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### Course: Microeconomics>Unit 6

Lesson 4: Types of profit

# Depreciation and opportunity cost of capital

How to account for things when you own the building instead of renting it. Created by Sal Khan.

## Want to join the conversation?

• Shouldn't the 2M cost of purchasing the building also be included in the costs? If not, why?
• No. If you buy a \$2000000 building for \$2000000 no value is being exchanged. You are not loosing any wealth when you buy the building.
• what if the value of the building increased? would there be depreciation? how would it work?
• No. If there is an improvement in the building its value will appreciate.
• At , why depreciation cost isn't an explicit cost? I think it should be because accounting takes it into account.
• Explicit cost is a direct payment, depreciation is not a direct payment.
• In the video, Sal said that the opportunity cost of not investing the building cost (\$2M) in something else is taken at \$2M * 5% = \$100,000, assuming that our return on capital would be 5%. So with that said, what if the person in question had continued has job as a doctor (getting \$150,000) and invested the money for all the other expenses (food, labor, equipment rent, which adds up to \$250,000) in the same 5% scheme? Would \$250,000 * 5% = \$12,500 not be an opportunity cost as well? Thank you!
• If he continued to work as a doctor, he can not manage the restaurant.
• I think it is assumed that we already have the \$2 million dollars. What if we didn't have it and we had to borrow it from a bank? Then the Opportunity cost of capital would not be so high right? Since we would have to pay the bank money as interest. Am I right?
• Hi there,

Technically, no. Borrowing money, as you said, causes implicit interest costs in having to pay back the loan (so the interest charged is counted as part of the costs that come out of economic profits). However, usually, in terms of borrowing money, the interest charged is often much higher than what you get for saving money (where I live anyway). So usually, your opportunity costs for borrowing money to buy capital are going to be HIGHER than for using your own money.

Hope that helps (:
• I'm just wondering, doesn't the Rent expenses now assumed into expenses as Mortgage payment on the (\$2MM), and if so, where is it accounted for in Accounting and Economic.
• Actually in scenario B there is no mortgage payment at all. It's assumed that the building was paid for in cash. That's why you're forgoing the opportunity of investing it. It would be great if Sal showed the 3rd option, where you paid for the building by taking out a mortgage, because that would actually show up for the accountants again as an "explicit" cost.
• Depreciation is the allocation of the cost of an asset across the span of its expected life, I think, and NOT the decrease in its value, at least in accounting. Is it different in an economic perspective?? this kind of confused me
• The term depreciation can refer to both definitions you provided. It's a problem with using the same term for more than one thing. In Canada, we talk about Capital Cost Allowances as a way of amortizing costs over an expected life time, which leaves the term depreciation to mean it as Sal intended at .
• Isn't the \$2M of buying the restaurant also a part of the costs??
• There are two different ways to look at money in microeconomics. The first one is profit and the second one is cash flow. Profit is the revenue minus all the costs and cash flow is all the money you receive minus all the money you spend. Most of the time revenue and receiving money are the same. The same applies to costs and paying money. However, there are a few exceptions and buying a building is one of them. You pay for it now, but you'll be using it for many, many more years. Therefore the costs of the building will get spread out over all those years.

Let's assume the \$2 mil of buying the building are costs. What will happen? The accounting profit will drop from \$150.000 to -\$1.850.000 and the economic profit from -\$-100.000 to -\$2.100.000. This gives the impression that owning a restaurant is a terrible, terrible idea, but let's now look at the profits of year 2.
In year 2 you're not going to spend the \$2 mil to buy the building. After all, you already bought a building at the beginning of year one, and it's still in good shape, so you can just keep using it. Let's also assume all other numbers like revenue and the costs of labor remain the same for simplicity. Now in year 2 the accounting profit is \$150.000 and the economic profit is -\$100.000. Strange. The food you serve is the same, you serve just as many customers, but both profits suddenly increased by \$2 mil. Now it suddenly looks a lot better to own a restaurant. To prevent the profit from fluctuating this much in between years economics decided that buying a building is an outgoing cash flow, but not a cost.