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Children’s monthly allowances

The idea of providing allowances for reading expenses to young students is an old one. Many children receive from their parents a monthly allowance on the condition that they spend it only on reading (i.e, buying books). It helps young people to manage a given amount of cash on their own.

Let us consider a consumer, Tobin, who receives this allowance. It is a welcome gift for him, however could it be more welcome if it was an unrestricted allowance? The answer to this question is obviously yes, however, it is worth illustrating the situation with a simple microeconomics analysis. To do so, one can consider a graph in which in the vertical axis it is plotted the value of other consumption of goods (in dollars) and in the horizontal axis the reading expenses (in dollars). The graph is depicted as follows:

Image

Before being awarded with the allowance, Tobin faces the budget constraint ST. With the introduction of this benefit, there is an outward expansion of the opportunity set, shown by the amount SB, as long as the full amount of the allowance is spent on reading. The initial consumption point lies on the indifference curve which allows him to reach the utility level (satisfaction level) U1 and is tangent to the budget line (point A).

For purposes of analysis it is assumed that preferences are convex. When given the monthly allowance, which must be spent on reading, Tobin moves from A to B, a corner solution, reaching the utility level U2. On the other hand, if the allowance could be spent on other consumption, Tobin’s choice would lie at point C, making him better-off, i.e. a reallocation of income in which more is spent on other consumption and less on reading can increase the consumer’s satisfaction.

In detail, B represents a corner solution because Tobin’s marginal rate of substitution of reading for other consumption is lower than the relative price of other consumption. Tobin would prefer to spend a fraction of the allowance on other goods, in addition to reading, and this scenario would not harm his long-run best interests (I will address this issue below).

If he faced no restrictions in the allocation of his monthly allowance, he would move to C, enjoying the highest level of satisfaction possible, U3, decreasing his reading expenses, but increasing her consumption of goods (e.g. tickets to cinema) that he enjoys more than reading. Unrestricted allowances, meaning that the allocation of income can be made across the two goods, enlarge the opportunity set for Tobin, which allows him to have a higher utility from consumption. Particularly, in the case of unrestricted allowances, the extra opportunity set would be given by the triangle below the blue dashed line.

Thus, recipients usually prefer unrestricted to restricted allowances. In fact, restricted allowances are popular, however, because they allow parents to control children’s expenditures in ways that they believe are in the children’s long-run best interests. One might ask: why kids tend to recognize their own long-run best interests? A possible answer to this question is that nowadays, due to the global financial and economic crisis, students see education as an asset, where differentiation is key word to achieve success in the labor market. Thus, they try to benefit as much as possible from education, where reading is a key-skill. However, they can decrease a bit reading expenses and enjoy the consumption of other goods, without harming their best-interests and they are made better-off.

This example clearly illustrates a case where there is a misalignment of incentives between parents and children. How can be designed an enforceable mechanism that aligns the incentives?

One can think in a weekly monitoring of the children’s expenditures, in which parents and students dialogue. They may end up taking measures regarding future provision of allowances: in case the children do not allocate the money only to reading expenses, parents might decide a cut off in the subsequent monthly allowance.

Nuno Lourenço #85

Source: Pindyck & Rubinfeld – Microeconomics, adapted example

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Author: studentnovasbe

Master student in Nova Sbe

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