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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 Services | Capital Goods |
|---|---|
| Provide immediate, direct enjoyment | Used to produce other goods and services |
| Can only be used for a short period of time | Can be used for years |
| Bought primarily by consumers | Bought 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?
Arbitrage
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
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
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