Interpreting Interest Rates in Three Ways
Suppose you are meeting friends at your favorite restaurant. They've already eaten and still have two tacos left. You have to decide if you want to get your favorite dish, a USD 12 seared tuna salad—which you value at USD 20—or eat the leftover tacos for free. How much would you need to value the tacos at in order for the two options to be equally desirable?
That’s right!
If you choose to order the salad, you need to compare its net benefit $$(20-12)$$ to the benefit you could gain by eating the tacos.
The benefit of what is not chosen is called the **opportunity cost**. In other words, it is the unrealized benefit of making a different choice. Picking the best option means that the opportunity cost won't be more than the benefit of what you chose.
Not quite. That's the cost of salad only. It doesn't factor in the benefit you derive from eating it. If you value the tacos at USD 12, you would prefer to get those for free than to pay USD 12 for the salad you value at USD 20.
Not exactly. While you value the salad at USD 20, you need to pay USD 12 to get it. On the other hand, the tacos are free, so you shouldn't need to value them as highly to make the options equally desirable.
Opportunity cost can also be expressed as a rate when the benefit is a rate of return. You are deciding on a savings account, and your options for interest rates are 2%, 1.5%, and 1%. What is the opportunity cost of selecting the 2% savings account?
No.
The opportunity cost is not the difference between two choices. It is 1.5%.
Not quite.
Given the options available, you'd probably select one of the two rates higher than 1%. It is 1.5%.
Indeed.
Incorrect.
This is the rate that has been chosen, so it is the opportunity taken. The opportunity cost is 1.5%.
Clearly, you'd want to invest in the highest savings rate possible, so the 2% makes sense. Suppose you deposit USD 100 into the savings account with a 2% interest rate. After one year, you withdraw the USD 102 in the account. Why did the bank pay you USD 2 interest to hold your USD 100 for a year?
Not so. The bank is in business to make money for its investors, not to ensure your buying power.
Not quite. Although USD 2 seems like a small amount, the bank may have millions of customers, so that small amount can add up.
That’s right.
The interest you are paid is compensation for being able to use your money while it is deposited. Or put another way, the **interest rate** is the rate of return that is required for compensation when making an investment.
An interest rate is just one way to think about the fact that having some money now can be equivalent to getting more money at some point in the future. Because of the many options you have with money you currently have, there is some minimum rate of return you would need to receive in order to invest it.
Suppose the car that you use to get to work breaks down, and you need all the available cash you currently have to fix it. How would that situation affect the minimum rate of return you would need in order to invest your available cash?
Correct!
Incorrect.
Incorrect.
If you take the risk that all your available funds would not be enough to ensure your car is properly fixed, you'd want to ensure that the rate of return properly compensates you for spending those funds on a car that's still broken.
The rate that equalizes the current value of the money to a value of money in the future is called the **discount rate**. It is another way of thinking about the time value of money and is used to calculate present and future values.
Nice try, but no.
The opportunity cost is the interest rate that was missed out on by selecting the 2% rate, which is 1.5% in this case.
Incorrect.
The opportunity cost is the value unrealized. Since all of the possible values are positive, it is a positive value. In this case, 1.5%.
To summarize:
[[summary]]
Even though you have multiple options, the opportunity cost is just the benefit of the best unchosen option because you can't get both the 1% and 1.5% rates of return on the same money. Essentially, you're forced to pick only one rate to invest in, and miss out on the opportunity to invest in those other savings opportunities.
USD 8
USD 12
USD 20
0.5
1
1.5
2
To offset the loss in value due to inflation
Because USD 2 doesn’t make a difference to a bank
The bank thought it could make more than USD 2 with the USD 100
Increase it
Decrease it
It would be unchanged
Other responses
0
-0.5
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