Ok. So we’ve gone over opportunity cost. What about Economic Profit?
This one’s simple; economic profit is simply the value of our choice minus the opportunity cost.
In the BCG / JP Morgan example, our economic profit would be the value of our BCG offer ($150K) minus the value of JP Morgan’s offer ($140K) = $10,000. Notice this is not how most people generally tend to measure things; most people would say Alex Rodriguez, the highest paid baseball player in America, makes an astronomical $30 million, not $30 million minus the second best offer he had on the table. No one would ever think this way… right?
Wrong. Here’s a better example:
Imagine you were lucky enough to get accepted into two MBA programs; Harvard and Wharton. Harvard charges $90,000 in tuition fees while Wharton charges $80,000. Harvard gave you a full-tuition scholarship. Tuition fees are the only discriminating factor (i.e. you'll will definitely go to the school that charges less tuition), and you value both schools equally. What’s the value of the scholarship… and how much economic profit does this scholarship lead to?
Many people would say the value of the scholarship is $90,000, because, well, that’s what it’s worth, right? Sure. After all, Harvard does charge $90,000 in tuition. But there’s more to it.
With a scholarship, you go to Harvard for free. Lucky you!
If there was no scholarship, you would’ve gone to Wharton at a cost of $80,000.
Do you see how you could argue that this scholarship only saved you $80,000... even though it might have been 'worth' $90,000? The $90,000 ‘value’ of the scholarship is not as important as the $80,000 you save because of the new choice that the scholarship makes available. This is the concept we're trying to teach.
The opportunity cost (i.e. the cost of the opportunity you left on the table by deciding to not attend Wharton) is -$80,000. The cost of attending Harvard = 0. So the economic profit = the value of our choice (0) minus the opportunity cost (-80,000). Crunching the math, economic profit = (0 minus -$80,000) for a grand total economic profit of $80,000. In qualitative terms, taking the scholarship means your costs went down (from $80,000 to zero), and that $80,000 saving is economic profit.
In the spirit of Managerial Economics, this $80,000 is actually what we're concerned with, because we're concerned with the choices we make relative to the other choices we have available. Yes, it may be backwards, and yes, it may be confusing.
But it will make sense, if it doesn't already. If it doesn't yet make intuitive sense, don't worry about it... instead stare at it, wrap your brain around it, dream about it… and get it to make sense because this idea is crucial to the course. Learn this concept as fast as you can. And then read on.
This idea of economic profit has limitations. The biggest one is that it's extremely hard to measure. Imagine talking about your salary relative to all the other salaries you might have in different jobs. It wouldn't make any sense, would it? Because in order to find out the salaries you might have as, say, a sports player or musician, a financier or consultant, you'd need to do some major research to find out what these salaries are, and somehow factor in the likelihood of getting the job in the first place. Crazy, right? But if we could do it, maybe we'd be able to better value our choices in a more applicable way.
It'll be our next topic. Decision trees.
^_^
Thursday, February 12, 2009
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Hi Ronjon, get the point of your example Harvard vs. Wharton. I am wondering suppose the average salary after graudaiton of Harvard is 180K, while Wharton's is 200k. If I choose Harvard for schorlarship, the economic profit= the value of our choice (0+180K) minus the opportunity cost (200K-80K)=60K. Does it make sense?
ReplyDeleteSophia
Hi Sophia,
ReplyDeleteBefore answering, I'd like to change the wording to say our expected salary after graduation is 180K / 200K. Our expected salary would factor in the chance of getting a job / standardizing across industry, etc.
In terms of your answer, your intuition is there, but...
The big difference between your question and the one we did in class (and the ones assigned for homework) is that salary's ongoing; assuming no raises, going to Wharton would make us $20,000 more, every year, for the rest of our working life. In other words, this is not the same as a one-off example where we make our money in one shot. In our new case, we'd need to find out how much that $20,000 / year difference is worth today, and we don't yet have the tools to move these cash flows through time (this is called discounting, we'll cover it briefly in this class and in detail in financial management).
If we were received our salary for only one year post graduation, or if we instead rewrote the question to say we'd get a one-time graduation signing bonus of 180/200K, then your intuition is right and economic profit would be 60K, provided everything else between the two MBAs are the same (salary, etc.), assuming no discounting for the difference in time between paying the tuition and receiving the signing bonus.
Hope that helps, see you on Tues. Any other questions, feel free to post or find me or Catherine on Tuesday during the break.
^_^
Thanks. It's pretty clear.
ReplyDeleteI understand that the salary issues may not a good exapmle, which are little bit complicated in this case.
just want to say that when consider the economic profit, should not only take input into account, but also outputs.
Btw, re Sat review class, do you have specific agenda ? will you cover the Extra Practice Problems Week 1 &2 posted on LSM (not the assignment)? 'cause I haven't touched them yet.