Opportunity cost

Faced with scarcity, we have to make choices. I made a choice to drink the red wine, instead of the white. The developed world made a choice not to forgive third world debt. I'm making a choice in sitting here, writing this node on 1am Christmas day.

Opportunity cost is the cost of what I'm missing out on. It is the value of the BEST alternative forgone. By best alternative in my case, is to be on my bike, cycling my way into the night and out of this joint.

An opportunity cost is expressed in relative prices. If a coffee and a chocolate bar were the only two goods that existed in the world (ok, just pretend), and a coffee cost $1, and a chocolate $0.50, then the opportunity cost of one coffee is two chocolates.

This writeup sounds a bit too bitter to be about economics.

In microeconomic theory, the term "cost" must be understood as "opportunity cost". Whenever a person (or a firm or some other economic agent) undertakes an action she foregoes a number of alternative actions. A day at the races cannot also be a day in June or Ralph (as one's preferences and opportunities may allow). Money spent on a night at the opera cannot also be spent on lingerie. The best foregone alternative to any action a person takes, that is, the action the person would have undertaken if they had not done what they did, is the opportunity cost of that action.

It is difficult to directly measure the opportunity cost of an action taken by a person as one needs to know how much the individual valued a hypothetical action, the next best alternative to the action undertaken. While it is common in microeconomics textbooks to see the claim that the opportunity cost of a consumption good is what could be purchased for the same price, this is only true if the net benefit the consumer gains from consumption (called consumer surplus) of the two alternatives is the same. It is easier to evaluate the opportunity cost of a profit-maximising firm as this is the largest profit the firm forewent when it chose what it did.

For a brief but deep discussion of opportunity cost see James M. Buchanan, 1987, Opportunity cost, in The New Palgrave: A Dictionary of Economics, Ed by John Eatwell et al, Vol. 3, MacMillan ISBN 0-935859-10-1 (set) pp. 718-21. For a history of the concept of cost in economics see James M. Buchanan, 1967-68, Cost and Choice, Liberty Press, available on-line at http://www.econlib.org/library/Buchanan/buchCv6Contents.html.

The problem with many text books concerning any subject is that each text book tends to define something in its own wording. One such definition states that opportunity cost is, "obtaining something (either a service, a product, or time, whatever tangible or intangible thing that can be obtained) by giving up something else." The best way to make any definition concrete is by stating examples, and listed below are some examples.

John Doe is faced with the choice of obtaining a note book from company A or company B, Doe chose company B, the cost of Doe's choice is giving up A to obtain B. Why? Because B is his best alternative, and there are many variables to consider, starting from price, his income, and the features he liked when comparing A over B.

John Doe is considering between working a full time job that pays $20,000, or getting a bachelor degree that will give him $40,000 after graduation. Doe choses education over work, the oppurtunity cost of education is losing the $20,000 job because education is his best alternative. However, he could work, and by working the oppurtunity cost of his working is losing the $40,000 income after graduation.

It all boils down to the best alternative since economics usualy have too many variables to take into consideration.

In economics, opportunity cost is value that you cannot consume because it is not possible to consume all alternatives.

This is often misunderstood, as opportunity costs only include the difference in value that is forgone, not the entire value. For example:

I need to eat breakfast. Sadly, I only have room in my stomach for one breakfast. I look at my options and see that I can buy pancakes for $5 or waffles for $5. I love both, and value them at $8 each. I'm getting a great deal either way, but I choose pancakes. If opportunity were not limited, I would buy both... but I can't. Opportunity cost is $3, the additional value that I was offered (in the form of delicious waffles), but that I could not take advantage of.

I need to eat lunch. Sadly, I only have room in my stomach for one lunch. I look at my options, and see that I can eat a bowl of oatmeal for $1, or steak for $10. As it happens, I don't much care for oatmeal, but it will fill me up, and I think that the oatmeal is indeed worth $1. I do like steak, and value it ten times as much as I do oatmeal. But... this means that both the oatmeal and the steak are priced at exactly the correct value. It doesn't matter which I eat, there is no opportunity cost. (If I choose oatmeal, any sadness that I feel at forgoing steak is exactly offset at the joy I feel at having those extra nine dollars in my pocket).

I need to eat supper. Sadly, I only have room in my stomach for one supper. I look at my options, and see that I could have pizza for $10, or calzone for $10. I like pizza more than calzone; I value a pizza at $12, but a calzone at only $8. If I chose the calzone (why?!), the opportunity cost would be $4 -- the $2 I spent above my perceived value of the calzone, and the $2 worth of value that I would have gained in enjoyment of the pizza.

Of course, usually opportunity cost isn't limited by stomach capacity. My breakfast conundrum could just as easily be caused by lack of funds; if I had only $5 in my pocket, then I would still have to make a choice with an opportunity cost of $3. Opportunity is also often limited by time (e.g., I only have 15 minutes to eat).

Unfortunately, most examples are much more complex than meal choices, and the opportunity cost of going to college vs. starting work four years earlier is not calculable in precise terms -- you would have to know exactly what career path you would follow, including how quickly you can be hired under each scenario, how much you will earn at each job, how often you change jobs, health risks and costs associated with each job, and extra-monetary concerns like stress and quality of work environment. However, we usually have ample information to determine which course to follow, even using vague intuitions of possible opportunities and costs, in large part because many of the values we are balancing are not monetary, but social or emotional.

Perhaps the most clear-cut cases of opportunity cost is in financial investment, where one can track both the results of one's investments and the outcomes of alternative investments one could have made. While this is interesting in helping provide a post-mortem of your finances, it doesn't provide much guidance for future investments, as the central question of planning investments is how much risk you are willing to tolerate, with the greatest potential rewards coming from those investments where opportunity cost is least calculable.