Introduction to Economics Elements of Personal Finance
Econ 109 Class Page <ul><li>Econ Home Page:   http://www. econ . ucsb . edu </li></ul>
Economics 109 Llad Phillips Fall 2002 Introduction to Economics Hour, Location: 2:00-3:15, Engineering 1104 Instructor: Ll...
 
Concepts in Economics <ul><li>This Time: How to think like an economist,  the economic paradigm </li></ul><ul><li>This Tim...
Personal Finance Examples <ul><li>Buying a Car </li></ul><ul><li>The most important thing about the example is  process : ...
Economists have a name for this process:  The Economic Paradigm <ul><li>Step One: List your options for choice </li></ul><...
Economists have a name for this process:  The Economic Paradigm <ul><li>Step One:  </li></ul><ul><li>Step Three: pick the ...
What Happened to Step Two? <ul><li>Step Two: value the options </li></ul>
Economics: Two Types of Issues  <ul><li>Efficiency </li></ul><ul><ul><li>step 3 of the paradigm: pick the best option </li...
 
 
What is the  next  most important thing to remember from the car example? <ul><li>Two Main Costs </li></ul><ul><ul><li>dep...
Depreciation: Taurus, GL Sedan
 
Walnut Creek Ford Dealer <ul><li>1996 Taurus </li></ul><ul><li>Advertised Price: $16,488 </li></ul>
Choice: cash  <ul><li>purchase price: $16,488 </li></ul><ul><li>tax at 7.5 %: $1,237 </li></ul><ul><li>documents: $35 </li...
Keep Your Money This Year  Next Year Year After $17,760 $17,760 $17,760 $1,225* $1,225 $1,225 * @ 6.9 % interest $17,76...
Another Decision: How to Pay?
Choice of Payment Method <ul><li>cash </li></ul><ul><li>lease </li></ul><ul><li>loan </li></ul>
http://www.fordcredit.com/
Advertised 2-Year Lease Deal for a 1996 Taurus <ul><li>drive-off costs(payments due at lease signing): $2,136.77 </li></ul...
Example Walnut Creek Dealer:  1996 , Ford Taurus, $16,488   5,976 + tax 249 + tax
Example 249 + tax 24 months 5,976 + tax
This Year  Next Year Year After $2,450 $1,225* $4,222 $6,672 * @ 6.9 % interest $4,038 Buy The Car, Cash foregone inter...
What is the advantage of leasing? <ul><li>Low drive-off compared to paying $17,760 cash </li></ul>
http://www.fordcredit.com/calculator/calcbuffer.html
 
Cost of Using a ‘96 Taurus for 2 Yrs. * foregone interest on the drive-off of $2,137
Elements of Personal Finance <ul><li>Economics in every day life </li></ul><ul><ul><li>loans </li></ul></ul><ul><ul><ul><l...
Example: Buying a New ‘96 Taurus <ul><li>Knowns </li></ul><ul><ul><li>advertised price + tax + documents: $17,760 </li></u...
Monthly Payment? <ul><li>Could use Ford calculator, but that was for a 48 month loan </li></ul><ul><li>could use the progr...
Using  Excel  5.0 for a Solution  Monthly Payment?
Cost of Using a ‘96 Taurus for 2 Yrs. * residual value: $11,480 vs. Kelly Blue Book resale value of $13,538 ** blue book: ...
Catch 22 <ul><li>The 2-year loan looks best </li></ul><ul><li>But, …. Ford was not offering a 2-year loan, but a 4-year lo...
Some General Facts About Loans <ul><li>From our car loan example </li></ul>
Using  Excel  5.0 for a Solution
Increasing the Length of the Loan Tradeoffs <ul><li>monthly payment amount decreases </li></ul><ul><li>amount of total pay...
Using  Excel  5.0 for a Solution
Interest as a Fraction of Cost
 
 
Summary: Loans <ul><li>interest is front-loaded in payment plan </li></ul><ul><li>interest cost increases with the loan te...
Personal Financial Planning Financing Life Events
Life Event* Approach <ul><li>Marriage/commitment to significant other </li></ul><ul><li>children </li></ul><ul><ul><li>fin...
Life Cycle Approach: Learning & Earning Age Infancy Nurturing Adolescence High School Education Young Adult College Adult ...
Life Cycle Approach: The Planners Age Infancy Adolescence Young  Adult Adult Senescence 100% 50% 0 % You Parents
Life Cycle Approach: Planning Age Nurturing High School Education College Work Retirement Education: Investment in  Human ...
 
 
Planning Tools <ul><li>Assets-Liabilities Statement </li></ul><ul><ul><li>Assets Minus Liabilities = Net Worth </li></ul><...
http://www.fordcredi.com/fplanner.cgi
Income-Expense Statement
Income-Expense Statement: US Population 1988 other: health, 5%; pensions & Soc. Sec., 7%; other, 15% Source:  Guide to Und...
Assets-Liabilities Statement
Strategies for Meeting Future Expenses <ul><li>Buy a House </li></ul><ul><li>Tax-Sheltered Savings Plans </li></ul><ul><li...
 
Buying a House <ul><li>Positives </li></ul><ul><ul><li>provides space </li></ul></ul><ul><ul><li>builds equity </li></ul><...
Summary - Vocabulary - Concepts <ul><li>economic paradigm </li></ul><ul><li>down payment </li></ul><ul><li>loan term </li>...
Excel : select cell for  monthly  payment, click on Function Wizard select Financial and PMT
Excel : click on the help button in the previous window for examples
The Economic Approach to Problem Solving The Economic Paradigm
The Economic Paradigm <ul><li>describing the alternatives to choose among </li></ul><ul><li>pricing the alternatives </li>...
The Economic Paradigm example: buying a car <ul><li>describing the alternatives to choose among </li></ul><ul><ul><li>cash...
The Principle of Opportunity Cost <ul><li>No matter what we do, there are always tradeoffs. </li></ul><ul><li>Scarcity -- ...
Opportunity Costs and Production Possibilities <ul><li>The production possibility curve illustrates the principle of oppor...
THE MARGINAL PRINCIPLE <ul><li>Marginal Benefit  </li></ul><ul><li>The extra benefit resulting from  a small increase in t...
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Lecture 2

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Lecture 2

  1. 1. Introduction to Economics Elements of Personal Finance
  2. 2. Econ 109 Class Page <ul><li>Econ Home Page: http://www. econ . ucsb . edu </li></ul>
  3. 3. Economics 109 Llad Phillips Fall 2002 Introduction to Economics Hour, Location: 2:00-3:15, Engineering 1104 Instructor: Llad Phillips, Llad@econ.ucsb.edu Office Hours: NH 3032, 9:30-10:15 TuTh and 10:30-11:15 W, and by appointment Arthur O’Sullivan and Steven Sheffrin, Economics, Principles and Tools, Third Edition(2003,2001)
  4. 5. Concepts in Economics <ul><li>This Time: How to think like an economist, the economic paradigm </li></ul><ul><li>This Time: You pay for the service of the car: one year, two years, three years </li></ul><ul><li>Last Time: scarcity </li></ul><ul><li>Last Time: opportunity cost </li></ul>
  5. 6. Personal Finance Examples <ul><li>Buying a Car </li></ul><ul><li>The most important thing about the example is process : </li></ul>
  6. 7. Economists have a name for this process: The Economic Paradigm <ul><li>Step One: List your options for choice </li></ul><ul><ul><li>for example pay cash or keep the cash </li></ul></ul>
  7. 8. Economists have a name for this process: The Economic Paradigm <ul><li>Step One: </li></ul><ul><li>Step Three: pick the best option for you </li></ul><ul><ul><li>for example: keep the cash </li></ul></ul>
  8. 9. What Happened to Step Two? <ul><li>Step Two: value the options </li></ul>
  9. 10. Economics: Two Types of Issues <ul><li>Efficiency </li></ul><ul><ul><li>step 3 of the paradigm: pick the best option </li></ul></ul><ul><ul><li>optimize </li></ul></ul><ul><li>Equity </li></ul>
  10. 13. What is the next most important thing to remember from the car example? <ul><li>Two Main Costs </li></ul><ul><ul><li>depreciation </li></ul></ul><ul><ul><li>foregone interest </li></ul></ul>
  11. 14. Depreciation: Taurus, GL Sedan
  12. 16. Walnut Creek Ford Dealer <ul><li>1996 Taurus </li></ul><ul><li>Advertised Price: $16,488 </li></ul>
  13. 17. Choice: cash <ul><li>purchase price: $16,488 </li></ul><ul><li>tax at 7.5 %: $1,237 </li></ul><ul><li>documents: $35 </li></ul><ul><li>total: $17,760 </li></ul>
  14. 18. Keep Your Money This Year  Next Year Year After $17,760 $17,760 $17,760 $1,225* $1,225 $1,225 * @ 6.9 % interest $17,760 $18,985 $20,210 Buy The Car, Cash Car’s Services For 1 Yr. Car’s Services For 2 Yrs. Resale value: $14,947** $13,538# ** MSRP - Depreciation = MSRP - MSRP * 0.194 = $18,545 * 0.806 # MSRP - Depreciation = MSRP - MSRP * 0.27 = $18,545 * 0.73 Cost of Car’s Services: $4,038(1 Yr.) & $6,672(2 Yrs.)
  15. 19. Another Decision: How to Pay?
  16. 20. Choice of Payment Method <ul><li>cash </li></ul><ul><li>lease </li></ul><ul><li>loan </li></ul>
  17. 21. http://www.fordcredit.com/
  18. 22. Advertised 2-Year Lease Deal for a 1996 Taurus <ul><li>drive-off costs(payments due at lease signing): $2,136.77 </li></ul><ul><li>monthly Payment: $249 + tax </li></ul><ul><li>remember: tax + documents = $1237 + $35 = $1272, spread over 24 months, or $53 per month </li></ul><ul><li>total monthly payment: $249 + $53= $302 </li></ul><ul><li>total payments: 24*$302=$7248 </li></ul><ul><li>drive-off + payments= $9384.77 </li></ul>
  19. 23. Example Walnut Creek Dealer: 1996 , Ford Taurus, $16,488   5,976 + tax 249 + tax
  20. 24. Example 249 + tax 24 months 5,976 + tax
  21. 25. This Year  Next Year Year After $2,450 $1,225* $4,222 $6,672 * @ 6.9 % interest $4,038 Buy The Car, Cash foregone interest on $17,760: depreciation: # price+tax-blue book = $17,760 - 0.806*$18,545 $2,813# Lease, 24 months total drive-off: $2,137 $2,137 total monthly payments @$302/m.: $3,624 $7,248 foregone interest on $2,137**: $147 $294 $5908 $9679 ** Assumes no opportunity cost of monthly payments
  22. 26. What is the advantage of leasing? <ul><li>Low drive-off compared to paying $17,760 cash </li></ul>
  23. 27. http://www.fordcredit.com/calculator/calcbuffer.html
  24. 29. Cost of Using a ‘96 Taurus for 2 Yrs. * foregone interest on the drive-off of $2,137
  25. 30. Elements of Personal Finance <ul><li>Economics in every day life </li></ul><ul><ul><li>loans </li></ul></ul><ul><ul><ul><li>car loans </li></ul></ul></ul>
  26. 31. Example: Buying a New ‘96 Taurus <ul><li>Knowns </li></ul><ul><ul><li>advertised price + tax + documents: $17,760 </li></ul></ul><ul><ul><li>down payment: $2,137 </li></ul></ul><ul><ul><li>loan amount: $15,623 </li></ul></ul><ul><ul><ul><li>loan amount = $17,760 - $2,137 </li></ul></ul></ul><ul><ul><li>annual interest rate: 6.9% </li></ul></ul><ul><ul><li>loan term in months: 24 months </li></ul></ul><ul><li>Unknowns </li></ul><ul><ul><li>monthly payment </li></ul></ul>
  27. 32. Monthly Payment? <ul><li>Could use Ford calculator, but that was for a 48 month loan </li></ul><ul><li>could use the program Excel </li></ul>
  28. 33. Using Excel 5.0 for a Solution Monthly Payment?
  29. 34. Cost of Using a ‘96 Taurus for 2 Yrs. * residual value: $11,480 vs. Kelly Blue Book resale value of $13,538 ** blue book: $13,538
  30. 35. Catch 22 <ul><li>The 2-year loan looks best </li></ul><ul><li>But, …. Ford was not offering a 2-year loan, but a 4-year loan </li></ul>
  31. 36. Some General Facts About Loans <ul><li>From our car loan example </li></ul>
  32. 37. Using Excel 5.0 for a Solution
  33. 38. Increasing the Length of the Loan Tradeoffs <ul><li>monthly payment amount decreases </li></ul><ul><li>amount of total payments increases </li></ul><ul><li>amount of total interest payments increases </li></ul><ul><li>total interest as % of total payments increases </li></ul>
  34. 39. Using Excel 5.0 for a Solution
  35. 40. Interest as a Fraction of Cost
  36. 43. Summary: Loans <ul><li>interest is front-loaded in payment plan </li></ul><ul><li>interest cost increases with the loan term </li></ul><ul><li>total cost increases with the loan term </li></ul><ul><li>equity is low at the beginning of the loan </li></ul>
  37. 44. Personal Financial Planning Financing Life Events
  38. 45. Life Event* Approach <ul><li>Marriage/commitment to significant other </li></ul><ul><li>children </li></ul><ul><ul><li>financial security: insurance </li></ul></ul><ul><ul><li>housing </li></ul></ul><ul><ul><li>education </li></ul></ul><ul><li>retirement </li></ul><ul><li>long term care </li></ul><ul><li>estate </li></ul>*reference: Ernst & Young’s Personal Financial Planning Guide, 2nd Ed. John Wiley
  39. 46. Life Cycle Approach: Learning & Earning Age Infancy Nurturing Adolescence High School Education Young Adult College Adult Work Senescence Retirement Activity/ Phase:
  40. 47. Life Cycle Approach: The Planners Age Infancy Adolescence Young Adult Adult Senescence 100% 50% 0 % You Parents
  41. 48. Life Cycle Approach: Planning Age Nurturing High School Education College Work Retirement Education: Investment in Human Capital or Earning Power Accumulating Assets cars appliances furnishings --------------------- house financial assets Spending
  42. 51. Planning Tools <ul><li>Assets-Liabilities Statement </li></ul><ul><ul><li>Assets Minus Liabilities = Net Worth </li></ul></ul><ul><ul><ul><li>measure of wealth </li></ul></ul></ul><ul><li>Income-Expenditure Statement </li></ul><ul><ul><li>Income Minus Expenditures = Saving </li></ul></ul><ul><ul><ul><li>measure of change in wealth </li></ul></ul></ul>
  43. 52. http://www.fordcredi.com/fplanner.cgi
  44. 53. Income-Expense Statement
  45. 54. Income-Expense Statement: US Population 1988 other: health, 5%; pensions & Soc. Sec., 7%; other, 15% Source: Guide to Understanding Personal Finance, p. 87
  46. 55. Assets-Liabilities Statement
  47. 56. Strategies for Meeting Future Expenses <ul><li>Buy a House </li></ul><ul><li>Tax-Sheltered Savings Plans </li></ul><ul><li>Stocks and Bonds </li></ul>
  48. 58. Buying a House <ul><li>Positives </li></ul><ul><ul><li>provides space </li></ul></ul><ul><ul><li>builds equity </li></ul></ul><ul><ul><li>interest is deductible </li></ul></ul><ul><li>Negatives? </li></ul><ul><ul><li>down payment requires saving for this goal </li></ul></ul><ul><ul><li>interest payments are front-loaded, equity growth delayed </li></ul></ul><ul><ul><li>opportunity cost of not investing in stocks </li></ul></ul>
  49. 59. Summary - Vocabulary - Concepts <ul><li>economic paradigm </li></ul><ul><li>down payment </li></ul><ul><li>loan term </li></ul><ul><li>monthly payment </li></ul><ul><li>annual percentage rate or APR </li></ul><ul><li>equity </li></ul><ul><li>personal financial planning </li></ul><ul><li>life event ananysis </li></ul><ul><li>human capital </li></ul><ul><li>assets </li></ul><ul><li>liabilities </li></ul><ul><li>net worth, wealth </li></ul><ul><li>income </li></ul><ul><li>expenditures </li></ul><ul><li>savings </li></ul>
  50. 60. Excel : select cell for monthly payment, click on Function Wizard select Financial and PMT
  51. 61. Excel : click on the help button in the previous window for examples
  52. 62. The Economic Approach to Problem Solving The Economic Paradigm
  53. 63. The Economic Paradigm <ul><li>describing the alternatives to choose among </li></ul><ul><li>pricing the alternatives </li></ul><ul><li>choosing the best alternative </li></ul>
  54. 64. The Economic Paradigm example: buying a car <ul><li>describing the alternatives to choose among </li></ul><ul><ul><li>cash: the opportunity cost of losing interest </li></ul></ul><ul><ul><li>lease: depreciation included in payments </li></ul></ul><ul><ul><li>loan: sell the car to account for depreciation </li></ul></ul><ul><li>pricing the alternatives: valuation </li></ul><ul><ul><li>Oscar Wilde- economists know the price of everything and the value of nothing </li></ul></ul><ul><li>choosing the best alternative </li></ul><ul><ul><li>best: lowest cost </li></ul></ul><ul><ul><li>possibly subject to a constraint: having the $ </li></ul></ul>
  55. 65. The Principle of Opportunity Cost <ul><li>No matter what we do, there are always tradeoffs. </li></ul><ul><li>Scarcity -- limited resources -- is the reason. </li></ul><ul><li>The opportunity cost of something is what you sacrifice to get it. </li></ul>
  56. 66. Opportunity Costs and Production Possibilities <ul><li>The production possibility curve illustrates the principle of opportunity cost for an entire economy. </li></ul><ul><li>-- shows all possible combinations of goods and services available to entire economy. </li></ul><ul><li>--- principle of opportunity cost explains why production possibility curve is negatively sloped. </li></ul>
  57. 67. THE MARGINAL PRINCIPLE <ul><li>Marginal Benefit </li></ul><ul><li>The extra benefit resulting from a small increase in the activity. </li></ul><ul><li>Marginal Cost </li></ul><ul><li>The additional cost resulting from a small increase in the activity. </li></ul>
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