2 Opportunity Costs “Outsourcing” Scene Econ 5313 Costs are associated with decisions
3 Econ 5313Foreign CurrencyYou've completed your vacation in a foreign country. At the airport, you discover you have the equivalent of $20 local currency left over. The exchange control officer tells you that you can't convert the local money back to dollars. Nor can you take it out of the country. Because the gift shop was closed, you decided to spend the remaining money on refreshments—for complete strangers!What is the cost of you providing the refreshments?The cost of the refreshments is zero. The money can not be converted to another currency neither taken out of the country; therefore the opportunity cost of spending this money on refreshments is zero.
4 Accounting vs. Economic Costs A construction manager earning $70,000 per year working for a regional home builder opened his own company. He took $100,000 out of one of his investment accounts that had been earning around 6% a year to use as start up money for the business. He worked hard the first year, hiring just one employee with total compensation costs of $40,000. Total material and subcontracted labor costs for the year were $900,000. He generated total sales of $1,000,000.What are his accounting profits?$1,000,000-$900,000-$40,000 = $60,000What are the opportunity costs for the manager of being in this business relative to returning to his old job?$70,000 + $100,000×6% = $76,000What is the economic profit of the business?$60,000-$76,000 = -$16,000Revenue of $1 million less costs of $940,000 indicates an accounting profit of $60,000.Had the construction manager stayed at this job, he would have earned $70,000 along with the $6,000 his $100,000 would have earned had he left it in his investment account. Opportunity costs are $76,000.Economic profit is thus -$16,000.
5 Econ 5313Own vs. RentYou currently pay $10,000 per year in rent for a $100,000 house, which you are considering purchasing. You can qualify for a loan of $80,000 at 9% if you put $20,000 down on the house. To raise money for the down payment, you would have to liquidate stock earning a 15% return. Neglect other concerns, like closing costs, capital gains, and taxes.Is it better to rent or own?80,000×9%+20,000×15% = $10,200 > $10,000Suppose that you can deduct mortgage interest from federal taxes and you are in the 25% tax bracket. Is it better to rent or own?80,000×9%×75%+20,000×15% = $8,400 < $10,000This is an example of the hidden-cost fallacy. The interest payments on the loan are $7,200 per year, so owning may appear to be a good deal, but you must also compute the opportunity cost of the down payment. You forego $3,000 in expected return each year if you sell the stock. So the cost of owning is $10,200 per year. Rent instead.
6 Econ 5313Input SupplyYour firm usually uses 200 to 300 tons of steel per year. Last year, you purchased 100 tons more steel than needed at a price of $200 per ton. Since then, the price of steel jumped and stabilized at $250 per ton delivered (i.e. the selling firm selling must pay any shipping costs). The cost of shipping steel to the nearest buyer would be $20 per ton. In the meantime, a business next door just went bankrupt, and the bank is offering a special deal where you can buy another 100 tons of steel for $180 per ton. Assume that the interest rate is 0%.What are your possible choices?What are the costs of these choices?You will need at least 200 tons next year which will cost $250/ton. You lose when you sell at $200 + $20 to buy back later at $250. You gain by buying at $180 and holding.
7 Econ 5313Can Divisions IA can manufacturing company produces and sells three different types of cans: Versions X, Y, and Z. Corporate overhead (rent, general and administrative expense, etc.) is allocated equally among the three product versions. A high-level, simplified profit/loss statement for the company is provided. After reviewing the statement, company managers are concerned about the loss on Version Z and are considering ceasing production of that version.
8 Can Divisions II Should they discontinue Version Z? Econ 5313Can Divisions IIVersion XVersion YVersion ZTotalNet Can Sales$180,000$240,000$105,000$525,000Variable Costs$135,000$82,500$322,500Corporate Overhead$60,000Contribution to Profit$15,000$45,000-$37,500$22,500Should they discontinue Version Z?How does overhead affect this decision?Overhead is not marginal to the decision. Since it is a sunk cost, it will not be recovered by this decision.
9 Washing Machine Agitator I Econ 5313Washing Machine Agitator IYou are a manager of a washing machine company considering outsourcing the production of an agitator. The following table summarizes costs.Which option is cheaper?InternalOutsourcedCategoryCostMaterial$0.60$0.50Labor$0.20$0.10DepreciationToolingOther OverheadDepreciation and overhead are sunk costs and are not relevant to this decision.
10 Washing Machine Agitator II Econ 5313Washing Machine Agitator IIThe washing machine company accountants tell you that if you outsource, your division will have to accept a one time charge of $400,000. (They get this amount because the plant invested $1,000,000 in sunk costs for internal production six years ago and expected to depreciate this cost over ten years.) Which option would you choose?Is this accounting charge appropriate?Suppose it was year 1 of the 10 years. Are the accounting charges appropriate now?Why might the company want these charges to apply?You might have proposed the initial decision so as to later propose to “save money” by outsourcing. Or you might have claimed a ten year depreciation life when you knew it was shorter.
11 10 Principles of Economics Standup EconomistHumor
12 All-Pay Auction Auctioning a dollar. Econ 5313All-Pay AuctionAuctioning a dollar.But this is an all-pay auction (like poker).If your bid is beaten by someone else, you still pay what you previously bid.However, if you bid twice, you only pay your highest bid.What is sunk and what is marginal to a bid decision?Past bids are sunk costs but affect benefits from winning. It might now make sense to bid over $1 if your previous bid has been beaten.
13 From the Blog Chapter 3 Pitfalls of Modeling in the Americas Cup Econ 5313From the BlogChapter 3Pitfalls of Modeling in the Americas CupCBO on Benefits and Costs of PolicyDesigning welfare to blunt work disincentives
14 Summary of Main Points Costs <==> Decisions. Econ 5313Summary of Main PointsCosts <==> Decisions.Opportunity cost is the value of what you give up.To consider all costs, identify hidden costs. Do not commit the hidden cost fallacy.To consider only the relevant costs, identify sunk costs. Do not commit the sunk cost fallacy.Fixed costs do not vary with output, variable costs do.Accounting profit (costs) usually differ from Economic profit (costs) in how they treat durable assets.Retrospective versus Prospective