The opportunity cost of a decision is the value of the next best alternative that must be forgone. Examples of personal opportunity costs are time, effort, and health, and examples of financial opportunity costs are interest, safety, and liquidity. Using the concept of opportunity costs allows you to address the personal consequences of choices because every decision inevitably involves trade-offs. For example, suppose that instead of reading this book you could have gone to a movie or watched television, but mainly you wanted to sleep. The lost benefit of that sleep the next best alternative is the opportunity cost when you choose to read. Knowing the opportunity cost of alternatives aids decisionmaking because it indicates whether the decision made is truly the best option.
In personal finance, opportunity cost reflects the best alternative of what one could have done instead of choosing to spend, save, or invest money. For example, by decid ing to put $2000 into a stock mutual fund for retirement rather than keeping the funds readily available in a savings account, you are giving up the option of using the money for a down payment on a new automobile. Keeping the money in a savings account has the opportunity cost of the higher return on investment that the stock mutual fund might pay. This opportunity to earn a higher rate of return is a primary consideration when making low-risk investment decisions. Other challenging opportunity cost decisions are renting versus buying housing, buying a new or used car, buying or leasing a vehicle, working or borrowing to pay for college, purchasing life insurance or not, and starting early or late to save and invest for retirement. Another opportunity cost decision often is returning to college for a graduate degree. If these costs are underestimated, then decisions will be based on faulty information, and judgments may prove wrong. Properly valuing the costs and benefits of alternatives represents a key step in rational decision making.
Marginal Utility and Costs in Decision Making
Utility is the ability of a good or service to satisfy a human want. A key task in personal finance is to determine how much utility you will gain from a particular decision. For example, if you decide to spend $70 on a ticket to a concert, you might beginby thinking about what you might gain from the expenditure. Perhaps you’ll enjoy a nice evening, good music, and so on. Marginal utility is the extra satisfaction derived from having one more incremental unit of a product or service. Marginal cost is the additional (marginal) cost of one more incremental unit of some item. When known, this cost can be compared with the marginal utility received. Thinking about marginal utility and marginal cost can help in decision making because it reminds us to compare only the most important variables. It requires that we examine what we will really gain if we also experience a certain extra cost.
To illustrate this idea, assume that you consider spending $150 instead of $90 (an additional $60) for a front-row seat at the concert. What marginal utility will you gain from that decision? Perhaps an ability to see and hear more or the satisfaction of having one of the best seats in the facility. You would then ask yourself whether those extra benefits are worth 60 extra dollars. In practice, people are inclined to seek additional utility as long as the marginal utility exceeds the marginal cost. In another example, imagine that two new automobiles are available on a dealership lot in Ferndale, Michigan, where retired engineer Charlene Hicks is trying to make a purchase decision. Both vehicles are similar models, but one is a Mercury and the other is a Ford. The Mercury, with a sticker price of $29,100, has a moderate number of options; the Ford, with a sticker price of $30,800, has numerous options. Marginal analysis suggests that Charlene does not need to consider all of the options when comparing the vehicles. Instead, the concept of marginal cost says to compare the benefits of the additional options with the additional costs—$1700 in this instance ($30,800 $29,100). Charlene need decide only whether the additional options are worth $1700
Marginal Income Tax Rate in Decision Making
When making financial decisions, consider the economic effects of paying income taxes. Of particular importance is the marginal tax rate, which is the tax rate at which your last dollar earned is taxed. As income rises, taxpayers pay progressively higher marginal income tax rates. Financially successful people often pay U.S. federal income taxes at the 25 percent, or higher, marginal tax rate. For example, if Juanita Martinez, an unmarried office manager working in Atlanta, Georgia, has a taxable income of $66,000 and receives a $1000 bonus from her employer, she has to pay an extra $250 in taxes on the bonus income ($1000 0.25 $250). Juanita also has to pay state income taxes of 6 percent, or $60 ($1000 0.06 $60), and Social Security taxes of 7.65 percent, or $76.50 ($1000 0.0765 $76.50). Therefore, Juanita pays an effective marginal tax rate of nearly 40 percent (25% 6% 7.65% 38.65%), or $386.50, on the extra $1000 of earned income
People who pay high marginal tax rates can do better by making tax-exempt
investments, such as buying bonds issued by various agencies of states and municipalities. For example, Serena Miller, a married chiropractor with two children from Cleveland, Ohio, currently has $5000 in utility stocks earning 5 percent, or $250 ($5000 0.05), annually. She pays $62.50 in federal income tax on that income at her 25 percent marginal tax rate ($250 0.25), leaving her with $187.50 after taxes. Alternatively, a tax-exempt $5000 state bond paying 4 percent will provide Serena with a better after-tax return, $200.00 instead of $187.50. That is, she would receive $200.00 tax free from the state bond ($5000 0.04) compared with $187.50 ($250 $62.50) after taxes on the income from the stocks
The Very Best Kind of Income Is Tax-Exempt Income The very best
kind of income, as this discussion implies, is tax-exempt income, which is income that is totally and permanently free of taxes. By legally avoiding paying one dollar in income taxes, you gain by not paying that dollar in taxes and, therefore, you receive the alternative use for that dollar. You also benefit by not having to earn another dollar to replace the one that might have been paid in taxes.
The Second Best Kind of Income Is Tax-Sheltered Income The
second-best kind of income for individuals is tax-sheltered (or tax-deferred) income that is, income that is exempt from income taxes in the current year but that will be subject to taxation in a later tax year. Figure 1.3 shows that tax-sheltered returns on savings and investments provide much greater returns than returns on which income taxes have to be paid because more money remains available to be invested. In addition, tax-sheltered funds grow more rapidly because compounding (the subject of the next section in this chapter) is enhanced when larger dollar amounts
Marginal Utility and Costs in Decision Making
Utility is the ability of a good or service to satisfy a human want. A key task in personal finance is to determine how much utility you will gain from a particular decision. For example, if you decide to spend $70 on a ticket to a concert, you might beginby thinking about what you might gain from the expenditure. Perhaps you’ll enjoy a nice evening, good music, and so on. Marginal utility is the extra satisfaction derived from having one more incremental unit of a product or service. Marginal cost is the additional (marginal) cost of one more incremental unit of some item. When known, this cost can be compared with the marginal utility received. Thinking about marginal utility and marginal cost can help in decision making because it reminds us to compare only the most important variables. It requires that we examine what we will really gain if we also experience a certain extra cost.
To illustrate this idea, assume that you consider spending $150 instead of $90 (an additional $60) for a front-row seat at the concert. What marginal utility will you gain from that decision? Perhaps an ability to see and hear more or the satisfaction of having one of the best seats in the facility. You would then ask yourself whether those extra benefits are worth 60 extra dollars. In practice, people are inclined to seek additional utility as long as the marginal utility exceeds the marginal cost. In another example, imagine that two new automobiles are available on a dealership lot in Ferndale, Michigan, where retired engineer Charlene Hicks is trying to make a purchase decision. Both vehicles are similar models, but one is a Mercury and the other is a Ford. The Mercury, with a sticker price of $29,100, has a moderate number of options; the Ford, with a sticker price of $30,800, has numerous options. Marginal analysis suggests that Charlene does not need to consider all of the options when comparing the vehicles. Instead, the concept of marginal cost says to compare the benefits of the additional options with the additional costs—$1700 in this instance ($30,800 $29,100). Charlene need decide only whether the additional options are worth $1700
Marginal Income Tax Rate in Decision Making
When making financial decisions, consider the economic effects of paying income taxes. Of particular importance is the marginal tax rate, which is the tax rate at which your last dollar earned is taxed. As income rises, taxpayers pay progressively higher marginal income tax rates. Financially successful people often pay U.S. federal income taxes at the 25 percent, or higher, marginal tax rate. For example, if Juanita Martinez, an unmarried office manager working in Atlanta, Georgia, has a taxable income of $66,000 and receives a $1000 bonus from her employer, she has to pay an extra $250 in taxes on the bonus income ($1000 0.25 $250). Juanita also has to pay state income taxes of 6 percent, or $60 ($1000 0.06 $60), and Social Security taxes of 7.65 percent, or $76.50 ($1000 0.0765 $76.50). Therefore, Juanita pays an effective marginal tax rate of nearly 40 percent (25% 6% 7.65% 38.65%), or $386.50, on the extra $1000 of earned income
People who pay high marginal tax rates can do better by making tax-exempt
investments, such as buying bonds issued by various agencies of states and municipalities. For example, Serena Miller, a married chiropractor with two children from Cleveland, Ohio, currently has $5000 in utility stocks earning 5 percent, or $250 ($5000 0.05), annually. She pays $62.50 in federal income tax on that income at her 25 percent marginal tax rate ($250 0.25), leaving her with $187.50 after taxes. Alternatively, a tax-exempt $5000 state bond paying 4 percent will provide Serena with a better after-tax return, $200.00 instead of $187.50. That is, she would receive $200.00 tax free from the state bond ($5000 0.04) compared with $187.50 ($250 $62.50) after taxes on the income from the stocks
The Very Best Kind of Income Is Tax-Exempt Income The very best
kind of income, as this discussion implies, is tax-exempt income, which is income that is totally and permanently free of taxes. By legally avoiding paying one dollar in income taxes, you gain by not paying that dollar in taxes and, therefore, you receive the alternative use for that dollar. You also benefit by not having to earn another dollar to replace the one that might have been paid in taxes.
The Second Best Kind of Income Is Tax-Sheltered Income The
second-best kind of income for individuals is tax-sheltered (or tax-deferred) income that is, income that is exempt from income taxes in the current year but that will be subject to taxation in a later tax year. Figure 1.3 shows that tax-sheltered returns on savings and investments provide much greater returns than returns on which income taxes have to be paid because more money remains available to be invested. In addition, tax-sheltered funds grow more rapidly because compounding (the subject of the next section in this chapter) is enhanced when larger dollar amounts
grow during the last years of an investment. Realize that eventually one must pay income taxes on the income deferred.
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