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Pastimes : Austrian Economics, a lens on everyday reality -- Ignore unavailable to you. Want to Upgrade?

To: Don Lloyd who wrote (1)	12/1/2001 9:16:12 AM
From: Terry Maloney	Read Replies (1) \| Respond to of 445

Hi Don, it's surprising no one has started an Austrian thread til now. Hope it does well. As for your puzzle, it seems obvious that you'd accept the offer. You'd only be selling that diamond in year 65 anyway, by which time the 125K would have compounded into 2 million. Best, Terry

To: Don Lloyd who wrote (1)	12/2/2001 2:06:38 AM
From: Don Lloyd	Read Replies (1) \| Respond to of 445

To All, I will repost the problem here and then space down and post the (my?) answer at the bottom. An Economic Puzzle Assume that you are the owner of a new, private, diamond marketing company located on a remote, tax-free island nation. Your entire company assets consist of an inventory of 65 large, identical, flawless, uniquely cut diamonds, which you have just acquired from the estate of a world famous diamond cutter for $24.375M in cash, or $375K each. Your company has a single employee, holding the title of President and Marketing Manager, and earning an annual salary of $250K, which represents and includes the entire annual expense budget for the company. The entire net cash flow of the company, revenues minus expenses, is paid out to you in an annual dividend and is placed in an interest-bearing demand account compounding at a 4.5% real (and nominal) rate per annum, a rate that results in a time to double of 16 years. The annual market demand schedule for your diamonds is presumed to be time-invariant, to have a perfect unitary price elasticity of demand and no possibility of price discrimination, and to have a demand independent of previous sales. In particular, a price of $1M produces a demand for 1 diamond per year, a price of $500K produces a demand for 2 diamonds per year, and so forth. Your President has just presented you with an offer to reduce his current year's salary from $250K to $125K in exchange for a single diamond which he intends to have crafted into a unique engagement ring to bestow on his prospective fiancee. Is a decision to accept this offer, a form of partial non-cash compensation, of a one-time salary reduction of $125K in exchange for a diamond whose cash acquisition cost was $375K, and which has a possible market value of up to $1M, and a net cash flow of up to $750K, financially justified? Why, or why not? . . . . . . . . . . . . . . Answer to an Economic Puzzle - The first thing to decide is the sales schedule. Since increasing the sales rate from 1 to 2 diamonds a year doesn't increase the total revenue, it is clear that 1 diamond will be sold a year for 65 years. The key is that the opportunity cost to the company of saving the $125K in salary is foregoing the $1M sale price of a diamond, but that is delayed 64 years into the future as there is no current opportunity cost at all until the last diamond is removed from inventory. Investment of the $125K savings at 4.5% for 64 years would result in $2M at that time, a 16 fold (four doubles) increase, as compared with the $1M sale price of the diamond in year 65 less the $250K salary for a net of $750K. Alternately, working backwards, the discounted present value of the net proceeds of $750K in year 65 is only $750K/16 or $46.875K. In either case, it is clear that the one time salary reduction is a good investment. Note that the initial acquisition cost of $375K per diamond does not figure in the answer to the salary reduction question. This is because it is a sunk cost as far as deciding whether or not to accept the salary reduction offer. However, even in the first year, the $375K cost diamond has only returned a double to $750K. In the ninth year, an investment of the $375K at 4.5% would have compounded to the $750K breakeven level. Thus only the first eight diamonds show a real profit, the ninth is breakeven and all the rest lose money. Not wanting to bother working out the total profit or loss for all 65 diamonds, it nevertheless seems likely that it is a loss. While this problem has little or no unique Austrian economic content, as the fact of opportunity cost (as opposed to accounting cost), sunk costs and the time value of money should all be mainstream economics as well, it serves to show that what looked initially like a silly choice, was fully justified. In fact this problem has a similar appearance, although for different reasons, to that of employee stock options. Regards, Don

To: Don Lloyd who wrote (1)	12/4/2001 5:15:11 AM
From: Don Lloyd	Respond to of 445

"...SANTA ROSA, Calif., Dec. 4 /PRNewswire/ -- To show the vast improvement in brilliance when diamonds are cut using high-precision technology, 8Star Diamond Co. is sending a $1-million diamond on tour to demonstrate the success of its new cutting method. (Photo: newscom.com ) To prove the 8Star approach benefits any diamond, the company bought a $1-million 15-carat diamond given the highest ratings for color, clarity and cutting by the Gemological Institute of America and is exhibiting the much-improved 13.41-carat recut, now the "American Star," in its 45 franchise stores nationwide. See www.eightstar.com. "When it comes to diamonds, it isn't size that matters. It's sizzle," says Richard von Sternberg, 8Star's president. "Most diamonds would have to lose at least 15% of their weight to become as beautiful as ours. Since we believe consumers should pay only for beauty, we cut only for beauty." Using an exclusive light-tracking instrument called a Firescope(TM), 8Star cutters align facets so precisely their diamonds achieve the highest brilliance possible -- making even the tiniest engagement stone blaze with light. To most of 8Star's competitors who cut for bulk not beauty, sacrificing 10% of a giant jewel's weight is a catastrophic loss. But von Sternberg sees the loss as a gain. The American Star took six weeks to recut after ten months of planning. On average, however, 8Stars require 32 hours to complete -- still a long time compared to 8 hours for other fine diamonds. But cutting for beauty takes time. "One reason for the slow grind is that 8Star cutters consult with the Firescope at every stage of work," von Sternberg says. "That usually means 200 Firescope checks. In the case of the American Star, I lost count at 500." Without a Firescope, diamond cutting is guesswork, according to von Sternberg. "With it, our cutters can look inside a diamond and fix problems fatal to diamond beauty other cutters never see." The Firescope isn't only a guidance tool for cutters. It's a quality assurance tool for consumers. When a diamond's facets are aligned, they make a distinctive 8-rayed pattern called an "8star." This pattern serves as visual proof that a diamond has reached what von Sternberg calls "8Star's norm of perfection."..." Regards, Don