PowerPoint Slides © Michael R. Ward, UTA 2014
Econ 5313
Opportunity Costs
• “Outsourcing” Scene
Econ 5313
Foreign Currency
You'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?
Econ 5313
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?
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What are the opportunity costs for the manager of being in this
business relative to returning to his old job?
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$1,000,000-$900,000-$40,000 = $60,000
$70,000 + $100,000×6% = $76,000
What is the economic profit of the business?
•
$60,000-$76,000 = -$16,000
Econ 5313
Own vs. Rent
You 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 > $10,000
• Suppose 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 < $10,000
Econ 5313
Input Supply
Your 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?
Econ 5313
Can Divisions I
A 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 highlevel, 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.
Econ 5313
Net Can Sales
Variable Costs
Corporate Overhead
Contribution to Profit
Can Divisions II
Version X Version Y Version Z
Total
$180,000 $240,000 $105,000 $525,000
$105,000 $135,000 $82,500 $322,500
$60,000 $60,000 $60,000 $180,000
$15,000 $45,000 -$37,500 $22,500
• Should they discontinue Version Z?
• How does overhead affect this decision?
Econ 5313
Washing Machine Agitator I
• You are a manager of a washing machine company
considering outsourcing the production of an agitator. The
following table summarizes costs.
Internal
Cost
Category
Material
Labor
Depreciation
Other Overhead
$0.60
$0.20
$0.10
$0.10
• Which option is cheaper?
Outsourced
Category
Cost
Material
$0.50
Labor
$0.10
Tooling
$0.10
Econ 5313
Washing Machine Agitator II
• The 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?
Econ 5313
10 Principles of Economics
• 10 Principles
• Standup Economist
Econ 5313
All-Pay Auction
• Auctioning 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?
Econ 5313
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From the Blog
Chapter 3
Pitfalls of Modeling in the Americas Cup
CBO on Benefits and Costs of Policy
Designing welfare to blunt work disincentives
Econ 5313
Summary of Main Points
• Costs <==> 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