04/19/23 1

Opportunity Opportunity Costs Ch. 12Costs Ch. 12

Claudia Garcia-SzekelyClaudia Garcia-Szekely

““The most powerful force in the The most powerful force in the universe is compound interestuniverse is compound interest””

Albert Einstein

2

3

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!

The Power of Compound The Power of Compound InterestInterest

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

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…

6

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

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

7

8

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.

9

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.

10

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.

11

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

12

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.

13

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)

14

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.

15

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

Your ResourcesYour Resources

16

ResourcesResourcesWorking SeparatelyWorking Separately

17

60,000 + 7,000 + 40,000 = $107,000

Tying your resources in a Tying your resources in a business only makes sense business only makes sense

18

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

Normal ProfitNormal Profit

19

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

Above Normal ProfitAbove 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 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