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Opportunity cost

From Academic Kids

Opportunity cost is a term used in economics, to mean the cost of something in terms of an opportunity foregone (and the benefits that could be received from that opportunity), or the most valuable foregone alternative. For example, if a city decides to build a hospital on vacant land that it owns, the opportunity cost is some other thing that might have been done with the land and construction funds instead. In building the hospital, the city has forgone the opportunity to build a sporting center on that land, or a parking lot, or the ability to sell the land to reduce the city's debt, and so on. In more personal terms, the opportunity cost of spending a Friday night drinking with your friends could be the amount of money you could have earned if you had devoted that time to working overtime.

Opportunity cost need not be assessed in monetary terms, but rather, is assessed in terms of anything that is of value to the person or persons doing the assessing. The consideration of opportunity costs is one of the key differences between the concepts of economic cost and accounting cost. Assessing opportunity costs is fundamental to assessing the true cost of any course of action. In the case where there is no explicit accounting or monetary cost (price) attached to a course of action, ignoring opportunity costs may produce the illusion that its benefits cost nothing at all. The unseen opportunity costs then become the hidden costs of that course of action.

The application of the concept of opportunity cost looks for the hidden cost of any and every individual economic decision. Ignorance of the economic concept of opportunity cost has produced common economic fallacies, such as the broken window fallacy described by Frederic Bastiat.

Contents

Applications and Complications

The simplest way to estimate the opportunity cost of any single economic decision is to consider, "What is the next best alternative choice that could be made?" (This is even though most economic decisions involve multiple alternatives.) The opportunity cost of paying for college this semester could be the ability to make car payments. The opportunity cost of a vacation in the Bahamas could be the down payment money for a house.

Note that opportunity cost is not the sum of the available alternatives, but rather of benefit of the best alternative of them. The opportunity cost of the city's decision to build the hospital on its vacant land is the loss of the land for a sporting center, or the inability to use the land for a parking lot, or the money that could have been made from selling the land, or the loss of any of the various other possible uses -- but not all of these in aggregate.

It is important, as individuals and as societies, to compare the opportunity costs associated with various courses of action. However, some opportunities may be difficult to compare along all relevant dimensions.

Economists often try to use the market price of each alternative to measure opportunity cost. This method, however, presents a considerable difficulty, since many alternatives do not have a market price. It is very difficult to agree on a way to place a dollar value on a wide variety of intangible assets. How does one calculate the cost in dollars, pounds, euros, or yen for the loss of clean air, or the loss of seaside views, or the loss of pedestrian access to a shopping center, or the loss of an untouched virgin forest? Since their costs are difficult to quantify, intangible values associated with opportunity cost can easily be overlooked or ignored.

To overcome this difficulty, economists have identified certain opportunity costs as spillover costs (or external costs). If a chemical producer dumps its waste products into a river, the company has effectively shifted part of the cost of its production onto those living downstream who like to fish. If a billboard company blocks the seaside view of passers-by, some of its gain in advertising revenue is being paid by the passers-by who enjoy natural vistas, instead of by the company's advertisers.

Typically, spillover costs are imposed by a narrower group (often called a special interest group) which benefits more quantifiably and more concretely, and they are borne by a wider group -- perhaps even the public at large -- which pays less quantifiably and less concretely. For this reason, spillover costs are most often controlled by politics and government regulation rather than by markets. Regulations against pollution and building codes restricting billboard locations are examples.

Special interest groups, with a particular political or financial gain in mind, usually find incentives to underestimate or ignore the opportunity costs associated with their activities or agendas (especially when the opportunity costs are spillover costs, that can be imposed upon others), but at times such groups find incentives to overestimate them.

Another difficulty in fixing opportunity cost exists on the macroeconomic level, and is empirical in nature. Discovering the real effect of a change in production of butter specific to the production of guns in an economy as large and multifarious as, say, that of the United States, would be nightmarishly complex.

For that reason, opportunity cost is usually figured within some specific budget of resources. For example, "If the state spends $200 million more on highways it will have $200 million less to spend on schools." Or, "If our company invests $10 million in R+D, it can't give a $1 million Christmas bonus to each of its top ten executives." Or, "If I buy fifty lottery tickets, I won't have these two twenties and one ten left in my wallet for groceries."

Although opportunity cost can be hard to quantify, its effect is universal and very real on the individual level. The principle behind the economic concept of opportunity cost applies to all decisions, not just economic ones. The word "decide" comes from the Latin decidere, meaning "to cut off"; being the prefix de plus the root caedere, "to cut". By definition, any decision that is made cuts off other decisions that could have been made. If one makes a right turn at an intersection, she or he precludes the possibility of having made a left turn. And so forth.

Since the work of the Austrian economist Friedrich von Wieser, opportunity cost has been seen as the foundation of the marginal theory of value.

An Eternal Truth?

Many see the concept of opportunity cost as one of the very few profound "eternal truths of economics," a result of the universal nature of scarcity as the economic problem. A classic illustration of the concept (posed by Otto von Bismarck) envisions an imaginary economy capable of producing only two products: Guns and Butter (i.e. military goods verses civilian goods). If all the resources of this economy were used to produce guns, let's imagine that 100,000 guns could be produced. If, instead, all the resources were used to produce butter, let's imagine that 100,000,000 units of butter could be produced.

So, should this economy's resources be used in practice to produce 50,000,000 units of butter, there will be an opportunity cost in terms of guns. Instead of the 100,000 guns the economy could have produced, it may now only be able to produce 50,000. Conversely, should this economy's resources be used in practice to produce 75,000 guns, there will be an opportunity cost in terms of butter. Instead of the 100,000,000 units of butter the economy could have produced, it may now only be able to produce 25,000,000.

Missing image
NewG_and_b.jpeg
the guns and butter PPF

The graph that depicts opportunity cost between any two given items produced by a given economy is known in economics as the production possibility frontier or curve or "PPF." The curve describing this frontier is not straight, but is curved outward away from the axes to reflect the higher marginal costs that become inevitable due to diminishing returns at the extremes. In the real world, the point on the graph that describes the two given items' position will always lie somewhere well within the frontier (as shown), due to the resources used by all the other goods and services that the given economy produces. However, in the imaginary economy discussed above which produces only guns and butter, the economy will be operating on the PPF (as shown by the arrow) if all resources (inputs) are fully utilized and used most appropriately (efficiently). The exact combination of guns and butter produced depends on the mechanisms used to decide the allocation of resources (i.e., some combination of markets, government, tradition, and community democracy).

This choice can also change. But any move upward or to the right along the PPF involves an opportunity cost. (Scarcity means that cannot go above or the right of the PPF.) Any increase in gun production (a move upward) would reduce the amount of butter that can be produced, while increase in civilian production (moving to the right) would reduce the economy's ability to produce military products. On the PPF, scarcity and opportunity cost prevail.

Others argue that while it is true for most individuals that most or even all choices incur some sort of opportunity cost (i.e., that something is being given up), the concept of opportunity cost does not always apply when viewed from the societal level. Suppose that the economy starts with large amounts of unused capital equipment and unemployed labor, as in the United States (and many other countries) in 1939. In that case, the "guns and butter" economy is inside its PPF (and not due to the production of other outputs). In this situation, it is possible to raise the employment of both capital goods and labor, raising the production of both military goods and civilian goods. In fact, the U.S. did exactly this at the onset of World War II.

This is an example of "Keynesian inefficiency" being solved by increasing aggregate demand. More generally, if inputs are either underemployed or inappropriately employed, the production of both guns and butter can be increased by abolishing inefficiency. In the graph, the economy moves from the "inefficient points" inside the PPF to the PPF itself.

Unfortunately, we may not always be able to get this "free lunch" because special interests often oppose such policies. They may impose institutional opportunity costs that represent more than natural or technological scarcity. Thus, we may see a price that represents political, economic, or social power rather than opportunity cost.

The position of the PPF is not static. It shifts outward (upward and/or to the right) when an economy’s ability to produce increases, i.e., an increase in the aggregate number of guns and butter that can be produced. This can happen if the availability of resources (factors of production) increases, or if technology or management skills improve. Few if any of these changes are "free": for example, increasing the amount of capital goods requires sacrifice of current consumption. Thus, there is a clear opportunity cost. Some shifts may be inexpensive, however, as with some technological change.

The PPF shifts inward when an economy’s ability to produce decreases, reflecting a decrease in the aggregate number of military and civilian goods that can be produced. This is possible due to some major disaster, such as hurricanes or military invasion. The PPF of the Roman Empire probably shifted inward due to the "barbarian" invasions and the end of regular law and order.

See also


External links

Topics in microeconomics

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Scarcity | Opportunity cost | Supply and demand | Elasticity | Economic surplus | Aggregation of individual demand to total, or market, demand | Consumer theory | Production, costs, and pricing | Market form | Welfare economics | Market failure
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