2. 8/14/2015 1 Opportunity Costs Ch. 12 Claudia Garcia-Szekely

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

4. 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!

5. The Power of Compound Interest 4 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

6. 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…

7. 6 Costs Explicit Implicit Out of pocket expense The money you did not earn 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

8. 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 7

9. 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.

10. 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.

11. 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.

12. 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

13. 12 Capital (Money) 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? NO! you still have the $1,000 not in money but in equipment: the hot dog stand is yours.

14. 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)

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

16. 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

17. Your Resources 16

18. Resources Working Separately 17 60,000 + 7,000 + 40,000 = $107,000

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

20. Normal Profit 19 Take home= $107,000 Economic Profit= $0 Accounting Profit= $107,000 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 Implicit costs= $107,000 Normal Profit = Zero Economic Profit

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