1.2: Opportunity Cost

• Anonymous by request

LEARNING OBJECTIVES

1. What is opportunity cost?
2. How is it computed?
3. What is its relationship to the usual meaning of cost?

Economists think of cost in a slightly quirky way that makes sense, however, once you think about it for a while. We use the term opportunity cost to remind you occasionally of our idiosyncratic notion of cost. For an economist, the cost of buying or doing something is the value that one forgoes in purchasing the product or undertaking the activity of the thing. For example, the cost of a university education includes the tuition and textbook purchases, as well as the wages that were lost during the time the student was in school. Indeed, the value of the time spent in acquiring the education is a significant cost of acquiring the university degree. However, some “costs” are not opportunity costs. Room and board would not be a cost since one must eat and live whether one is working or at school. Room and board are a cost of an education only insofar as they are expenses that are only incurred in the process of being a student. Similarly, the expenditures on activities that are precluded by being a student—such as hang-gliding lessons, or a trip to Europe—represent savings. However, the value of these activities has been lost while you are busy reading this book.

Opportunity cost is defined by the following:

The opportunity cost is the value of the best forgone alternative.

This definition emphasizes that the cost of an action includes the monetary cost as well as the value forgone by taking the action. The opportunity cost of spending $19 to download songs from an online music provider is measured by the benefit that you would have received had you used the$19 instead for another purpose. The opportunity cost of a puppy includes not just the purchase price but the food, veterinary bills, carpet cleaning, and time value of training as well. Owning a puppy is a good illustration of opportunity cost, because the purchase price is typically a negligible portion of the total cost of ownership. Yet people acquire puppies all the time, in spite of their high cost of ownership. Why? The economic view of the world is that people acquire puppies because the value they expect exceeds their opportunity cost. That is, they reveal their preference for owning the puppy, as the benefit they derive must apparently exceed the opportunity cost of acquiring it.

Even though opportunity costs include nonmonetary costs, we will often monetize opportunity costs, by translating these costs into dollar terms for comparison purposes. Monetizing opportunity costs is valuable, because it provides a means of comparison. What is the opportunity cost of 30 days in jail? It used to be that judges occasionally sentenced convicted defendants to “thirty days or thirty dollars,” letting the defendant choose the sentence. Conceptually, we can use the same idea to find out the value of 30 days in jail. Suppose you would pay a fine of $750 to avoid the 30 days in jail but would serve the time instead to avoid a fine of$1,000. Then the value of the 30-day sentence is somewhere between $750 and$1,000. In principle there exists a critical price at which you’re indifferent to “doing the time” or “paying the fine.” That price is the monetized or dollar cost of the jail sentence.

The same process of selecting between payment and action may be employed to monetize opportunity costs in other contexts. For example, a gamble has a certainty equivalent, which is the amount of money that makes one indifferent to choosing the gamble versus the certain payment. Indeed, companies buy and sell risk, and the field of risk management is devoted to studying the buying or selling of assets and options to reduce overall risk. In the process, risk is valued, and the riskier stocks and assets must sell for a lower price (or, equivalently, earn a higher average return). This differential, known as a risk premium, is the monetization of the risk portion of a gamble.

Buyers shopping for housing are presented with a variety of options, such as one- or two-story homes, brick or wood exteriors, composition or shingle roofing, wood or carpet floors, and many more alternatives. The approach economists adopt for valuing these items is known as hedonic pricing. Under this method, each item is first evaluated separately and then the item values are added together to arrive at a total value for the house. The same approach is used to value used cars, making adjustments to a base value for the presence of options like leather interior, GPS system, iPod dock, and so on. Again, such a valuation approach converts a bundle of disparate attributes into a monetary value.

The conversion of costs into dollars is occasionally controversial, and nowhere is it more so than in valuing human life. How much is your life worth? Can it be converted into dollars? Some insight into this question can be gleaned by thinking about risks. Wearing seatbelts and buying optional safety equipment reduce the risk of death by a small but measurable amount. Suppose a $400 airbag reduces the overall risk of death by 0.01%. If you are indifferent to buying the airbag, you have implicitly valued the probability of death at$400 per 0.01%, or $40,000 per 1%, or around$4,000,000 per life. Of course, you may feel quite differently about a 0.01% chance of death compared with a risk 10,000 times greater, which would be a certainty. But such an approach provides one means of estimating the value of the risk of death—an examination of what people will, and will not, pay to reduce that risk.

KEY TAKEAWAYS

• The opportunity cost is the value of the best-forgone alternative.
• Opportunity cost of a purchase includes more than the purchase price but all of the costs associated with a choice.
• The conversion of costs into dollar terms, while sometimes controversial, provides a convenient means of comparing costs.