8/14/2015 1 Opportunity Costs Ch. 12 Claudia Garcia-Szekely.
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Transcript of 8/14/2015 1 Opportunity Costs Ch. 12 Claudia Garcia-Szekely.
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04/19/23 1
Opportunity Opportunity Costs Ch. 12Costs Ch. 12
Claudia Garcia-SzekelyClaudia Garcia-Szekely
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““The most powerful force in the The most powerful force in the universe is compound interestuniverse is compound interest””
Albert Einstein
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The Power of Compound The Power of Compound InterestInterest
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 The Power of Compound InterestInterest
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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
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What is the cost of that car?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 $1,778,831.91Brent has $ 1,242,758.23:Brent gave up $536,073 to get the car…
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CostsCosts
Explicit Implicit
Out of pocket expense
The money you did not
earn
The Cost of a Missed
Opportunity
The Opportunity
CostThe money paid for the car: $30,000 The money you did not earn:
$500,000
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Your ResourcesYour 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
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LaborLabor
• 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 LandOpportunity 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)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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CostsCosts
• 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
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Capital (Money)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.
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Accountants only track Accountants only track ExplicitExplicit Costs… Costs…
• An Accountant’s job is to “follow the money”.
• Accounting costs include only explicit costs (out-of-pocket expenses)
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Economists track both Economists track both ImplicitImplicit and and ExplicitExplicit Costs 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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When are you When are you reallyreally making making money?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 ResourcesYour Resources
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ResourcesResourcesWorking SeparatelyWorking Separately
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60,000 + 7,000 + 40,000 = $107,000
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Tying your resources in a Tying your resources in a business only makes sense business only makes sense
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If your business produce MORE than
you get with your resources working
separatelyIf your business produce MORE than
you get with your resources working
separately
> $107,000
> $107,000
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Normal ProfitNormal Profit
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Take home= $107,000
Economic Profit= $0Accounting 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 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
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 Normal Profit = Zero Economic Profit Profit
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Above Normal ProfitAbove Normal Profit
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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 the MORE than what you get with your resources
working separatelyTake home more than what is needed to cover Implicit
Costs
Take home more than what is needed to cover Implicit
Costs
Abnormal ProfitAbnormal Profit