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Opportunity Cost, Profits, and Value


Opportunity Cost, Profits, and Value Shyam Sunder, Yale University National University of Colombia, Bogota August 16, 2005 An Overview Opportunity costs is the ... – PowerPoint PPT presentation

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Title: Opportunity Cost, Profits, and Value

Opportunity Cost, Profits, and Value
  • Shyam Sunder, Yale University
  • National University of Colombia, Bogota
  • August 16, 2005

An Overview
  • Opportunity costs is the concept of cost
    necessary for economic decisions
  • Explore its nature and measurement for different
    kinds of resources
  • Economic profit, the appropriate criterion for
    choice, depends on opportunity cost, and
    different from various agents
  • Value is the capitalization of profit
  • Value of the organization can be viewed as the
    some of the value generated for all participating

What Is Opportunity Cost?
  • Sometimes it is easier to understand a concept
    starting out what it is not
  • Usually we think of costs as out-of-pocket costs
  • 1 (cost of a cup of coffee)
  • 20,000 (cost of a car)
  • At the time we make the decision to buy the cup
    of coffee or the car, this out-of-pocket cost is
    also (usually) the opportunity cost
  • With the passage of time, the two tend to diverge
    from each other

Opportunity Costs
  • How are opportunity costs different from
    out-of-pocket costs?
  • Opportunity cost of choosing a decision (e.g.,
    choosing A over B) is the sacrifice we make by
    not choosing B
  • Costs that were never, and would never, be
  • Subjective, hypothetical (what might have been),
    speculative and uncertain, must be estimated
  • Opportunity cost has no existence apart from a
    decision problem
  • It is associated with the road not taken
  • Why should such costs count in our decisions?
  • Let us see a simple example

Example of Opportunity Cost
  • An old painting bought for 5
  • You plan to give it to a friend
  • Just before you give it to your friend, you find
    out that it is a rare painting by an old master
    which costs 5,000
  • What is the cost of giving the painting to your

More Examples
  • Cost of material with no other use
  • Cost of material with other uses
  • Cost of material not yet bought
  • Interest on inventory
  • Cost of labor
  • Cost of capacity
  • Cost of excess capacity

Decision with Opportunity Cost
  • Example illustrates that we can use one of two
  • Calculate the net benefit of each available
    option and pick the better one
  • Calculate the net benefit of one option, after
    subtracting the net benefit of the other option
    as the opportunity cost
  • If we calculate correctly, the decision would be
    the same from both methods of making decisions

Opportunity Cost Illustration
Contrast with Sunk Costs
  • One person buys a ticket to see the Olympics
    final of soccer for 200 dollars
  • A second person gets the ticket for free from a
    friend who has an emergency
  • Severe weather is predicted for the day of the
  • Which person is more likely to attend the game?

Measuring Opportunity Costs
  • In single person contexts,
  • use subjective or objective probability to model
    and solve the decision problem
  • In multiperson contexts,
  • Absence of objective measures of opportunity
    costs exacerbates agency costs
  • In either case, reduction in subjectivity of
    opportunity cost estimates may help make better
  • Perhaps we can use public information to reduce
    subjectivity in measured opportunity costs

How resources behave with time may have to do
with the problems of estimating opportunity costs
  • Cash, being a timeless resource, offers no
    problems (or perhaps merely because it is defined
    as the numeraire)
  • Let us explore the time dimension of resources

How Do Resources Behave Over Time?
  • In acquisition
  • In expiration of their benefits
  • In consumption of their benefits

Resources Vary in Their Lumpiness or Granularity
Along All Three Dimensions
  • Let us look at their
  • Acquisition granularity
  • Expiration granularity
  • Consumption granularity

Acquisition Granularity
  • Three crude classes
  • Low (electrical power, contract labor)
  • Acquisition and utilization are proximate
  • Not inventoried, JIT
  • Medium (groceries)
  • Economic order quantity (EOQ) Model
  • High (car, house, machinery and plant)
  • One-off

Determinants of Acquisition Granularity
  • Transaction costs
  • Storage costs
  • Technology of supply

Expiration Granularity
  • Same as storability
  • Low (highway sign, receptionist)
  • Medium (bag of sugar, fruit, car)
  • High (gold bar)
  • Note Distinguish expiration granularity or
    storability from the rate of expiration of

Consumption Granularity (Closely linked to
expiration granularity)
  • Extent of owner's control over the rate of
    extraction of benefits
  • Low (street sign, gold ring)
  • Medium (car)
  • High (sugar, production gold)

Cross Tabulation
  • Consider a decision
  • List options
  • List resource consequences of options
  • For each resource, consider
  • Acquisition Granularity
  • If low, OC purchase price
  • If high, consider expiration granularity of each
    relevant attribute of the resource

Decisions (Continued)
  • Expiration granularity
  • If low, it is a pure capacity resource Use time
    as the cost driver,
  • If high, consider consumption granularity of each
    attribute of the

Decisions (Continued)
  • Consumption granularity
  • List driver for each attribute i
  • For each attribute/driver i calculate cost/unit
  • If a product consumes ui units of attribute i,
    cost of the resource assigned to the product
    maxi (ciui)

Example Rental Car
  • Cost (net of salvage value) 24,000
  • Attribute 1 Time (Capacity 600 days)
  • Attribute 2 Mileage (Capacity 60,000 m)
  • Time Rate 24,000/600 40 per day
  • Mil. Rate 24,000/60,000 0.40 per m.
  • Cost of rental max (40.Days, 0.40. miles)

  • Economic profit of an agent from a decision is
    the revenue less the opportunity cost of the
  • The profit from participation in an organization
    can be defined not only for the shareholders but
    for every participating agent
  • We can determine who gets how much profit and
    what is the total profit generated by an
    organization for all participants combined

Neoclassical Firm
  • Firm is the instrument of the owner- entrepreneur
  • Every other agent gets the opportunity cost of
    the resource he/she contributes (i.e. no goodies)
  • All these factor markets are assumed to be
    perfectly competitive
  • All the surplus goes to the owner-entrepreneur
  • Value of the firm is the discounted present value
    of cash flows to the owner
  • IRR O.C. of capital gt zero value

Contract or Organization Theory
  • If the total surplus is negative the firm is
    infeasible redesign the contracts or shut down
  • If the total surplus is zero, there is a unique
    distribution in which everyone gets zero surplus
  • If the total surplus is positive, there are
    multiple feasible allocations. There is no basis
    for choosing one allocation over another.
    Therefore, the distribution of surplus among
    agents is undetermined

Firm as a Set of Contracts
A Brief Detour
  • Am I talking about social accounting?
  • Yes, there are some common elements
  • But it differs in perspective
  • Let us do a brief overview of social accounting

Social Accounting
  • Also called socioeconomic accounting, social
    responsibility accounting and social audit
  • Measure and report efforts, achievements and
    impact of firms on social dimensions
  • E.g., energy conservation, minority hiring,
    environmental preservation, support of community
    organizations (see Appendix A)
  • Often descriptive, may include financial and
    non-financial data

Typical Elements of Social Accounts
  • A. Community Involvement General philanthropy,
    Public and private transportation, Health
    services, Housing, Aid in personal and business
    problems, Community planning and improvement,
    Volunteer activities, Specialized food programs,
  • B. Human Resources Employment practices,
    Training programs, Promotion policies, Employment
    continuity, Remuneration, Working conditions,
    Drugs and alcohol, Job enrichment,
  • C. Physical Resources and Environmental
    Contributions Air, Water, Sound, Solid waste,
    Use of scarce resources, Aesthetics
  • D. Product or Service Contributions Labeling,
    Warranty, Responsiveness to consumer complaints,
    Consumer education, Product quality, Product
    safety, Advertising, Constructive research

Examples of Social Accounting
  • Tradecraft, http//www.globalnet.co.uk/traidcra
  • British Telecom, http//www.groupbt.com/society/in
  • General Motors, http//www.gm.com/company/gmabilit
  • Intel http//www.intel.com/intel/finance/social.ht
  • United Airlines http//www.ual.com/site/primary/0,

Social Accounting Perspective
  • Social is construed narrowly, leaves out
    production, sale and distribution of goods and
    services, taken for granted
  • Managers responsible for preparing the social
  • Information inherently dispersed
  • Uses perspective of the firm, not the members of
  • Fuzzy image

Profit/Value of the Firm
  • Extensive income as the sum of
  • To the shareholders
  • To customers
  • To Vendors
  • To employees
  • To creditors
  • To government
  • To community, etc.
  • Inducement from the firm O.C. of contributions

Profit/Value to Investors
  • Residual income and corresponding shareholder
    value created
  • Focus of current financial reports
  • Apply similar perspective to other participants
    in the firm

Profit/Value to Customers
  • Customers investment in the form in the form
    of search, learning, negotiation, payments,
    settlement of disputes
  • Expected PV of benefits from goods received
    should exceed the PV of investments
  • Includes immediate transaction as well as the
    consequences of the transaction for resource
    flows associated with any future transactions
    (reduction in time, cost, search etc. for later
  • In a perfect product market, consumers surplus
    from the firm is zero (may be ve from industry)

Value to Government
  • Various levels of government provide mostly
    non-priced services plus some priced goods
  • Resources from taxation
  • Value of the firm to the government from
    providing priced services is the same as for
  • Value of the firm to the government from
    providing non-priced services is taxes plus fees
    minus O.C. of resources spent on providing
  • Major challenge to put this in practice

Value of the Firm to Community
  • Local, national and global
  • Most exchanges in form of externalities
  • Value of the firm to the community is the sum of
    net externalities plus the net payments

Measurement of Profit/Value
  • J.M. Clark (1936) Three fundamental challenges
    to determining the value of private enterprise
  • Imperfect and incomplete markets
  • Fundamental values not as exact as market values
  • Fundamental concepts should be independent of
    specific institutions of exchange (generality)

Markets and Value of the Firm
  • In a perfect market Law of one price holds,
    everyone gets the same price
  • Value to the supplier of factor is zero
  • Existence of value gtmarket imperfection
  • Perfection can be the tendency of markets under
    certain conditions, not the goal of any agent
  • Agents seek and create imperfections
    (specialization, differentiation, monopolies)
  • Value creation as a treadmill, not ski lift
  • Market frictions/trans. Costs create room for

Externalities in Value of the Firm
  • Difficult problems of measurement because there
    is no help from markets
  • Most organizations produce and consume public
  • Extensive concept of income includes the value of
    these benefits consumed and bestowed on the

Difficulties of Measuring Externalities
  • Example Vans to transport employees from train
  • Cost of service to the firm, and benefits of
    lowered costs of parking, absenteeism, morale,
  • Employee savings cash, time, fatigue, etc. best
    estimated by employees
  • Benefits to fellow commuters, local government,
  • Lump together as community, apply social
    cost-benefit analysis to determine income to
  • Sensitive to identity of preparer
  • Valuation social rate of discount lower than

Implications Mergers and Acquisitions
  • Extensive debates surrounding the consequences of
    corporate mergers and acquisitions
  • Empirical studies Target firm shareholders gain,
  • Acquiring firm shareholders wealth effect not
  • Occasional attention to bondholders, and tax
  • Effects on labor, customers, vendors, community
    rarely examined
  • What kind of policy decisions possible on the
    basis of shareholder value alone?

Justification for Shareholder Value Criterion
  • Assume neoclassical model of the firm (all
    surplus always goes to the owner, income/value to
    all other agents is zero both before and after
    the event) no need to look at the effects on any
    other class of agents
  • Capital markets are said to be efficient, at
    least more perfect than other factor markets
  • Contradiction between the two assumptions

Who Gets the Goodies?
  • Agents who transact in relatively perfect markets
    should get prices close to O.C.
  • U.S. capital markets said to be more perfect than
  • Suppliers of capital should be expected to get
    close to their O.C.
  • Surplus/value of the firm should accrue mostly to
    agents who transact through less perfect markets
  • Yet, we assume that the surplus goes to the

Contract Renegotiation
  • Shareholders have the only open-ended contract in
    the firm
  • All other contracts are periodically
    renegotiated these agents try to capture a share
    of the surplus whenever possible
  • Short term contract agents have an option value
    that shareholders lack
  • Shareholders (as a group) and unvested pensioners
    cannot quit when faced with having to absorb
    negative surplus
  • Many mergers and acquisitions are followed by
    contract renegotiations

Need Analysis of Extensive Income and Values
  • For policy, need analysis of income/values to all
    agents, not just shareholders
  • Given their long term inflexible contract,
    imperfections in corporate governance, they may
    not be able to capture all, or even most, of the
    ex post benefits of value-enhancing mergers and
  • Possible leakage to other agents through market
    imperfections, holes in corporate governance when
    value is enhanced
  • Shareholders left holding the bag on depletion
  • Would not know without analysis of extensive
    income/value of the firm

Shareholder Value As Guide for Accounting Policy
  • Event, ERC, Value-Relevance, R2 studies cited as
    justifications for accounting policy
  • What is the theoretical justification for using
    shareholder value for this purpose (other than
    neoclassical perspective)
  • Law of the Instrument (Kaplan) Use whatever data
    is available, extensive income/value measures

Concluding Remarks
  • Neoclassical perspective is not useful for
    analyzing many accounting issues
  • Income and value concepts driven by this
    perspective have their limitations, and
  • For important classes of accounting matters, we
    may need extensive concepts of income and value
  • Lessons from national income accounting

Thank you
  • The presentation will be available for
    downloading from
  • www.som.yale.edu/faculty/sunder
  • Please send your comments to
  • Shyam.Sunder_at_yale.edu
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