1. Llad Phillips1 Introduction to Economics Elements of Personal Finance

2. Llad Phillips2 Econ 109 Class Page n Econ Home Page: http://www.econ.ucsb.edu http://www.econ.ucsb.edu

3. Economics 109Llad PhillipsFall 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)

5. Llad Phillips5 Concepts in Economics n This Time: How to think like an economist, the economic paradigm n This Time: You pay for the service of the car: one year, two years, three years n Last Time: scarcity n Last Time: opportunity cost

6. Llad Phillips6 Personal Finance Examples n Buying a Car n The most important thing about the example is process:

7. Llad Phillips7 Economists have a name for this process: The Economic Paradigm n Step One: List your options for choice u for example pay cash or keep the cash

8. Llad Phillips8 Economists have a name for this process: The Economic Paradigm n Step One: n Step Three: pick the best option for you u for example: keep the cash

9. Llad Phillips9 What Happened to Step Two? n Step Two: value the options

10. Llad Phillips10 Economics: Two Types of Issues n Efficiency u step 3 of the paradigm: pick the best option u optimize n Equity

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13. Llad Phillips13 What is the next most important thing to remember from the car example? n Two Main Costs u depreciation u foregone interest

14. Llad Phillips14 Depreciation: Taurus, GL Sedan

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16. Llad Phillips16 Walnut Creek Ford Dealer n 1996 Taurus n Advertised Price: $16,488

17. Llad Phillips17 Choice: cash n purchase price: $16,488 n tax at 7.5 %: $1,237 n documents: $35 n total: $17,760

18. Llad Phillips18 Keep Your Money This Year  Next Year Year After $17,760 $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.)

19. Llad Phillips19 Another Decision: How to Pay?

20. Llad Phillips20 Choice of Payment Method n cash n lease n loan

21. http://www.fordcredit.com/

22. Llad Phillips22 Advertised 2-Year Lease Deal for a 1996 Taurus n drive-off costs(payments due at lease signing): $2,136.77 n monthly Payment: $249 + tax n remember: tax + documents = $1237 + $35 = $1272, spread over 24 months, or $53 per month n total monthly payment: $249 + $53= $302 n total payments: 24*$302=$7248 n drive-off + payments= $9384.77

23. Example Walnut Creek Dealer: 1996, Ford Taurus, $16,488   5,976 + tax 249 + tax

24. Example 249 + tax 24 months 5,976 + tax

25. Llad Phillips25 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 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

26. Llad Phillips26 What is the advantage of leasing? n Low drive-off compared to paying $17,760 cash

27. http://www.fordcredit.com/calculator/calcbuffer.html

29. Llad Phillips29 Cost of Using a ‘96 Taurus for 2 Yrs. * foregone interest on the drive-off of $2,137

30. Llad Phillips30 Elements of Personal Finance n Economics in every day life u loans F car loans

31. Llad Phillips31 Example: Buying a New ‘96 Taurus n Knowns u advertised price + tax + documents: $17,760 u down payment: $2,137 u loan amount: $15,623 F loan amount = $17,760 - $2,137 u annual interest rate: 6.9% u loan term in months: 24 months n Unknowns u monthly payment

32. Llad Phillips32 Monthly Payment? n Could use Ford calculator, but that was for a 48 month loan n could use the program Excel

33. Using Excel 5.0 for a Solution Monthly Payment?

34. Llad Phillips34 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

35. Llad Phillips35 Catch 22 n The 2-year loan looks best n But, …. Ford was not offering a 2-year loan, but a 4-year loan

36. Llad Phillips36 Some General Facts About Loans n From our car loan example

37. Using Excel 5.0 for a Solution

38. Llad Phillips38 Increasing the Length of the Loan Tradeoffs n monthly payment amount decreases n amount of total payments increases n amount of total interest payments increases n total interest as % of total payments increases

39. Using Excel 5.0 for a Solution

40. Llad Phillips40 Interest as a Fraction of Cost

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43. Llad Phillips43 Summary: Loans n interest is front-loaded in payment plan n interest cost increases with the loan term n total cost increases with the loan term n equity is low at the beginning of the loan

44. Llad Phillips44 Personal Financial Planning Financing Life Events

45. Llad Phillips45 Life Event* Approach n Marriage/commitment to significant other n children u financial security: insurance u housing u education n retirement n long term care n estate *reference: Ernst & Young’s Personal Financial Planning Guide, 2nd Ed. John Wiley

46. Life Cycle Approach: Learning & Earning Age Infancy Nurturing Adolescence High School Education Young Adult College Adult Work Senescence Retirement Activity/Phase:

47. Life Cycle Approach: The Planners Age InfancyAdolescence Young AdultAdultSenescence 100% 50% 0 % You Parents

48. Life Cycle Approach: Planning Age Nurturing High School Education CollegeWorkRetirement Education: Investment in Human Capital or Earning Power Accumulating Assets cars appliances furnishings --------------------- house financial assets Spending

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51. Llad Phillips51 Planning Tools n Assets-Liabilities Statement u Assets Minus Liabilities = Net Worth F measure of wealth n Income-Expenditure Statement u Income Minus Expenditures = Saving F measure of change in wealth

52. http://www.fordcredi.com/fplanner.cgi

53. Llad Phillips53 Income-Expense Statement

54. Llad Phillips54 Income-Expense Statement: US Population 1988 other: health, 5%; pensions & Soc. Sec., 7%; other, 15% Source: Guide to Understanding Personal Finance, p. 87

55. Llad Phillips55 Assets-Liabilities Statement

56. Llad Phillips56 Strategies for Meeting Future Expenses n Buy a House n Tax-Sheltered Savings Plans n Stocks and Bonds

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58. Llad Phillips58 Buying a House n Positives u provides space u builds equity u interest is deductible n Negatives? u down payment requires saving for this goal u interest payments are front-loaded, equity growth delayed u opportunity cost of not investing in stocks

59. Llad Phillips59 Summary - Vocabulary - Concepts n economic paradigm n down payment n loan term n monthly payment n annual percentage rate or APR n equity n personal financial planning n life event ananysis n human capital n assets n liabilities n net worth, wealth n income n expenditures n savings

60. Excel: select cell for monthly payment, click on Function Wizard select Financial and PMT

61. Excel: click on the help button in the previous window for examples

62. Llad Phillips62 The Economic Approach to Problem Solving The Economic Paradigm

63. Llad Phillips63 The Economic Paradigm n describing the alternatives to choose among n pricing the alternatives n choosing the best alternative

64. Llad Phillips64 The Economic Paradigm example: buying a car n describing the alternatives to choose among u cash: the opportunity cost of losing interest u lease: depreciation included in payments u loan: sell the car to account for depreciation n pricing the alternatives: valuation u Oscar Wilde- economists know the price of everything and the value of nothing n choosing the best alternative u best: lowest cost u possibly subject to a constraint: having the $

65. Llad Phillips65 The Principle of Opportunity Cost n No matter what we do, there are always tradeoffs. n Scarcity -- limited resources -- is the reason. The opportunity cost of something is what you sacrifice to get it.

66. Llad Phillips66 Opportunity Costs and Production Possibilities n The production possibility curve illustrates the principle of opportunity cost for an entire economy. -- shows all possible combinations of goods and services available to entire economy. -- shows all possible combinations of goods and services available to entire economy. --- principle of opportunity cost explains why production possibility curve is negatively sloped. --- principle of opportunity cost explains why production possibility curve is negatively sloped.

67. Llad Phillips67 THE MARGINAL PRINCIPLE n Marginal Benefit The extra benefit resulting from a small increase in the activity. The extra benefit resulting from a small increase in the activity. n Marginal Cost The additional cost resulting from a small increase in the activity. The additional cost resulting from a small increase in the activity.