Lecture 2

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Introduction to EconomicsIntroduction to Economics

Elements of Personal FinanceElements of Personal Finance

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Econ 109 Class PageEcon 109 Class Page

Econ Home Page:Econ Home Page: http://www.http://www.econecon..ucsbucsb..eduedu

Economics 109 Llad Phillips Fall 2002Introduction to Economics

Hour, Location: 2:00-3:15, Engineering 1104Instructor: Llad Phillips, [email protected] Hours: NH 3032, 9:30-10:15 TuTh and 10:30-11:15 W, and by appointment

Arthur O’Sullivan and Steven Sheffrin, Economics, Principles and Tools, Third Edition(2003,2001)

Labs(sections)12617 F 9:00-9:50 AM Jalama Lab, Phelps 1517

MCL 12625 M 2:00-2:50 PM Rincon Lab, Phelps 151812633 M 7:00-7:50 PM Jalama Lab, Phelps 151712641 W 8:00-8:50 AM Jalama Lab, Phelps 1517

Note 12658 Th 6:30- 7:20 PM Rincon Lab, Phelps 151812666 F 1:00-1:50 PM Rincon Lab, Phelps 1518

Teaching Assistants: Dunghun Cho, Office: NH 2048Taeil Kang, Office: NH 2048Kirk Lesh, Office: NH 2043

Exams:Quiz: Tuesday, Oct. 22. You will need scantron sheet and #2 pencil.Midterm: Tuesday, Nov. 5, 2:00-3:15 PM. You will need scantron sheet

and #2 pencil.Final: Thursday, Dec. 12, 4:00-7:00 PM, You will need scantron sheet and

#2 pencil.

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Concepts in EconomicsConcepts in Economics

This Time: How to think like an economist, This Time: How to think like an economist, the economic paradigmthe economic paradigm

This Time: You pay for the This Time: You pay for the serviceservice of the of the car: one year, two years, three yearscar: one year, two years, three years

Last Time: scarcityLast Time: scarcity Last Time: opportunity costLast Time: opportunity cost

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Personal Finance ExamplesPersonal Finance Examples

Buying a CarBuying a Car The most important thing about the example The most important thing about the example

is is processprocess::

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Economists have a name for this process: The Economic ParadigmEconomists have a name for this

process: The Economic Paradigm Step One: List your options for choiceStep One: List your options for choice

for example pay cash or keep the cashfor example pay cash or keep the cash

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Economists have a name for this process: The Economic ParadigmEconomists have a name for this

process: The Economic Paradigm Step One: Step One: Step Three: pick the best option for youStep Three: pick the best option for you

for example: keep the cashfor example: keep the cash

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What Happened to Step Two?What Happened to Step Two?

Step Two: value the optionsStep Two: value the options

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Economics: Two Types of Issues Economics: Two Types of Issues

EfficiencyEfficiency step 3 of the paradigm: pick the best optionstep 3 of the paradigm: pick the best option optimizeoptimize

EquityEquity

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What is the next most important thing to remember from the car example?What is the next most important thing to remember from the car example?

Two Main CostsTwo Main Costs depreciationdepreciation foregone interestforegone interest

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Depreciation: Taurus, GL SedanDepreciation: Taurus, GL Sedan

Year MSRP Kelley* Depreciation1996 18,5451995 18,295 14,750 3,5451994 18,280 13,350 4,9301993 17,675 11,700 5,9751992 17,619 10,200 7,4191991 16,595 8,800 7,7951990 16,054 7,750 8,304

* Excellent Condition

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Taurus Depreciation As Fraction of MSRP

0

0.1

0.2

0.3

0.4

0.5

0.6

0 2 4 6Age of Vehicle

Fra

cti

on

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Walnut Creek Ford DealerWalnut Creek Ford Dealer

1996 Taurus1996 Taurus Advertised Price: $16,488Advertised Price: $16,488

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Choice: cash Choice: cash

purchase price: $16,488purchase price: $16,488 tax at 7.5 %: $1,237tax at 7.5 %: $1,237 documents: $35documents: $35 total: $17,760total: $17,760

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KeepYourMoney

This Year Next Year Year After

$17,760 $17,760 $17,760

$1,225* $1,225

$1,225

* @ 6.9 % interest$17,760 $18,985 $20,210

BuyTheCar,Cash

Car’s ServicesFor 1 Yr.

Car’sServicesFor 2 Yrs.

Resale value: $14,947** $13,538#** MSRP - Depreciation = MSRP - MSRP * 0.194 = $18,545 * 0.806

# MSRP - Depreciation = MSRP - MSRP * 0.27 = $18,545 * 0.73

Cost of Car’s Services: $4,038(1 Yr.) & $6,672(2 Yrs.)

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Another Decision: How to Pay?Another Decision: How to Pay?

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Choice of Payment MethodChoice of Payment Method

cashcash leaselease loanloan

http://www.fordcredit.com/

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Advertised 2-Year Lease Deal for a 1996 Taurus

Advertised 2-Year Lease Deal for a 1996 Taurus

drive-off costs(payments due at lease drive-off costs(payments due at lease signing): $2,136.77signing): $2,136.77

monthly Payment: $249 + taxmonthly Payment: $249 + tax remember: tax + documents = $1237 + $35 remember: tax + documents = $1237 + $35

= $1272, spread over 24 months, or $53 per = $1272, spread over 24 months, or $53 per monthmonth

total monthly payment: $249 + $53= $302total monthly payment: $249 + $53= $302 total payments: 24*$302=$7248total payments: 24*$302=$7248 drive-off + payments= $9384.77drive-off + payments= $9384.77

Example

Walnut Creek Dealer: 1996, Ford Taurus, $16,488

5,976 + tax249 + tax

Example

249 + tax24 months

5,976 + tax

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This YearNext Year Year After

$2,450$1,225*

$4,222

$6,672* @ 6.9 % interest $4,038

Buy TheCar, Cash

foregone interest on $17,760:

depreciation:

# price+tax-blue book = $17,760 - 0.806*$18,545

$2,813#

Lease, 24 monthstotal drive-off: $2,137 $2,137

total monthly payments @$302/m.: $3,624 $7,248

foregone interest on $2,137**: $147 $294

$5908 $9679** Assumes no opportunity cost of monthly payments

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What is the advantage of leasing?What is the advantage of leasing? Low drive-off compared to paying $17,760 Low drive-off compared to paying $17,760

cashcash

http://www.fordcredit.com/calculator/calcbuffer.html

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Cost of Using a ‘96 Taurus for 2 Yrs.Cost of Using a ‘96 Taurus for 2 Yrs.

Cost item Cash Lease Loanforegone interest $2,450 $294*depreciation $4,222total drive-off $2,137monthly payments $7,428down paymentmonthly payments -blue book**total $6,672 $9,679

* foregone interest on the drive-off of $2,137

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Elements of Personal FinanceElements of Personal Finance

Economics in every day lifeEconomics in every day life loansloans

car loanscar loans

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Example: Buying a New ‘96 TaurusExample: Buying a New ‘96 Taurus KnownsKnowns

advertised price + tax + documents: advertised price + tax + documents: $17,760$17,760

down payment: $2,137down payment: $2,137 loan amount: $15,623loan amount: $15,623

loan amount = $17,760 - $2,137loan amount = $17,760 - $2,137 annual interest rate: 6.9%annual interest rate: 6.9% loan term in months: 24 monthsloan term in months: 24 months

UnknownsUnknowns monthly paymentmonthly payment

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Monthly Payment?Monthly Payment?

Could use Ford calculator, but that was for a Could use Ford calculator, but that was for a 48 month loan48 month loan

could use the program Excelcould use the program Excel

Using Excel 5.0 for a Solution Using Excel 5.0 for a Solution Price + tax + documents 17760 17760 17760down payment 2137 2137 2137loan amount 15623 15623 15623annual interest rate 6.9% 6.9% 6.9%loan term in months 24 36 48

monthly payment ($698.77) ($481.68) ($373.39)

total payments 16770.58 17340.44 17922.61

total interest 1147.58 1717.44 2299.61

Monthly Payment?

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Cost of Using a ‘96 Taurus for 2 Yrs.Cost of Using a ‘96 Taurus for 2 Yrs.

Cost item Cash Lease Loanforegone interest $2,450 $294 $294depreciation $4,222total drive-off $2,137monthly payments $7,428*down payment $2,137monthly payments -blue book**

$3,233

total $6,672 $9,679 $5,664

* residual value: $11,480 vs. Kelly Blue Book resale value of $13,538

** blue book: $13,538

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Catch 22Catch 22

The 2-year loan looks bestThe 2-year loan looks best But, …. Ford was not offering a 2-year But, …. Ford was not offering a 2-year

loan, but a 4-year loanloan, but a 4-year loan

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Some General Facts About LoansSome General Facts About Loans

From our car loan exampleFrom our car loan example

Using Excel 5.0 for a Solution Using Excel 5.0 for a Solution Price + tax + documents 17760 17760 17760down payment 2137 2137 2137loan amount 15623 15623 15623annual interest rate 6.9% 6.9% 6.9%loan term in months 24 36 48

monthly payment ($698.77) ($481.68) ($373.39)

total payments 16770.58 17340.44 17922.61

total interest 1147.58 1717.44 2299.61

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Increasing the Length of the LoanTradeoffs

Increasing the Length of the LoanTradeoffs

monthly payment amount decreasesmonthly payment amount decreases amount of total payments increasesamount of total payments increases amount of total interest payments increasesamount of total interest payments increases total interest as % of total payments total interest as % of total payments

increases increases

Using Excel 5.0 for a Solution Using Excel 5.0 for a Solution Price + tax + documents 17760 17760 17760down payment 2137 2137 2137loan amount 15623 15623 15623annual interest rate 6.9% 6.9% 6.9%loan term in months 24 36 48

monthly payment ($698.77) ($481.68) ($373.39)

total payments 16770.58 17340.44 17922.61

total interest 1147.58 1717.44 2299.61

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Interest as a Fraction of CostInterest as a Fraction of Cost

Term inmonths

24 36 48

Fraction .068 .094 .128

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Interest as a Fraction of the Monthly Payment

0

0.02

0.04

0.06

0.08

0.1

0.12

0.14

0 5 10 15 20 25Payment Number

Fra

cti

on

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Equity in a '96 Taurus Vs. Payment Number

02000400060008000

1000012000140001600018000

0 5 10 15 20 25Payment Number

Eq

uit

y,

$

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Summary: LoansSummary: Loans

interest is front-loaded in payment planinterest is front-loaded in payment plan interest cost increases with the loan terminterest cost increases with the loan term total cost increases with the loan termtotal cost increases with the loan term equity is low at the beginning of the loanequity is low at the beginning of the loan

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Personal Financial PlanningPersonal Financial Planning

Financing Life EventsFinancing Life Events

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Life Event* ApproachLife Event* Approach Marriage/commitment to significant otherMarriage/commitment to significant other childrenchildren

financial security: insurancefinancial security: insurance housinghousing educationeducation

retirementretirement long term carelong term care estateestate

*reference: Ernst & Young’s Personal Financial Planning Guide, 2nd Ed. John Wiley

Life Cycle Approach: Learning & Earning

AgeInfancy

Nurturing

Adolescence

High SchoolEducation

Young Adult

College

Adult

Work

Senescence

Retirement

Activity/Phase:

Life Cycle Approach: The Planners

AgeInfancy Adolescence Young Adult Adult Senescence

100%

50%

0 %

You

Parents

Life Cycle Approach: Planning

Age

Nurturing High SchoolEducation

College Work Retirement

Education: Investment in Human Capital or Earning Power

Accumulating Assets cars appliances furnishings--------------------- house financial assets

Spending

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Planning ToolsPlanning Tools

Assets-Liabilities StatementAssets-Liabilities Statement Assets Minus Liabilities = Net WorthAssets Minus Liabilities = Net Worth

measure of wealthmeasure of wealth

Income-Expenditure StatementIncome-Expenditure Statement Income Minus Expenditures = SavingIncome Minus Expenditures = Saving

measure of change in wealthmeasure of change in wealth

http://www.fordcredi.com/fplanner.cgi

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Income-Expense StatementIncome-Expense Statement

Income Amount Expenditure Amountown salary taxesspouse “ life insuranceinsurance carsdividends foodinterest clothingrent housingother otherTotal Total

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Income-Expense Statement: US Population 1988Income-Expense Statement: US Population 1988Income Amount Expenditure Amountown salary taxes excludingspouse “ life

insuranceinsurance cars 20%dividends food 16%interest clothing 6%rent housing 31%other other 27%Total Total 100%

other: health, 5%; pensions & Soc. Sec., 7%; other, 15%Source: Guide to Understanding Personal Finance, p. 87

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Assets-Liabilities StatementAssets-Liabilities StatementAsset Amount Liability Amountcash bank loanstocks margin loanbondsinsurance(surrender)

policy loans

other card balanceshouse equity mortgagepersonalproperty

car loan

Total Total

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Strategies for Meeting Future ExpensesStrategies for Meeting Future Expenses

Buy a HouseBuy a House Tax-Sheltered Savings PlansTax-Sheltered Savings Plans Stocks and BondsStocks and Bonds

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Buying a HouseBuying a House

PositivesPositives provides spaceprovides space builds equitybuilds equity interest is interest is

deductibledeductible

Negatives?Negatives? down payment down payment

requires saving for requires saving for this goalthis goal

interest payments interest payments are front-loaded, are front-loaded, equity growth equity growth delayeddelayed

opportunity cost of opportunity cost of not investing in not investing in stocksstocks

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Summary - Vocabulary - ConceptsSummary - Vocabulary - Concepts economic paradigmeconomic paradigm down paymentdown payment loan termloan term monthly paymentmonthly payment annual percentage rate or annual percentage rate or

APRAPR equityequity personal financial planningpersonal financial planning life event ananysislife event ananysis

human capitalhuman capital assetsassets liabilitiesliabilities net worth, wealthnet worth, wealth incomeincome expendituresexpenditures savingssavings

Excel: select cell for monthly payment, click on Function Wizard

select Financial and PMT

Excel: click on the help button in the previous window for examples

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The Economic Approach to Problem Solving

The Economic Approach to Problem Solving

The Economic ParadigmThe Economic Paradigm

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The Economic ParadigmThe Economic Paradigm

describing the alternatives to choose amongdescribing the alternatives to choose among pricing the alternativespricing the alternatives choosing the best alternativechoosing the best alternative

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The Economic Paradigmexample: buying a car

The Economic Paradigmexample: buying a car

describing the alternatives to choose amongdescribing the alternatives to choose among cash: the opportunity cost of losing interestcash: the opportunity cost of losing interest lease: depreciation included in paymentslease: depreciation included in payments loan: sell the car to account for depreciationloan: sell the car to account for depreciation

pricing the alternatives: valuationpricing the alternatives: valuation Oscar Wilde- economists know the price of Oscar Wilde- economists know the price of

everything and the value of nothingeverything and the value of nothing choosing the best alternativechoosing the best alternative

best: lowest costbest: lowest cost possibly subject to a constraint: having the $possibly subject to a constraint: having the $

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The Principle of The Principle of Opportunity CostOpportunity CostThe Principle of The Principle of Opportunity CostOpportunity Cost

No matter what we do, there are always No matter what we do, there are always tradeoffs.tradeoffs.

Scarcity -- limited resources -- is the Scarcity -- limited resources -- is the reason.reason.

The opportunity cost of something The opportunity cost of something is what you sacrifice to get it.is what you sacrifice to get it.

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Opportunity Costs and Production Opportunity Costs and Production PossibilitiesPossibilitiesOpportunity Costs and Production Opportunity Costs and Production PossibilitiesPossibilities

The production possibility curve illustrates The production possibility curve illustrates the principle of opportunity cost for an entire the principle of opportunity cost for an entire economy.economy.

-- shows all possible combinations of goods -- shows all possible combinations of goods and services available to entire economy.and services available to entire economy.

--- principle of opportunity cost explains why --- principle of opportunity cost explains why production possibility curve is negatively production possibility curve is negatively sloped.sloped.

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THE MARGINAL PRINCIPLETHE MARGINAL PRINCIPLETHE MARGINAL PRINCIPLETHE MARGINAL PRINCIPLE

Marginal Benefit Marginal Benefit

The extra benefit resulting from The extra benefit resulting from a small increase in the activity.a small increase in the activity.

Marginal CostMarginal Cost

The additional cost resulting The additional cost resulting from a small increase in the from a small increase in the activity.activity.