Welcome back.
We were discussing opportunity costs and how economists estimate them.
Let me give you a few other examples to drive home
the point and some of the nuances that are involved in estimating them.
Take the case of LeBron James who ended up leaving a couple of years
ago the Cleveland Cavaliers to go to a new opportunity at Miami.
Some of the benefits that LeBron had to estimate such as
the desire to win an NBA championship and would
the odds be higher playing from Miami versus Cleveland.
That entered into his decision making process.
He also had to look at people like Dwayne Wade and
Chris Bosh playing with prospective teammates that he
enjoyed playing with versus the ones that were on
his team at Cleveland and that was part of the motivation as well.
How to put a dollar value in the calculus to figure out,
should I go to Miami or stay with Cleveland?
Cleveland offered the highest salary in terms of explicit benefits.
Why Miami?
Well, economists have also shown one of the considerations that LeBron thought of is,
what happens in differential taxes and have estimated that by going to
Miami he saves seven million dollars in terms of lower state and local taxes.
In the city of Akron, for example,
there is a 7% plus tax rate whereas the city of Miami has
a 0% tax rate and that also impacted his decision making.
Or another example, the Sarbanes-Oxley Act that got passed in 2002.
The accounting costs are very easy to measure.
They range on the order of 14 billion to 25 billion a year, filling out paperwork,
hiring accountants to help publicly traded firms making sure they're
adhering to the government's rules established by SOX, by Sarbanes-Oxley.
The economic costs though are much
more difficult to measure but are also more significant.
They've been estimated to be as high as 150 billion a year.
Why are there economic costs?
Fundamentally because when managers of
leading firms are figuring out how do we adhere to good governance?
How do we fill out the right forms?
Their time is limited and that time could be spent on
evaluating new business risks, new business opportunities.
And so, those are important costs associated with
adhering to the good governance that SOX was designed to promote.
Ivy Zhang, a PhD graduate
of the Simon school and now a member of the faculty at
the Carlson School University of Minnesota,
has also estimated how much was lost in market value because
of Sarbanes-Oxley and through undertaking an event study analysis,
looking as Sarbanes-Oxley was being passed in 2002,
what happened to the shares of publicly traded firms.
She estimates that about 12% of
the market value of publicly traded firms in the United States was lost along the way.
So on a total of about $11 trillion of value in publicly traded firms,
she estimates roughly 1.4 trillion was lost along the way.
A huge economic cost that isn't readily detected if we just look at the accounting costs.
Now let's extend beyond what we just covered in the last example of when to
pursue an MBA or if at all to pursue an MBA and let's develop another related concept.
It's called the sunk cost and there's also something analogous called a sunk benefit.
What happens, for example,
let me go back to the previous slide.
You had four potential choices and as you're making your decision,
let's say you buy a lottery ticket and the lottery ticket proves to be a winner.
You end up winning $10,000 from the lottery ticket.
How should that affect your decision making among those four options?
As I think you'll see when you reflect on it,
it shouldn't because the $10,000 is what economists would call a sunk benefit.
What we mean by sunk it's common across any alternative you can choose.
So it'll show up as an explicit benefit if you pursue the MBA now.
We can add 10,000 to the 2 million in that column.
It'll show up as the same 10,000 if you pursue the MBA in five years,
an additional 10,000 in value there and
similarly on the third and fourth potential choices.
That $10,000 winnings will change your accounting profit.
Each potential branch of the tree you follow from an accountants perspective,
you'd say, "Look, I'm $10,000 richer."
Yet an economist would say when it comes time to making a choice of
whether and when to pursue an MBA you're no richer.
That $10,000 is a sunk benefit and
when we measure the relative profitability of one decision versus the other,
since that 10,000 benefit is common to all the options,
it will get filtered out.
The million $10,000 in accounting profit from pursuing the MBA now will still be just
200,000 greater than the $810,000 accounting profit from waiting for five years.
A sunk cost works the same way.
Say instead of being,
say instead of winning a lottery ticket you get
robbed right before you're going to make this decision.
They steal, the thief steals a $1,000 from you.
How should that affect your decision making?
Which of the four choices to choose?
That $1,000 theft, an economist would call it sunk cost.
As soon as it occurs now when you face the prospect what to
do vis-a-vis the MBA and when and even if to pursue it.
It's common to all your choices.
In accounting terms you're a $1,000 poorer because of the thief.
When we totaled the explicit costs,
instead of a million, it's a million a thousand in pursuing the MBA now.
Pursuing the MBA in five years it's
a million two hundred and one thousand dollars in explicit costs and so on.
And so while that sunk cost will affect your accounting profit,
it won't affect the relative value of one option relative to the other.
When we look at the economic profit of pursuing the MBA now,
it's still 200,000 greater than the next best option even though the accounting profits,
you've been robbed by a 1,000 whatever you choose to do.
So the key takeaway from this segment is sunk costs, sunk benefits,
anything that's common to whatever choices you have can be filtered out of the analysis.
Another example of the importance of looking at
sunk costs and how to take them into account and
also focusing on economic costs and economic profitability.
A few years ago an incredibly profitable, in accounting terms,
hotel was demolished in Hong Kong in the central business district.
It was the Hong Kong Hilton.
It was the first luxury hotel built in the central business district in 1963.
When it was demolished in the late 90's it was generating accounting profits of
close to 25 million a year on annual revenues of about 53 million.
The hotel's lobby, furthermore,
had recently undergone a face lift for $16 million and to break
the contract with Hilton the owners of the land would have to pay $70 million,
sorry a $120 million in additional costs,
a breakage fee to abrogate the contract and yet the owners of
the real estate opted to have this hotel demolished, the contract abrogated?
Why? Because the land on which it sat had become so incredibly valuable.
They figured out that by instead of using the land as a hotel they could
use it for an office building and by converting that use
to office they would generate an additional 70 million
beyond the 25 million that the hotel was generating in accounting profits per year.
How that drives home the point of sunk costs?
Take the $16 million that had just been spent on renovating the lobby.
When it comes time to decide whether you should stick with the hotel as
a hotel or convert the land office space you're stuck with
that 16 million no matter which branch of the tree you decide to
follow so it should be filtered out of the analysis.
Then the importance of always looking at what else the resources could be doing.
So looking just at the accounting profit of 25 million
isn't the correct analysis to determine the economic profitability of your asset,
the land that you own in the central business district.
What constantly owners of those assets need to be looking at is
what is the highest and best use of my assets?
And in the case of the owners of the land in
the central business district it was using it as office space.
So from the economists perspective demolishing this profitable,
in accounting terms, hotel that had just been renovated make complete sense.
