Aye Kyu Kyu Khin

Diploma in Business And Management (DBM – 29)

Fundamental of Economic

Assignment – 3

Assessor – Su Myat Naing Wai

 Table of Contents
Page
1. Opportunity Cost 1
2. Explicit Cost 4
3. Implicit Cost 6
4. Economies of Scale 6
5. What is GDP? 8
6. Inflation 10
7. Conclusion 12
8. References: 13
1. Opportunity Cost
Opportunity costs represent the benefits an individual, investor or business misses out
on when choosing one alternative over another. While financial reports do not show
opportunity cost, business owners can use it to make educated decisions when they have
multiple options before them. Bottlenecks are often a cause of opportunity costs.

Opportunity Cost Formula and Calculation

Opportunity Cost=FO−CO
Where:
FO=Return on best foregone option
CO=Return on chosen option

The formula for calculating an opportunity cost is simply the difference between the
expected returns of each option. Say that you have option A, to invest in the stock market
hoping to generate capital gain returns. Option B is to reinvest your money back into the
business, expecting that newer equipment will increase production efficiency, leading to
lower operational expenses and a higher profit margin.
Assume the expected return on investment in the stock market is 12 percent over the
next year, and your company expects the equipment update to generate a 10 percent return
over the same period. The opportunity cost of choosing the equipment over the stock market
is (12% - 10%), which equals two percentage points. In other words, by investing in the
business, you would forgo the opportunity to earn a higher return.

KEY TAKEAWAYS
Opportunity cost is the return of a foregone option less than the return on your chosen
option.
Considering opportunity costs can guide you to more profitable decision-making.
You must assess the relative risk of each option in addition to its potential returns.

Opportunity Cost and Capital Structure

Opportunity cost analysis also plays a crucial role in determining a business's capital
structure. While both debt and equity require expense to compensate lenders and shareholders
for the risk of investment, each also carries an opportunity cost. Funds used to make

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payments on loans, for example, are not being invested in stocks or bonds, which offer the
potential for investment income. The company must decide if the expansion made by
the leveraging power of debt will generate greater profits than it could make through
investments.
Because opportunity cost is a forward-looking calculation, the actual rate of return for
both options is unknown. Assume the company in the above example foregoes new
equipment and invests in the stock market instead. If the selected securities decrease in value,
the company could end up losing money rather than enjoying the expected 12 percent return.
For the sake of simplicity, assume the investment yields a return of 0%, meaning the
company gets out exactly what it put in. The opportunity cost of choosing this option is 10% -
0%, or 10%. It is equally possible that, had the company chosen new equipment, there would
be no effect on production efficiency, and profits would remain stable. The opportunity cost
of choosing this option is then 12% rather than the expected 2%.
It is important to compare investment options that have a similar risk. Comparing
a Treasury bill, which is virtually risk-free, to investment in a highly volatile stock can cause
a misleading calculation. Both options may have expected returns of 5%, but the U.S.
Government backs the rate of return of the T-bill, while there is no such guarantee in the
stock market. While the opportunity cost of either option is 0 percent, the T-bill is the safer
bet when you consider the relative risk of each investment.

Comparing Investments
When assessing the potential profitability of various investments, businesses look for
the option that is likely to yield the greatest return. Often, they can determine this by looking
at the expected rate of return for an investment vehicle. However, businesses must also
consider the opportunity cost of each option.
Assume that, given a set amount of money for investment, a business must choose
between investing funds in securities or using it to purchase new equipment. No matter which
option the business chooses, the potential profit it gives up by not investing in the other
option is the opportunity cost.

Opportunity Cost vs. Sunk Cost

The difference between an opportunity cost and a sunk cost is the difference between
money already spent and potential returns not earned on an investment because the capital

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was invested elsewhere, possibly causing financial distress. Buying 1,000 shares of company
A at $10 a share, for instance, represents a sunk cost of $10,000. This is the amount of money
paid out to make an investment, and getting that money back requires liquidating stock at or
above the purchase price.
From an accounting perspective, a sunk cost could also refer to the initial outlay to
purchase an expensive piece of heavy equipment, which might be amortized over time, but
which is sunk in the sense that you won't be getting it back. An opportunity cost would be to
buy a piece of heavy equipment with an expected return on investment (ROI) of 5% or one
with an ROI of 4%.
Again, an opportunity cost describes the returns that one could have earned if he or
she invested the money in another instrument. Thus, while 1,000 shares in company A might
eventually sell for $12 a share, netting a profit of $2,000, during the same period, company B
increased in value from $10 a share to $15. In this scenario, investing $10,000 in company A
netted a yield of $2,000, while the same amount invested in company B would have netted
$5,000. The $3,000 difference is the opportunity cost of choosing company A over company
B.
As an investor that has already sunk money into investments, you might find another
investment that promises greater returns. The opportunity cost of holding the
underperforming asset may rise to where the rational investment option is to sell and invest in
the more promising investment.

Risk vs. Opportunity Cost

In economics, risk describes the possibility that an investment's actual and projected
returns are different and that the investor loses some or all of the principal. Opportunity cost
concerns the possibility that the returns of a chosen investment are lower than the returns of a
forgone investment. The key difference is that risk compares the actual performance of an
investment against the projected performance of the same investment, while opportunity cost
compares the actual performance of an investment against the actual performance of a
different investment.
Still, one could consider opportunity costs when deciding between two risk profiles. If
investment A is risky but has an ROI of 25% while investment B is far less risky but only has
an ROI of 5%, even though investment A may succeed, it may not. And if it fails, then the
opportunity cost of going with option B will be salient.

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Example of Opportunity Cost
When making big decisions like buying a home or starting a business, you will
probably scrupulously research the pros and cons of your financial decision, but most day-to-
day choices aren't made with a full understanding of the potential opportunity costs. If they're
cautious about a purchase, many people just look at their savings account and check their
balance before spending money. Often, people don't think about the things they must give up
when they make those decisions.
The problem comes up when you never look at what else you could do with your
money or buy things without considering the lost opportunities. Having takeout for lunch
occasionally can be a wise decision, especially if it gets you out of the office for a much-
needed break.
However, buying one cheeseburger every day for the next 25 years could lead to
several missed opportunities. Aside from the missed opportunity for better health, spending
that $4.50 on a burger could add up to just over $52,000 in that time frame, assuming a very
achievable 5% rate of return.
This is a simple example, but the core message holds true for a variety of situations. It
may sound like overkill to think about opportunity costs every time you want to buy a candy
bar or go on vacation. Even clipping coupons versus going to the supermarket empty-handed
is an example of an opportunity cost unless the time used to clip coupons is better spent
working in a more profitable venture than the savings promised by the coupons. Opportunity
costs are everywhere and occur with every decision made, big or small.

2. Explicit Cost
An explicit cost is a physical outlay of cash or financial expenditure that the firm
reports on its financial statements. These costs pertain to the production factors that a firm
owns, utilizes, and spends money for, and have a direct impact on its profitability.
Explicit costs require cash outflows towards the compensation of wages, rent,
mortgage, raw materials, advertising, utilities, inventory, and equipment. Some accountants
include depreciation and amortization in the explicit costs, but this is incorrect as depreciation
and amortization do not pertain to tangible expenses. Conversely, employee wages, payments
towards the purchase of raw materials, rent, and utility bills are explicit because they require
an outlay of cash and the firm reports them on its financial statements.

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Example
The manager of Company X asks Philip, the general accountant, to calculate the
explicit costs for a period of five years. The manager wants to see if the cost-cutting policy he
implements brings, in fact, any results. Philip collects the information from 2011 to 2015, and
he creates an excel file as follows:

Philip finds out that between 2001 and 2015, the company’s explicit costs have
increased by 44.9%. The main increases are in inventory by 8.2%, rent by 11.1%, mortgage
by 20.0% and advertising by 30.1%. Raw materials have declined by 1.7% and wages by
6.3%, whereas the electricity bills have slightly increased by 2.9%.
Explicit costs have a direct impact on the firm’s profitability. With a 45% increase in
explicit costs, it is evident that the cost-cutting policy that the manager implements is
ineffective. Explicit costs need to be managed so that the firm can increase its profitability by
lowering its advertising, mortgage and inventory expenses. In the long-term, the manager
needs to make sure that the company’s revenues remain strong so that inventories are sold. If
on the other hand, the sales decline, the company needs to cut down on inventories and
perhaps on staff hours to lower its explicit costs.

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3. Implicit Cost
An implicit cost is an opportunity cost of using a firm’s internal resources that isn’t
reported as separate, distinct expense. In fact, these costs do not explicitly state the cost of
using these resources for a project.
Implicit costs are costs on which the firm waives any opportunity of earning a profit
from the use of its internal resources by third parties, such as the rent that a firm would earn if
it leased out a building that it owns instead of using it for its own operations.
They are also costs that the firm cannot account for, such as the depreciation of
equipment or the cost of hiring an employee. For this reason, they are not recorded on any
financial statement. These costs are generally hard to quantify since there is no physical
exchange of cash or transaction directly related to them; however, some businesses single out
these as costs of potential sources of income.

Example
A manufacturing company owns a building, which is used for its own operations
instead of renting out to another firm. The company has a net profit of $25,000 per month,
and the opportunity cost of rent is $10,000. The actual economic profit of the manufacturing
company is $25,000 – $10,000 = $15,000 per month.
Because the firm uses its own resources, it does not earn income on these assets, and
it cannot report any explicit costs for using the building for its own operations. In doing so,
the company waives a potential income of $10,000 per month.
If the company earned $13,000 from the rent with a net income was $10,000 per month, it
would face a loss of $10,000 – $13,000 = – $3,000. This means that the asset is underutilized,
and the company should rent out the building to earn an additional profit per month instead of
using it for its operations.

4. Economies of Scale
Economies of scale are cost advantages reaped by companies when production
becomes efficient. Companies can achieve economies of scale by increasing production and
lowering costs. This happens because costs are spread over a larger number of goods. Costs
can be both fixed and variable.
The size of the business generally matters when it comes to economies of scale. The
larger the business, the more the cost savings.

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Types of Economies of Scale
There are two main types of economies of scale: internal and external. Internal
economies are controllable by management because they are internal to the company.
External economies depend upon external factors. These factors include the industry,
geographic location, or government.

Internal Economies of Scale

Internal economies result from a larger volume of production. You'll typically see
them in large organizations.
For example, large companies have the ability to buy in bulk. This lowers the cost per
unit of the materials they need to make their products. They can use the savings to
increase profits. Or they can pass the savings to consumers and compete on price.
There are five main types of internal economies of scale.
1. Technical economies of scale result from efficiencies in the production
process itself. Manufacturing costs fall 70% to 90% every time the business
doubles its output. Larger companies can take advantage of more efficient
equipment.
2. Monopsony power is when a company buys so much of a product that it can
reduce its per unit costs. For example, Wal-Mart's "everyday low prices" are
due to its huge buying power.

3. Managerial economies of scale occur when large firms can afford specialists.
They more effectively manage particular areas of the company. For example, a
seasoned sales executive has the skill and experience to get the big orders.
They demand a high salary, but they're worth it.
4. Financial economies of scale mean the company has cheaper access to capital.
A larger company can get funded from the stock market with an initial public
offering. Big firms have higher credit ratings. As a result, they benefit from
lower rates on their bonds.
5. Network economies of scale occur primarily in online businesses. It costs
almost nothing to support each additional customer with existing
infrastructure. So, any revenue from the new customer is all profit for the
business. A great example is eBay.

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External Economies of Scale
A company has external economies of scale if its size creates preferential treatment.
That most often occurs with governments.
For example, a state often reduces taxes to attract the companies that provide the most
jobs. Big real estate developers convince cities to build roads to support their buildings. This
saves the developers from paying those costs. Large companies can also take advantage of
joint research with universities. This lowers research expenses for these companies.
Small companies don't have the leverage to benefit from external economies of scale. But
they can band together.
Small companies can cluster similar businesses in a small area. That allows them to
take advantage of geographic economies of scale. For example, artist lofts, galleries, and
restaurants benefit by being together in a downtown art district.

5. What Is GDP?
Gross Domestic Product (GDP) is the total monetary or market value of all the
finished goods and services produced within a country's borders in a specific time period. As
a broad measure of overall domestic production, it functions as a comprehensive scorecard of
the country’s economic health.
Though GDP is usually calculated on an annual basis, it can be calculated on
a quarterly basis as well. In the United States, for example, the government releases
an annualized GDP estimate for each quarter and also for an entire year. Most of the
individual data sets will also be given in real terms, meaning that the data is adjusted for price
changes, and is, therefore, net of inflation.

KEY TAKEAWAYS
Gross Domestic Product (GDP) is the monetary value of all finished goods and
services made within a country during a specific period.
GDP provides an economic snapshot of a country, used to estimate the size of an
economy and growth rate.
GDP can be calculated in three ways, using expenditures, production, or incomes. It
can be adjusted for inflation and population to provide deeper insights.
Though it has limitations, GDP is a key tool to guide policymakers, investors, and
businesses in strategic decision making.

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The Basics of GDP
GDP includes all private and public consumption, government outlays, investments,
additions to private inventories, paid-in construction costs, and the foreign balance of
trade (exports are added, imports are subtracted).
There are several types of GDP measurements:

Calculating GDP
The components of GDP include personal consumption expenditures plus business
investment plus government spending plus (exports minus imports). Now that you know what
the components are, it's easy to calculate a country's gross domestic product using this
standard formula: C + I + G + (X - M).
When economists talk about the “size” of an economy, they are referring to GDP.

Types
There are many different ways to measure a country's GDP. It's important to know all
the different types and how they are used.

Nominal GDP
This is the raw measurement that includes price increases. In 2018, nominal U.S.
GDP was $20.580 trillion.

Real GDP
To compare GDP by year, the BEA removes the effects of inflation. Otherwise, it
might seem like the economy is growing when really it's suffering from double-digit
inflation. The BEA calculates real GDP by using a price deflator. It tells you how much
prices have changed since a base year. The BEA multiplies the deflator by the nominal GDP.
Income from U.S. companies and people from outside the country are not included. That
removes the impact of exchange rates and trade policies.
Real GDP is lower than nominal. In 2018, it was $18.638 trillion. The BEA provides
it using 2012 as the base year in the National Income and Product Accounts, Table 1.1.6.
Real Gross Domestic Product-Chained Dollars.

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Growth Rate
The GDP growth rate is the percentage increase in GDP from quarter to quarter. It
changes depending on the phase of the business cycle. If the growth rate is negative, the
economy contracts, signaling a recession. If it contracts for years, that’s a depression. If the
growth rate is too high, it creates inflation. The BEA provides the U.S GDP growth
rate monthly. In 2018, it was 2.9%.
Many economists agree that the ideal growth rate for developed economies is between
2% and 3%.4 Rates that are faster than that can lead to inflation and asset bubbles.

GDP per Capita

GDP per capita is the best way to compare gross domestic product between countries.
This divides the gross domestic product by the number of residents. Some countries have a
big GDP only because they have so many people. It also measures the country's standard of
living. In 2018, the U.S. GDP per capita was $62,795.5
The best way to compare GDP per capita by year or between countries is with real
GDP per capita. This takes out the effects of inflation, exchange rates, and differences in
population.

6. Inflation
Inflation is a quantitative measure of the rate at which the average price level of
a basket of selected goods and services in an economy increases over a period of time. It is
the constant rise in the general level of prices where a unit of currency buys less than it did in
prior periods. Often expressed as a percentage, inflation indicates a decrease in
the purchasing power of a nation’s currency.
There are four main types of inflation, categorized by their speed. They are creeping,
walking, galloping and hyperinflation. There are specific types of asset inflation and also
wage inflation. Some experts say demand-pull and cost-push inflation are two more types,
but they are causes of inflation. So is expansion of the money supply.

Creeping Inflation
Creeping or mild inflation is when prices rise 3% a year or less. According to
the Federal Reserve, when prices increase 2% or less it benefits economic growth. This kind

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of mild inflation makes consumers expect that prices will keep going up. That
boosts demand. Consumers buy now to beat higher future prices. That's how mild inflation
drives economic expansion. For that reason, the Fed sets 2% as its target inflation rate.

Walking Inflation
This type of strong, or pernicious, inflation is between 3-10% a year. It is harmful to
the economy because it heats up economic growth too fast. People start to buy more than they
need, just to avoid tomorrow's much higher prices. This drives demand even further so that
suppliers can't keep up. More important, neither can wage. As a result, common goods and
services are priced out of the reach of most people.

Galloping Inflation
When inflation rises to 10% or more, it wreaks absolute havoc on the economy.
Money loses value so fast that business and employee income can't keep up with costs and
prices. Foreign investors avoid the country, depriving it of needed capital. The economy
becomes unstable, and government leaders lose credibility. Galloping inflation must be
prevented at all costs.

Hyperinflation
Hyperinflation is when prices skyrocket more than 50% a month. It is very rare. In
fact, most examples of hyperinflation have occurred only when governments printed money
to pay for wars. Examples of hyperinflation include Germany in the 1920s, Zimbabwe in the
2000s, and Venezuela in the 2010s. The last time America experienced hyperinflation was
during its civil war.

7. Conclusion
The science of political economy is growing and its area can never be rigid. In other
words, the definition must not be inflexible. Because of modern research, many new areas of
economics are being explored.

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 That is why the controversy relating to the definition of economics remains and will
remain so in the future. It is very difficult to spell out a logically concise definition. In this
connection, Mrs. Barbara Wotton’s remarks may be noted – ‘Whenever there are six
economists, there are seven opinions!’

8. References:
https://www.thebalance.com/types-of-inflation-4-different-types-plus-more-3306109
https://www.investopedia.com/terms/g/gdp.asp
https://www.investopedia.com/terms/o/opportunitycost.asp

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https://www.investopedia.com/terms/e/explicitcost.asp

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