Capital and Rental Cost

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Factors of Production: Land, Labor, and Capital

What is capital? Machinery, equipment

Movie theaters' capital: projectors; ticket machines; popcorn machines; seats; etc.

Consumer Goods and ServicesCapital Goods
Provide immediate, direct enjoymentUsed to produce other goods and services
Can only be used for a short period of timeCan be used for years
Bought primarily by consumersBought primarily by businesses

Capital is produced, land is not

Buildings are capital

Consumer-bought capital is called Consumer Durables (e.g. refrigerators, cars)

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Physical Capital vs. Financial Capital

Cost of Capital and the Rent-or-Buy Formula

Profitability = Rental Rate + Appreciation - Interest Cost

You buy when profitability is greater than zero; you rent when profitability is less than zero

Example: Lease a car for one year for $12,000; or borrow money at 5 percent to buy the car new for $32,000 and sell it in one year for $24,000?

rental rate = $12,000/$32,000 = 37.5 %

appreciation rate = ($24,000 - $32,000)/$32,000 = - 25%. (the car depreciates)

interest cost = 5 %

profitability = 37.5 + (-25) - 5 = 7.5   since profitability is positive, you should buy rather than lease

What if you could only sell the car for $20,000?

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Appreciation = -37.5% and you're better off leasing

What if you didn't need to borrow the money, but you had the cash?

Opportunity Cost (*important concept*)

repairing the damage caused by the hurricane will create demand for all sorts of goods and services, isn't that good? no, because of opportunity cost

definition: opportunity cost = what you must give up in order to have something

alternative definition: the value of the next best thing that the resources could be used for; opportunity cost of airport security personnel

going to a movie--time and money

If medical checkups were free and caused no discomfort, would you get one once a week?

Why should the profitability usually be close to zero?


definition--take advantage of a discrepancy in prices by buying the good where it is cheap and selling it where it is expensive. Example--hire computer programmers in Rumania for $5 an hour and sell their services in the U.S. for $40 an hour

rent-buy arbitrage: when renting is cheap, sell your house and rent it from the buyer; when renting is expensive, buy other houses and rent them out

Is there a Housing Bubble?

Using the rent-buy formula to check the reasonableness of house prices

Are houses in my neighborhood overpriced? A few years ago, typical house cost $350,000 and now sells for $600,000. That same house rents for $2000 a month; mortgage interest rate = 6 percent;

Need annual rental rate. $2000 x 12 = $24,000  Divide this by $600,000 and the rental rate = 4 percent.

profitability = 4 % + ? - 6%

How much will house prices keep going up? If they go up at 2 percent per year, then rent-buy analysis is breakeven. If we expect faster appreciation, we should buy. If we expect slower appreciation, we should keep renting.

A bubble is when the only way buying is profitable is if the appreciation rate is unrealistically high.

one sign of a bubble--rents and prices move in opposite direction

recent story that rents are going up, suggests no bubble

Self-fulfilling expectations--until the bubble pops

Cash Flow vs. Capital Gains

If you bought the house and rented it out, you would have negative cash flow: $600,000 x 6 percent means $36,000 in interest expense, but only $24,000 in rental income. But if appreciation is 4 percent per year, it's a good investment.

Capital gain

Other uses of rent vs. buy:

Valuing Common Stock

Deciding whether to rent or buy a movie projector

What if your only choice is to buy?

Review: Factors of Production; Capital; ***Rent vs. Buy profitability formula***; Arbitrage; Opportunity Cost; Capital Gain