

Costs (both measurable and not measurable)Benefits (measurable?)

What are benefits of having kids? Why do people have them? When is the decision made?

Kid Care

Important if considering a second job Also important for low-wage earners. Typically work irregular hours or at night, hard to

find day care Rebates for child-care costs (middle class

families) does not benefit low-income families since they generally owe little or no tax

Poor families with preschoolers spend 18% of income on childcare, while those above poverty line spent 7% of their income (1993)

How much is an education worth? (Ch 7)

Continuing with OC…Going to school vs. working

Also how much schooling?How to decide?Again, turn to marginal analysis cost/

benefitA correlation between people’s

education and their wage rates

Education Pays

We don’t need no education…?

Why the difference in wages?

Often, education is a signal to the employer that one can learn and be taught.

Also, education gives one tools/ skills. Generally, without education can only work low-

skill jobs which do not pay much. Over the years many manufacturing jobs (low

skills) moved overseas, where abundant low-skilled labor can pay lower wages.

High tech, high skill jobs stay back need education

Obvious question…

So why does not everyone just get higher education?

While benefits are clear, we also need to consider the costs (both measurable and unmeasurable)

Measurable cost: Tuition, textbooks, materials Cost has been rising, both at private and public

universities, although faster at private Public universities instead increase class size,

reduce full-time faculty, especially with state budget cuts

Average price of attendance, public and private universities, selected years

0

5000

10000

15000

20000

25000

1987 1991 1997 1998 1999 2000 2001

PublicPrivate

 *Middle states are defined as NY, NJ, PA, DE, MD

 Source: The College Board

PUBLIC COLLEGES & UNIVERSITIES:

Region 

Avg tuition/fees '04-05 

New England  $6,839 

Middle states  $6,300 

Midwest  $6,085 

Southwest  $4,569 

South  $4,143 

West  $4,130 

The Price of College

Price paid by students = entire cost? No, since education, both private and public is

subsidized average of $8 200 per student What are other costs?

Just paying tuition does not guarantee an education Need to exert effort Could instead be working (opportunity cost)

Compare the benefits (higher pay, satisfaction from obtaining college degree) to costs (tuition and other OC)

What’s your time worth? (Ch 8)

Continuing along with theme of OC… Time is limited, so it is valuable. Every moment can be used in a

productive way, whatever that may be. How do you value your time? Depends on what activity you could

have been doing instead.

Time is money…

If instead of being in class for the two hours, if you could have been working then the cost of these two hours is the wage sacrificed.

If you could instead be watching “Jerry Springer”, then the cost of being in class is the benefit you would have received from watching the show.

Value of time varies across people and across activities.

I'm so late! I'm so very, very late!

To ease calculation, we value time as a fraction of the person’s wage.

Since we have to choose, having a value assigned to time will make the choice a little easier.

Generally, people value their ‘free’ time (not working) between 20 and 70% of their wage.

Those who do not have a paying wage (homemakers) estimated $10 /hr

So many choices, so little time…

So when choosing between ‘free’ activities, choose one which costs the least.

Eg. W. Rabbit does not have too much free time, so he values his free time at 50% of his wage. It costs him $20/ week to get to work. C. Catt and W. Knight propose they carpool, to save money and to help out their wonderful land. They calculate it will cost $8/ week for each to commute. W. Rabbit’s commute time will increase from 5 hrs a week to 7 hrs. If W. Rabbit makes $14/ hr, should he carpool?

Example cont…

W. Rabbit’s free time = 0.5 x 14 = $7 When commuting alone:

Gas and other expenses $20 Time costs: $7 x 5 $35

Total $55

Carpooling: Gas and other expenses $ 8 Time costs: $7 x 7 $49

Total $ 57

Another example Somebody says “better to shop at Von’s,

Albertson’s and Trader Joe’s rather than just one, so can take discounts offered everywhere”. You spend $50/ week at Trader Joe’s and it takes you an hour to shop. If your job pays you $20/ hr (you value your time at 50%) should you follow this advice if you can save 25%/ week, but it takes you an hour and a half more/ week?

Another example cont…

Shopping only at TJ’s:Grocery costs $50Time costs: ($20x0.5x1) $10

Total $60

Shopping all over:Grocery costs: ($50 – 0.25x50) $37.5Time costs: ($10 x 2.5) $25.5

Total costs: $63

Now you try it!

Let’s assume you make $10 an hour. What percentage of that do you value your free time?

Now, evaluate the costs and benefits of taking the bus instead of driving to school. Assume a bus pass costs $25 per month.

Markets…

In economics, we tie the measure of our free time to the market.

Market determines our wage. How?Supply and demand.What is supply?What is demand?

Markets cont…

Why do professional athletes make so much more than the rest of us?

Value of contributionLet’s consider more closely supply

and demand…

Supply and demandP

Q

S

D

P*

Q*

EQUILIBRIUM

Forever equilibrium?

Are prices always in equilibrium? Not necessarily. Sometimes, events occur in the market such that

prices are not at equilibrium. Could be for some reason, the price is higher than

equilibrium, then people are willing to sell more (compared to equilibrium) and people are willing to buy less (compared to equilibrium) surplus.

Forever Equilibrium?

If price is below equilibrium, then people are willing to sell less (compared to equilibrium) but people are willing to buy more (compared to equilibrium) shortage.

Graphing supply and demand: In class activity

Price Q demanded Q supplied

$ 0 19 0

0.50 16 0

1.00 13 1

1.50 10 4

2.00 7 7

2.50 4 10

3.00 1 13

Graph the table and find the equilibrium price and quantity.

Supply and Demand Together

Price Quantity$0.00 00.50 01.00 11.50 42.00 72.50 103.00 13

Price Quantity$0.00 190.50 161.00 131.50 102.00 72.50 43.00 1

Demand Schedule Supply Schedule

At $2.00, the quantity demanded is equal to the quantity supplied!

Supply

Demand

Price

Quantity

Equilibrium of Supply and Demand

21 3 4 5 6 7 8 9 10 12110

$3.00

2.50

2.00

1.50

1.00

0.50

Equilibrium

Supply and demand

Not always in equilibrium. Can either have shortage or surplus. Shortage Q supplied < Q demanded,

because price is too low. How is it fixed? Price has to rise.

Surplus Q supplied > Q demanded, because price is too high. How is it fixed? Price has to fall.

Price

Quantity 21 3 4 5 6 7 8 9 10 12110

$3.00

2.50

2.00

1.50

1.00

0.50

Supply

Demand

Surplus

Excess Supply

Price

Quantity 21 3 4 5 6 7 8 9 10 12110

$3.00

2.50

2.00

1.50

1.00

0.50

Supply

Demand

Excess Demand

Shortage