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Opportunity Costs Ch. 12

Opportunity Costs Ch. 12. Claudia Garcia-Szekely. “ The most powerful force in the universe is compound interest ”. Albert Einstein. The Power of Compound Interest. A Native American tribe accepted goods worth 60 guilders for the sale of Manhattan in 1626.

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Opportunity Costs Ch. 12

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  1. Opportunity Costs Ch. 12 Claudia Garcia-Szekely

  2. “The most powerful force in the universe is compound interest” Albert Einstein

  3. The Power of Compound Interest A Native American tribe accepted goods worth 60 guilders for the sale of Manhattan in 1626. If they had invested the money at 6.5% interest, compounded annually, in 2005 their investment would be worth around $1,000 billion dollars!. More than value of the real estate in all five boroughs of New York City. With a 6.0% interest however, the value of their investment today would have been 7 times less!

  4. The Power of Compound Interest Nicole and Brent can save $6,000 a year. Nicole puts her $6000 to earn 7% right away and continues to save $6,000 a year until she retires 45 years later. Brent, decides instead to use his $6,000/ year for car payments the first 5 years and then saves $6,000/year earning 7% for 40 years

  5. What is the cost of that car? $30,000 The price of the car? Brent could have earned 7% interest on the $30,000 if he had not used the money to buy the car… is the cost of the car is $30,000 + interest lost? At age 65, Nicole has $1,778,831.91 Brent has $ 1,242,758.23: Brent gave up $536,073 to get the car…

  6. Costs Explicit Implicit The money you did not earn Out of pocket expense The Cost of a Missed Opportunity The Opportunity Cost The money paid for the car: $30,000 The money you did not earn: $500,000

  7. Your Resources • Your time: • Run your own business • Work for a salary • Your building: • Use your building for your business • Rent your building • Your savings • Use the money to open your business • Earn a return on your money

  8. Labor • Hired workers represent an explicit cost: • The wage you pay. • The time you spend running your business represents an implicit cost: • The best salary you give up.

  9. Opportunity cost of Land • If you pay rent for the building you use for your business, you incur an explicit cost: • The Rent you pay. • If you own the building, you incur an implicit cost: • The Rent you are NOT earning because you have the building tied up in your business.

  10. Capital (Money) • If you borrow money and pay interest on it you incur an explicit cost: • The interest you pay the bank on that loan. • If you use your own money, you incur an implicit cost: • The interest you ARE NOT earning on that money.

  11. Costs • Explicit costs are “easy to see” because a payment is made. • Rent • Interest on loan • Wages • Implicit costs are "hidden”, they represent a missed opportunity to make money: • Rent for your building • Interest on your money • Salary you are not earning

  12. Capital (Money) NO! you still have the $1,000 not in money but in equipment: the hot dog stand is yours. You borrow $1,000 to buy equipment (a hot dog stand). The interest on the loan is 5%. You must include this explicit expense as part of your cost:1,000 * 0.05 = 50. Should you ALSO include the $1,000 you paid for the hot dog stand?

  13. Accountants only track Explicit Costs… • An Accountant’s job is to “follow the money”. • Accounting costs include only explicit costs (out-of-pocket expenses)

  14. Economists track both Implicit and Explicit Costs • Economists explain “economic decisions.” • Economic decisions are explained by profits. • Profits are explained by Costs and revenues • Costs (implicitand explicit) must be taken into consideration to determine profits.

  15. When are you really making money? Profits = Total Revenues – Total Costs. Accounting Profit = Total Revenues – Explicit Costs Economic Profits = Total Revenues – Explicit Costs – Implicit Costs

  16. Your Resources

  17. ResourcesWorking Separately 60,000 + 7,000 + 40,000 = $107,000

  18. Tying your resources in a business only makes sense > $107,000 If your business produce MORE than you get with your resources working separately

  19. Normal Profit Normal Profit = Zero Economic Profit You earn a “Normal Profit” when you take home the same amount of money you get with your resources working separately You earn a “Normal Profit” when you take home only as much as would cover Implicit Costs Take home= $107,000 Accounting Profit= $107,000 Economic Profit= $0 Implicit costs= $107,000

  20. Abnormal Profit Above Normal Profit Take home the MOREthan what you get with your resources working separately Take home more than what is needed to cover Implicit Costs Take home= $167,000 Accounting Profit= $167,000 Economic Profit= $60,000

  21. Tom borrows $40,000 from a bank to buy the equipment necessary to open a doughnut shop. The interest on this loan is 5% a year. He spends $25,000 on supplies (year) and pays $10,000 /year in rent. He quits his $25,000/ year job to work in his shop. Total Revenue = 40,000 Charles uses $40,000 from his savings to buy the equipment necessary to open a doughnut shop. The interest on his savings was 5% a year. He spends $25,000 on supplies (year) and pays $10,000 /year in rent. He quits his $25,000/ year job to work in his shop. Total Revenue = 40,000 AP = 40,000 – 25,000 – 10,000 – 2,000 = 3,000 AP = 40,000 – 25,000 – 10,000 = 5,000 EP = 40,000– 25,000 – 10,000 – 2,000 –25,000EP= -22,000 Explicit Cost is now implicit EP = 40,000– 25,000 – 10,000 – 2,000 –25,000EP= -22,000

  22. Jack won’t paint houses for long Profitable for Mark but not for Jack Jack quits his job as a computer programmer earning$7,000/month. He paints two homes/month and charges $3,500/house. Supplies come to $2,400 and he pays $100 for storage. He used 4,000 he had in a savings account earning 1% to purchase the necessary equipment. Mark a high school drop out paints houses for a living. His only other employment opportunity is to work at a fast food restaurant for $1,200/month. He paints two homes/month and charges $3,500/house. Supplies come to $2,400 and he pays $100 for storage. He used 4,000he had in a savings account earning 1% to purchase the necessary equipment. Accounting Profit = Accounting Profit = 7,000-2,500=4,500 Accounting Profit = Accounting Profit = 7,000-2,500=4,500 Economic Profit Economic Profit = 7,000-2,500 -1,240 =3,260 Economic Profit = 7,000-2,500 -7,040 =-2,540

  23. Consider the following costs for a farmer: He used $100,000 he had in a savings account earning 7% interest per year to purchase equipment. He pays $15,000 per year for rent for the land he uses. His only other employment opportunity is managing a retail store at a salary of $25,000 per year. Payments for supplies come to $30,000 per year. Revenue from sales is $70,000 per year. He borrowed $100,000 at 7% interest per year to purchase equipment. He inherited the land for which he was paying $15,000 per year for rent. His only other employment opportunity is managing a retail store at a salary of $25,000 per year. Payments for supplies come to $30,000 per year. Revenue from sales is $70,000 per year. Accounting Profit =70,0000 - 15,000 - 30,000 = 25,000 Accounting Profit =70,0000 - 30,000 – 7,000 = 33,000 Economic Profit =70,0000-15,000-30,000 –7,000 -25,000 = -7,000 Economic Profit =70,0000-15,000-30,000 –7,000 -25,000 = - 7,000

  24. You are thinking about opening a fast-food vending business at a nearby resort during your summer break. This will entail serving pizzas out of a vendor’s truck. This is an alternative to working a factory job where you can earn $7,000 over the summer break. A fully equipped truck could be leased for $9,000. Insurance and other operating expenses total $1,000. You anticipate your costs for materials to total $8,000. If you use the money you have saved to open your business, you will forego $1,500 in interest income. You expect sales revenues to be $35,000. • Calculate: • Accounting Profit: ______________ • Economic Profit: _______________ • Is it a good economic decision to run the business? _______ • Why? ___________

  25. You are thinking about opening a fast-food vending business at a nearby resort during your summer break. This will entail serving pizzas out of a vendor’s truck. This is an alternative to working a factory job where you can earn $7,000 over the summer break. A fully equipped truck could be leased for $9,000. Insurance and other operating expenses total $1,000. You anticipate your costs for materials to total $8,000. If you borrow $30,000 to open your business, the bank will charge 5% interest. You expect sales revenues to be $35,000. • Calculate: • Accounting Profit: ______________ • Economic Profit: _______________ • Is it a good economic decision to run the business? _______ • Why? ___________

  26. Joe runs a small boat factory. He can make ten boats per year and sell them for $25,000 each. The cost of materials (fiberglass, wood, paint) is $150,000. He pays $10,000 in rent. Joe has invested $400,000 from his own savings in the factory and equipment needed to produce the boats (assume that Joe could have loaned his money out at 10%). Joe can work at a competing boat factory for $70,000 per year. • Calculate: • Accounting Profit • Economic Profit. Is it a good economic decision to continue in this business?

  27. Joe runs a small boat factory. He can make ten boats per year and sell them for $25,000 each. • Total Revenue = 25,000*10=250,000 • The cost of materials (fiberglass, wood, paint) is $150,000. He pays $10,000 in rent. • Explicit Costs = 150,000+ 10,000 = 160,000 • Joe has invested $400,000 from his own savings in the factory and equipment needed to produce the boats (assume that Joe could have loaned his money out at 10%). Joe can work at a competing boat factory for $70,000 per year. • Implicit costs = 400,000*0.1=40,000 + 70,000 =110,000 • Accounting Profit=250,000 – 160,000 • Economic Profit= 250,000 – 160,000-110,000 • Is it a good economic decision to continue in this business? No. Because he incurs a loss

  28. Consider the following costs for a farmer: • He borrowed from a bank $100,000 at 8% interest per year to purchase equipment. • He owns the land he uses and he could rent it for $20,000 per year if he did not use it for farming. • He supplies his own labor and he considers farming as attractive as his only other employment opportunity, managing a retail store at a salary of $35,000 per year. • Payments for supplies come to $30,000 per year. • Revenue from sales is $70,000 per year. • Calculate: • Accounting Profit • Economic Profit. Is it a good economic decision to continue farming?

  29. Consider the following costs for a farmer: • He borrowed from a bank $100,000 at 8% interest per year to purchase equipment. • Payments for supplies come to $30,000 per year. • Explicit Costs = 100,000*0.08 =8,000+30,000 • He owns the land he uses and he could rent it for $20,000 per year if he did not use it for farming. • He supplies his own labor and he considers farming as attractive as his only other employment opportunity, managing a retail store at a salary of $35,000 per year. • Implicit Costs = 20,000+35,000 • Revenue from sales is $70,000 per year. • Accounting Profit=70,000-38,000 • Economic Profit=70,000-38,000-55,000 • Is it a good economic decision to continue farming? No. He incurs a loss

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