The Truth about Economics by MICHAEL RYAN

Author:MICHAEL RYAN [MICHAEL RYAN]
Language: eng
Format: epub
Publisher: Gatekeeper Press
Published: 2017-12-01T05:00:00+00:00

The following instructions from Mankiw explain option B, with $200,000 financing.

“Caroline’s accountant, who only measures explicit costs, will now count the $10,000 (See #1 above) interest toward the cost . . . By contrast, according to an economist, the opportunity cost of owning the business is still $15,000. The opportunity cost equals the interest on the bank loan ($10,000) plus the forgone interest on savings ($5,000) (See #2 above)

In the case of the economist, the economic profit is EXACTLY the same for the two financing alternatives, $35,000, making it impossible to make a decision.

In the case of the accountant, the profit for the two alternatives are either $50,000 self-financed or $40,000 with a $200,000 loan. The irony is that by applying the economist’s idea of opportunity costs, Caroline is not able to choose between self-financing $300,000 or borrowing $200,000. If Caroline sticks with her accountant, she can clearly see the effect of financing her acquisition, profits will be reduced by the amount of interest expense.

Mankiw concludes the discussion with the following sentence:

“To understand business decisions, we need to keep an eye on economic profit.”49

Opportunity costs and economic profits don’t make sense when discussing profitability.

Conclusion:

Opportunity Cost is a simple way to compare choices. Opportunity Costs have no relationship to actual profits. Financial analysis using present value is the preferred method for assessing choices in business. No one in the real world uses opportunity costs to measure ongoing profitability.

Economists confuse the student by claiming that Opportunity Cost is an implicit cost when, in fact, it is not a cost at all. It is a value trade-off between two different choices.

Economists confuse the student further by claiming accountants do not address implicit costs. In reality, accountants must address implicit costs all the time.

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