Agricultural Economics: Opportunity Costs
1.0 Introduction
Economics is a social science and is primarily concerned with the study of human decision-making. Decision-making involves making choices between competing alternatives. For example, (i) should I go to class today or sleep in; (ii) should I walk to campus or drive my car; and (iii) should I major in agricultural economics or animal science? In all of these and other decisions that we make, we have to make trade-offs. That is, to make one choice we have to give up something else. In economics, we formalize this trade-off or what has to be given up. We call this trade-off between making competing choices an opportunity cost. This chapter will introduce you to the concept of an opportunity cost; present different aspects of opportunity costs; and take you through a couple of detailed case studies about how opportunity costs are calculated and assessed. The case studies are provided to help illustrate the identification and calculation of opportunity costs. These case studies will help you to examine opportunity costs in different decision-making contexts and include questions that will help you go through the associated economic decision-making process.
1.1 Learning Objectives
At the end of this chapter you should be able to:
(1) Define what an opportunity cost is; and
(2) Be able to understand how to assess and calculate an opportunity cost in different problem situations.
2.0 What is an Opportunity Cost?
By definition, an opportunity cost of making a choice or decision is the value of the next best alternative that you gave up to make that choice or decision. More specifically, an opportunity cost is the value of a resource in its next best alternative use. The use is what a firm or decision-maker could have done instead of making the choice or decision they did. While a person has the option of making many different choices, it is important to recognize that the opportunity cost only considers the value of the next best alternative, not of all the other possible choices or uses of a resource. This is an important distinction to keep in mind [1,2].
A couple of examples may help to solidify this idea.
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Picture: Sleepy Student [3]
Example 1: As an undergraduate student, you usually have the option of going to class. Each day you have to decide if you will attend class or do something else. The other options could include sleeping in, going to the park, having lunch, studying for another class, watching a movie, etc. The opportunity cost of choosing to attend class is the value of the next best alternative. Assume in this case that you could narrow down the choice to either going to class or sleeping in. The opportunity cost would then be the lost value you would have received from sleeping in a couple of extra hours (i.e. the value of that rest). This value could be measured in different ways, including time, alertness, or even satisfaction.
Picture: Restaurant Investment? [4]
Example 2: Consider a restaurant owner deciding on whether to open a new restaurant on the other side of town from his current location. The owner has saved $300,000 to invest in the new restaurant. The owner was approached by a good friend to invest that money in the stock market instead, where he could have earned a 15% annual return on the investment. Assume this is the next best alternative. The opportunity cost of investing in the new restaurant is the value of using the money (or resource) in its next best alternative. That is, investing the money in the stock market. In this case, we can calculate the monetary value of the opportunity cost, which represents the lost value or return from the investment. This value would be equal to $300,000 × 0.15 = $45,000. The value of the opportunity cost here is what the owner could have earned from the investment, not the $300,000, because the owner already has the $300,000 in their possession.
Example 3: Watch the following video. This video provides a brief explanation of comparative advantage, an important concept in economics. A comparative advantage exists when an individual has a superior or better ability to undertake an activity using their resources relative to other individuals [2]. For example, a trained accountant has a comparative advantage in preparing taxes compared to a carpenter given their specialized training and skills in accounting, which reduces the use of resources (e.g. time and labor) for them in this task. When examining comparative advantages we have to take into account opportunity costs. That is, we determine if a comparative advantage exists based on the opportunity costs. Go back to the example with the accountant and carpenter and preparing taxes. Consider the amount of time used in preparing the taxes. For the accountant, preparing a tax return may take 2 hours, while for the carpenter it may take 8 hours. Based on the amount of time it takes, the accountant has a comparative advantage with respect to time in preparing tax returns. The carpenter would be better off spending that time building, as he would lose 6 hours of his time if he prepared the tax return, which could be done by the accountant in 2 hours. That is, the opportunity cost of having the carpenter prepare a tax return is equal to 6 hours instead of the accountant. That time likely could be put to better use.
Comparative Advantage [5]
The three examples illustrate that opportunity costs can have actual monetary values, but can also be measured in other terms, such as lost time, satisfaction, rest, etc. There are other aspects of opportunity costs to take into account, as well. These are outlined below.
2.1 Aspects of Opportunity Costs
Here we talk about different aspects of opportunity costs that you will need to be aware of.
(1) Opportunity costs only consider the value of the next best alternative. - While firms and individuals face many choices or alternatives for every decision they make, opportunity costs are the value of only the next best alternative. By focusing on the next best alternative, it makes sure that people examine all the potential choices or alternatives available to determine that next best alternative. Furthermore, including opportunity costs in calculating the cost of making a decision using the next best alternative helps to make sure that we are making the best or optimal choice with the information we have available. In economics, when we calculate the cost of making a decision we take into account the actual monetary cost out of pocket, which we call the accounting cost, and the value of the resources being used in their next best alternative. We refer to these costs as economic costs. That is:
economic costs = accounting costs + opportunity costs.
(2) The value of an opportunity cost does not necessarily have to be in monetary terms. - As illustrated in Example 1, an opportunity cost does not have to take a monetary value. The value of the opportunity cost could be measured in the satisfaction lost or the minutes of sleep (time) lost. This is illustrated in the following video about an entrepreneur's decision to keep their coffee shop.
Coffee Shop Economic Decision Making [6]
(3) All resources used have opportunity costs attached to them. - All the resources used in completing a task or job have an associated opportunity cost [2]. Consider the case of deciding to plant corn on your farm next year. The primary resources used to plant the corn include the land the corn is planted on, the labor needed to manage the corn crop, the capital (or machinery) needed for the corn enterprise, and the operating capital (or money) needed to buy the inputs (e.g. seed, fertilizer, pesticides, etc.) to grow the crop. The opportunity cost of the land could be the value the farmer could earn by renting the land to a neighboring farmer. The opportunity cost of the labor (or farmer's time) could be the lost income from working off the farm at another job. The opportunity cost of the capital (or machinery) could be the value of that machinery being used in another enterprise. Finally, the opportunity cost of operating capital could be the return we would earn by investing that money in the stock market over the growing season. The overall or total opportunity cost of deciding to plant corn would be the sum of the values of all these opportunity costs.
(4) Every decision may have one or more associated opportunity costs - As illustrated in point (3) above, a decision can have multiple opportunity costs that need to be considered, one for each resource that would be used and its next best use. This aspect especially becomes useful when examining problems from an economic perspective, as economics is concerned with the allocation of scarce resources.
(5) Taking into account opportunity costs helps individuals make the best "economic" choice. - By taking into account opportunity costs, a decision-maker has to explicitly consider potential alternative choices and/or uses for their resources for the decision being made. Furthermore, the decision-maker has to rank these choices by valuing them in some manner to identify the best and next best alternatives. Thus, the decision-maker ensures that they make the choice that makes the best use of their resources, making the best "economic" choice.
To explore these aspects of opportunity costs we consider two detailed case studies below. The case studies will take you through a detailed decision-making situation and have you contemplate the potential opportunity costs and their associated values.
3.0 Case Study 1: To go or not to go to college?
The purpose of this case study is to examine the opportunity cost of going to college. While many of you have already chosen to attend college, did you consider the opportunity cost of that decision? The video below provides an overview of the decision-making process one may go through in deciding to go to college. Use this information to examine the college decision and answer the questions asked here in the case study. The video below will help to provide a basis to consider the aspects of this decision process.
Should I go to College? [7]
3.1: The Opportunity Cost of Earning a Bachelor's Degree
A significant decision lying ahead of most high school graduates is whether or not to attend college and obtain a college degree. The concept of opportunity cost can help us understand whether going to college is the right decision, or if you would be better off working after high school. To be able to consider this decision, we need to know the difference in earning potential from earning a college degree. To do this, we examine the net earnings (after expenses are accounted for) for each possible choice over a 15-year time horizon (or period of time) starting when a student is a freshman.
Consider a student who wants to attend Kansas State University. The total cost of attending Kansas State University includes 4 primary costs. The largest cost of attendance is tuition, which averages $9,500 per year. Tuition is closely followed by housing, which averages $8,400 per year. On top of housing, food expenses need to be included, which amounts to approximately $100 a week for groceries, providing a total food cost of $5,200 per year. Miscellaneous expenses then add up to $4000 per year. These expenses include books, supplies, going out to eat, concerts, athletics, gas, and other vehicle expenses, as well as clothing, travel, parking permits, etc [8]. Thus, assuming a degree is completed in four years, the total expense of attendance at Kansas State University adds up to $108,400. That is:
Total expenses of college: (9,500 + 8,400 + 5,200 + 4,000) x 4 = $108,400.00
Assume the student has the good fortune of having access to scholarships, grants, and a part-time job on campus while earning their degree at Kansas State University. We will assume the student (i) receives a scholarship for $2,000 per year and (ii) has a part-time job on campus that pays $12.00/hour. The student works 20 hours a week during the school year (36 weeks). During the summer, the student can work full-time (40 hours per week) at a job that pays $13.00/hour. The summer is 12 weeks in length. The total earnings by the student from the scholarship and job during their college career is $67,520. That is:
Total earnings during college: (2,000 + ($12 x 20 x 36) + ($13 x 40 x 12)) x 4= $67,520.00
After graduation, assume the student can find a job that pays an annual salary of $55,000. While the student now earns significantly more than they did in college, their living expenses are expected to double (after tuition is dropped). Individuals that have graduated and have higher incomes, will likely spend more money on higher quality items and more items in general. Living expenses for a college graduate are assumed to be $35,200 per year. Thus, a college graduate in industry will earn a net of $19,800 per year. That is:
Net earnings per year for a college graduate in industry: $55,000 - $35,200 = $19,800.00
The next best alternative for the student, if they did not attend college, is to find a full-time job after graduating high school. Assume a graduate from high school will earn on average, $15/hour working 40-hour weeks for 50 weeks of the year (2 weeks off for vacation). At this wage rate, the high school graduate will earn $30,000 per year. Assume a high school graduate will accrue living expenses totaling $22,000 per year (a slight increase in expenses over a college student). Thus, a high school graduate will earn $8,000 net per year. That is:
Net earnings per year for a high school graduate: $30,000 - $22,000 = $8,000
We now have the needed information to calculate the total net earning from both options available to the high school graduate: go to college or take a full-time job.
The total net earnings from each of these options will allow us to assess what is the best "economic" decision and the opportunity cost of going to college.
While this provides one example, the question of whether college is worth it for a particular individual is going to be dependent on the individual, where you go to school, how you pay for school, and what career path you choose, among others.
Now consider the opportunity cost or decision of going to graduate school.
3.2: The Opportunity Cost of Earning a Masters Degree
Following graduation from Kansas State University, and with a superb Agricultural Economics degree, a student has a few paths they might take. Many students wonder whether or not to go to graduate school. Fortunately, opportunity cost applies to this decision, as well. In this continuation of the above case study, you will do more of the calculations yourself. Again, answers will be provided with the questions to help you review and learn. Finally, as with the decision to go to college or not, we need to consider the earnings after earning a graduate degree, so for this example, we will consider a 10-year time horizon after graduation from K-State.
Graduation [9]
Now consider a student who has just recently graduated from Kansas State University. This student has to decide to find a job in industry or pursue a Master of Science degree (MS) in Agricultural Economics. The MS will take the student 2 years to complete, upon which they will obtain a job in industry.
In graduate school, graduate students have the opportunity to receive a tuition waiver and/or a graduate research assistantship to help with the cost of graduate school. The tuition waiver covers all in-state tuition. The graduate research assistantship hires the student as a part-time university employee and provides them with a stipend for living expenses. Based on competitive rates, assume the annual stipend for the student is $17,000 per year. The assistantships are year-round, and most students do not work during their master’s program outside of school. Expenses for a grad student are similar to those for an undergraduate student, except that we will assume they receive a tuition waiver. Housing runs an average of $8,400 per year. Food expenses need to be included, which are approximately $100 a week, totaling $5,200 per year. Miscellaneous expenses add up to $4000 per year. Finally, we assume the student is responsible for books and fees, which come to $1000 per year. Totaling all the expenses for the student while earning their MS degree over 2 years, barring any extenuating circumstances is equal to $37,200.
Now assume that after earning their MS degree, the student finds an industry job that pays an annual salary of $75,000. Assume living expenses after graduation are $35,200 per year. Use this information to answer the following questions.
Alternatively, if a student were to choose not to go to graduate school, they would earn approximately $55,000 per year from their first industry job and their living expenses would be $35,200 (as before). We will assume they stay in the same job for all 10 years. Use this information to answer the following questions.
4.0 Case Study 2: Investing in Agricultural Livestock
Many farms in Kansas and around the nation raise livestock. One of the most significant livestock industries is cattle. Kansas ranks 3rd in the nation for the size of its cattle livestock industry. As of the beginning of 2018, Kansas had 6.3 million cattle, almost twice the state's human population. This industry generated revenues of over $7.8 billion in 2016 and was responsible for over $12.9 billion in direct and associated economic activities in 2012 [10].
Kansas State University Cattle [11]
To be able to do economic assessments of livestock enterprises on farms, a common tool is the use of enterprise budgets, which provide a detailed outlay of the costs that are faced by a livestock producer. For this case study, enterprise budgets were developed for a rangeland-based ranching operation that included production activities for stocker cattle and is based on an actual livestock operation in Kansas [12]. Stocker cattle are weaned calves grazing pastureland that are allowed to grow to a mature size that will be later moved to a feedlot.
With this information, consider the case of a rancher who owns and operates a 500-head stocker cattle ranch on 5000 acres in central Kansas. The rancher has recently received a significant inheritance from past relatives of $200,000 in cash and 2000 acres of rangeland. The rancher is interested in estimating the opportunity cost of purchasing an additional 200 head of stocker cattle this upcoming year, which would require both land and capital. Assume that each additional acre of rangeland and every dollar of the inheritance would be used in raising the additional 200 head of stocker cattle.
Provided the mortality rate remains low (i.e. below 2%), there is an opportunity for profit. The tables below provide a breakdown of the returns and additional costs per head of cattle for the coming year, providing us with a basis for opportunity cost analysis for the land and capital resources [12].
| Return Per Head |
|
| Price at Market ($/cwt) |
$165.00 |
| Initial Weight at Purchased (lbs) |
550 |
| ADG (Average Daily Gains) (lbs) |
1.8 |
| Weight at Sale (lbs) |
820 |
| Sale Value ($/cwt) |
$138.00 |
| Revenue Per Head ($) |
$1,131.60 |
| Less Cost of Animal Purchase Price |
$907.50 |
| Less Death Loss (2%) |
$18.15 |
| Return Per Head |
$205.95 |
| Additional Costs Per Head |
|
| Supplemental Mineral and Salt |
$6.00 |
| Veterinary Drugs and Supplies |
$15.00 |
| Commissions and Marketing |
$10.00 |
| Professional Fees |
$2.00 |
| Miscellaneous |
$8.00 |
| Additional Costs per Head |
$41.00 |
If the rancher decides not to purchase an additional 200 head of stocker cattle, the next best alternative would be to rent out the rangeland at $16 per acre and invest the $200,000 in the stock market at an annual interest rate of 6% for the grazing season (which is approximately 5 months or 41% of the year).
The rancher is interested in whether the net benefits of purchasing an additional 200 head of stocker cattle outweigh the net benefits of the next best alternative. Use this information to answer the following questions.
Remember, that an opportunity cost can represent the value of a resource in its next best use. The farmer had two resources that would be needed to manage the 200 additional stocker cattle: land and operating capital. The land is the additional 2000 acres they inherited and the operating capital is the $200,000 they inherited (or the money needed to purchase the cattle and inputs). Using this information, determine the opportunity costs of land and operating capital for the farmer.
5.0 Concluding Remarks
This chapter introduced you to the concept and aspect of opportunity costs used in economics. The notion of an opportunity cost allows decision-makers to take explicit account of the alternatives available to them to make sure that they are making the best "economic" decisions. This was illustrated in detail in both case studies examining the decision to earn a college degree and purchase additional stocker cattle on a ranch. Whether we recognize it or not, when making decisions and taking account of alternative choices or options, we are taking into account the opportunity costs of those decisions.
6.0 References
References:
[1] Anderson, D.A. Economics by Example. New York, NY: Worth Publishers, 2007.
[2] Barkely, A. and P.W. Barkley. Principles of Agricultural Economics, 2nd ed. New York, NY: Routledge, 2016.
[3] Image courtesy of D Sharon Pruitt through Wikimedia Commons, under license CC BY 2.0.
[4] Image courtesy of Flickr, under license CC Public Domain Mark 1.0.
[5] Video courtesy of The Land Geek through Youtube, under license CC BY Attribution 3.0 Unported.
[6] Video courtesy of Saylor Academy through Youtube, under license CC BY Attribution 3.0 Unported
[7] Video courtesy of BU Newsservice through Youtube, under licencse CC BY Attribution 3.0 Unported.
[8] Kansas State University, Office of Student Financial Assistance, Undergraduate Students 2017-2018, Costs. Available at: http://www.k-state.edu/sfa/cost/undergraduate.html.
[9] Image courtesy of Quan Nguyen through Wikimedia Commons, under license CC Attribution-ShareAlike 3.0 Unported. No changes were made to the image.
[10] Kansas Livestock Association. "Economic Impact of the Kansas Livestock Industry." 2018. Available at: https://www.kla.org/industryeconomics.aspx.
[11] Image courtesy of K-State Research and Extension through Flickr, under license CC BY 2.0.
[12] D. McCollum, personal communication, 2018.
