Opportunity Costs Ch. 12

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Opportunity Costs Ch. 12

• Claudia Garcia-Szekely

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The most powerful force in the universe is
compound interest

• Albert Einstein

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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!
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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
35 years
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What is the cost of that car?
The price of the car 30,000?
Brent could have earned interest on the 30,000
if he had not used the money for the car FORGONE
interest is also part of the cost of the carso
the cost of the car to Brent is 30,000
interest lost
At age 65, Nicole has 1,700,000 Brent has
829,000 a difference of 880,000!
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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 880,000
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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
• Get return on your money
• Use the money to open your business

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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.

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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.

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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.

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Costs

• Explicit costs are easy to see because a
  payment is made.
• Rent
• Interest on loan
• Wages
• Implicit costs are "hidden, they represent a
  cost even though no actual payment is made. They
  represent what you are NOT earning in
• Rent for your building
• Interest on your money
• Salary you are not earning

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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.
• To calculate costs, you must include this
  explicit expense as part of your cost.
• The use of this money cost you 1,000 0.05 50.
  Should you ALSO include the 1,000 you paid for
  the hot dog stand?

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Accountants only track Explicit Costs

• An Accountants job is to follow the money.
• Accounting costs include only explicit costs
  (out-of-pocket expenses)

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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 (implicit and explicit) must be taken into
  consideration to determine profits.

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Are you really making money?

• Profits Total Revenues Total Costs.
• Accounting Profit Total Revenues Explicit
  Costs
• Economic Profits Total Revenues Explicit
  Costs Implicit Costs

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Your Resources
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ResourcesWorking Separately
60,000 7,000 40,000 107,000
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Tying your resources in a business only makes
sense
If your business produce MORE than you get with
your resources working separately
gt 107,000
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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
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Abnormal Profit
You earn Above Normal Profit when you take
home the MORE than what you get with your
resources working separately
You earn a abnormal Profit when you take home
more than what is needed to cover Implicit Costs
Take home 167,000
Accounting Profit 167,000
Economic Profit 60,000
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Example 1

• A farmer gives piano lessons for 50 an hour. One
  day she spends 10 hours planting 100 worth of
  seeds on her farm. The seeds yield 200 worth of
  crops
• What are her explicit costs? ______________
• What are her implicit costs? ______________
• According to her accountant is she making a
  profit? How much profit? ___________
• If you include also the hidden costsis she
  making a profit?
• How much? ____________

100
500
Yes 200 100 100
200 100 - 500 -400
She should go back to teaching piano
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• 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.
• Toms explicit costs are
• ________________________
• Toms implicit costs are
• _________________________

25,000 10,000 2,000 37,000
25,000
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• Toms explicit costs are
• ________________________
• Toms implicit costs are
• _________________________
• Tom sold 80,000 donuts during the year at a price
  of 50 cents per donut.
• Toms total revenues are____________
• Toms profit according to his accountant was
• Toms economic profit was

25,000 10,000 2,000 37,000
25,000
80,000 x 0,5 40,000
40,000 37,000 3,000
40,000 37,000 -25,000 -22,000
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• 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

• Tom 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 25,000 EP
-22,000
Explicit Cost is now implicit
EP 40,000 25,000 10,000 2,000 25,000 EP
-22,000
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Jack wont paint houses for long

• 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 4,000 he had in
  a savings account earning 1 to purchase the
  necessary equipment.

• 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.

Profitable for Mark but not for Jack
Accounting Profit
Accounting Profit
Accounting Profit 7,000-2,5004,500
Economic Profit 7,000-2,500 -1,240 3,260
Economic Profit 7,000-2,500 -7,040 -2,540
Economic Profit
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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
Accounting Profit 70,0000-15,000-30,000 7,000
Economic Profit 70,0000-15,000-30,000 7,000
-25,000
Economic Profit 70,0000-15,000-30,000 7,000
-25,000
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• 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?

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• Joe runs a small boat factory. He can make ten
  boats per year and sell them for 25,000 each.
• Total Revenue 25,00010250,000
• 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 400,0000.140,000 70,000
  110,000
• Accounting Profit250,000 160,000
• 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

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• 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?

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• 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 100,0000.08 8,00030,000
• 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 20,00035,000
• Revenue from sales is 70,000 per year.
• Accounting Profit70,000-38,000
• Economic Profit70,000-38,000-55,000
• Is it a good economic decision to continue
  farming? No. He incurs a loss