1-1

Opportunity Costs

The highest value that is surrendered when a decision to invest funds is made.

1-2

Choices Available for Funds

Expected financial returns of investment opportunity

Investment opportunity Expected annual rate of return (%)

Purchase stock 11

Purchase home 9

Purchase bonds 6

Place cash in saving account

2

Buy a new car -15

1-3

Examples of Opportunity Cost

Decide to purchase car (-15%)

Opportunity cost = Stock (11%)

1-4

However, if you decided to purchase stock rather (11%) than the car

Opportunity cost = Home (9%)

1-5

Opportunity cost defined

The cost of any activity measured in terms of the best alternative forgone.

It is the sacrifice related to the second best choice available to someone who has picked among several mutually exclusive choices.

In economics› It’s "the basic relationship between scarcity and choice.”› The notion of opportunity cost plays a crucial part in ensuring that scarce

resources are used efficiently.› Opportunity costs are not restricted to monetary or financial costs: the real

cost of output forgone, lost time, pleasure or any other benefit that provides utility should also be considered opportunity costs

1-6

Opportunity costs in consumption

Opportunity cost is assessed in not only monetary or material terms, but also in terms of anything which is of value

E.g., In a restaurant situation, the opportunity cost of eating steak could be trying the salmon. For the dinner, the opportunity cost of ordering both meals could be twofold - the extra $20 to buy the second meal, and his reputation with his peers, as he may be thought gluttonous or extravagant for ordering two meals.

1-7

Opportunity costs in production

Explicit costs are opportunity costs that involve direct monetary payment by producers.

The opportunity cost of the factors of production not already owned by a producer is the price that the producer has to pay for them.

For instance, a firm spends $100 on electrical power consumed, the opportunity cost is $100. The firm has sacrificed $100, which could have been spent on other factors of production.

Fun fact: Coors of Golden, CO, ran a coal mining operation in northeastern CO to generate its own electricity

1-8

Opportunity costs in production

Implicit costs are the opportunity costs that involve only factors of production that a producer already owns.

They are equivalent to what the factors could earn for the firm in alternative uses, either operated within the firm or rent out to other firms.

Example:

1-9

A San Antonio dining tradition since 1933

1-10

Timeline

1933-1940: Earl Abel opens chain of fried chicken restaurants throughout San Antonio

1940: Closes all restaurants but one to keep landmark location at city’s north side

1940-2006: Popular menu for city’s well-to-do, etc. 2006: Jerry’s son sells property to condominium

developers, moves to new location on Austin Hwy; menu stays the same, help staff turn over

1-11

Broadway to Austin Highway 2.5 miles

1-12

New home!

1-13

A San Antonio dining tradition since 1933

1-14

Take-(out)-aways

Property more valuable being sold for high-rise condos than for selling fried chicken (Opportunity cost for selling chicken is not selling the property)

Second-generation (Jerry) ran business for decades: “The sixty-something Abel wouldn't discuss financial terms of the deal but said he's "tired" of operating the restaurant his father started in 1933. Abel grew up working in the family business and has served as its president for 20 years.”

Menu remains the same, but value from new location << old location

1-15

Evaluation

Assessing opportunity costs is fundamental to assessing the true cost of any course of action. In the case where there is no explicit accounting or monetary cost (price) attached to a course of action, or the explicit accounting or monetary cost is low, then, ignoring opportunity costs may produce the illusion that its benefits cost nothing at all.

The unseen opportunity costs then become the implicit hidden costs of that course of action.

1-16

“This time it’s personal” (Part 1)

You graduate from the University with a dual-major BS degree in marketing and chemical engineering.› You can work for Procter & Gamble for $70,000 starting salary, or› Start your own marketing consulting business for personal care

product manufacturers with starting salary of $0, but potential salary of $150,000

1-17

“This time it’s personal” (Part 2)

You took the P&G job and have been working for them for five years. You have a salary of $85,000 and a wealth of understanding of the personal care products industry.› You can continue to work for Procter & Gamble for $85,000

salary with annual 4% raises, or› Start your own marketing consulting business for personal care

product manufacturers with starting salary of $0, but potential salary of $500,000

1-18

“This time it’s personal” (Part 3)

Three years later you are still working for P&G and have been working for them for eight years. You have a salary of $95,000, but heard that the company may sell off your unit to a company known for its ruthless cost cutting.› Stick with the unit and lobby the acquiring company to keep your

$95,000 salary (probably no chance of a raise, though), or› Start your own marketing consulting business for personal care

product manufacturers with starting salary of $0, but potential salary of $500,000