Question

You currently pay $10,000 per year in rent to a landlord for a $100,000 house, which you are considering purchasing. You can qualify for a loan of $80,000 at 9% if you put $20,000 down on the house. To raise money for the down payment, you would have to liquidate stock earning you a 15% return. We neglect other concerns, like closing costs, capital gains, and tax consequences of owning. 1. Explain the concept of opportunity cost. 2. Explain the fixed cost and the the hidden cost fallacy. 3. Given the described situation, determine whether it is better to rent or own. Show all your calculations and logical arguments.

Answer 1

Answer:

1. Opportunity Cost: This is the alternatives forgone when a decision is taken. If we intend to buy two items for example rule and pen. If we decide to purchase pen, the opportunity cost of purchasing pen is the price of ruler. If we keep our cash balance in safe at home instead of depositing in a saving account, the opportunity cost is interest lost.

Opportunity cost is also known as implicit cost. If you work in your company instead of getting another job. The opportunity cost is the salary you would have earned in the other employment.

2. Fixed Cost: Fixed cost is the cost that remain the same irrespective of  the level of output. Fixed cost is different from variable cost because variance costs varies with the level output. Example of fixed cost is rent, administrative cost, etc.

The hidden-cost fallacy is the situation when all cost or relevant costs   are not considered. Example of hidden cost fallacy is when opportunity costs are ignored.

3. Cost of Rent:

Rent per year: $10,000.

Cost of purchase:

Annual interest on loan - $7,200

Stock interest forgone    -$3,000

                                          $10, 200

It is better to rent.

Explanation:

Rent will cost only $10,000 per annual while purchasing will cost $10,200 per annual. Annual cost of purching is higher by $200.

Answer 2

Answer:

1.

The concept of opportunity cost is the benefit(s) which one has to sacrifice in order to pursue for other options/decision-making. In the described situation, the opportunity cost is the return on $20,000 investment on stock that earns 15% per year return as this investment has to be liquidated to finance for the house purchase.

2.

The fixed cost fallacy referring to the situation where economic decision-maker let irrelevant costs/ sunk cost(s) wrongly affect their decision-making.

The hidden cost fallacy is quite the contrary to the fixed cost fallacy; which refers to the situation where decision-makers fails to take into account relevant cost in their decision-making process.

3.

In the described situation, it is better to rent a house because it is more economical.

* If we rent the house, the total cost per year is $10,000

* If we buy the house, the total cost per year includes:

+ Cost of borrowing $80,000 + Opportunity cost of sacrificing 15% return per year on $20,000 stock investment = 80,000 *9% + 20,000*15% = $10,200;

So, it is cheaper to rent a house, rather than own it.

 

Explanation: