Question

1. Suppose that ten years ago, Cece had $1,000 to either invest in a certificate of deposit (CD) or purchase a used car. By the end of year 10, the CD would earn $100 in interest and the used car would be worth $200. Assume Cece decided to buy the used car instead of investing her money in the CD. (2 pts.)
   1. Identify the forgone interest
2. 2. Calculate the economic depreciation.

Answer 1

a. This forgone interest is called Opportunity Cost.

Opportunity Cost of an activity is equal to the value of next best alternative forgone(sacrificed).In other words,opportunity cost represents the benefits an individual,investor or business misses out when choosing one alternative over other.Since,the available resources are fixed at any point of time,so we have to give up one alternative to choose another.Business owners should consider opportunity cost to make better and profitable decisions when they have multiple options before them.

Similarly,here Cece had a choice to either invest in CD or purchase a used car.By the end of year 10,the CD would earn $100 in interest and the used car would would be worth $200.She chose to buy the used car which made her sacrifice $100 that she could have earned if she had chosen to invest in CD.She made a good decision because in this way she is gaining more i.e. $200 than what she would have gained by investing in CD i.e. $100.

b. Economic Depreciation means a reduction in the value of an asset over time due to wear and tear.

Here,Cece purchased the used car for $1000 but after 10 years the used car would be worth only $200.So,the reduction in its value is called economic depreciation i.e. $1000- $200 = $800.