Opportunity Cost

People face choices at every turn: in deciding to go to the hockey game tonight, you may have to forgo a concert, or you will have to forgo some leisure time this week to earn additional income for the hockey game ticket. In economics we say that these limits or constraints reflect opportunity cost. The opportunity cost of a choice is what must be sacrificed when a choice is made. That cost may be financial, it may be measured in time, or simply defined by the foregone alternative.

Opportunity costs play a determining role in markets. It is precisely because individuals and organizations have different opportunity costs that they enter into exchange agreements. If you are a skilled plumber and an unskilled gardener, while your neighbor is a skilled gardener and an unskilled plumber, then you and your neighbor not only have different capabilities, you also have different opportunity costs, and you could gain by trading your skills.

Fixing a leaking pipe has a low opportunity cost for you in terms of time: you can do it quickly. But pruning your apple trees will be costly because you must first learn how to avoid killing them, and this research may require many hours. Your neighbor has exactly the same problem, with the tasks in reverse positions. In a sensible world you would fix your own pipes and your neighbor’s pipes, and he or she would ensure the health of the apple trees in both backyards.

If you reflect upon this “sensible” solution—one that involves each of you achieving your objectives while minimizing the time input—you will quickly realize that it resembles the solution provided by the marketplace. You may not have a gardener as a neighbor, so you buy the services of a gardener in the marketplace. Likewise, your immediate neighbor may not need a leaking pipe repaired, but many others in your neighborhood do, so you can sell your service to them. You each specialize in the performance of specific tasks as a result of having different opportunity costs or different efficiencies.

Economists think of cost in a slightly quirky way that makes sense once you give it further thought. 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, not all costs are opportunity costs. Room and board would not be an opportunity 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 for this course.

Opportunity cost is defined as 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.

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 them 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 “30 days or 30 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 percent. If you are indifferent to buying the airbag, you have implicitly valued the probability of death at $400 per 0.01 percent, or $40,000 per 1 percent, or around $4,000,000 per life. Of course, you may feel quite differently about a 0.01 percent 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.

Consider the following figure, which shows the number of weeks an average human lives. Sometimes feels like our lives are made up of a countless number of weeks. But there they are—fully countable—staring you in the face. This isn’t meant to scare you, but rather to emphasize that a rational consumer doesn’t ignore time, but incorporates it into the analysis of any decision they make.

A representation of the 52 weeks in a year for every year up to age 90.
Weeks in the Average Human Lifespan

So, how do you “spend” your time? In economics, we want to place a value on each different opportunity we have so we can compare them.

What if your friends were to ask you if you want to go out to the club? How much do you value that experience? As economists, we want to measure the happiness you will get from this experience by finding your maximum willingness to pay. Let’s say that for a five-hour night at the club, the most you are willing to pay is $100. Seem high? If you have gone clubbing, this is likely close to what you paid for it.

Suppose the costs of going clubbing are $50 ($15 cover, $20 for drinks, and $15 for a ride home). With that analysis it seems like you should go, but so far we have only considered the explicit costs of the experience. An explicit cost represents a clear direct payment of cash (whether actual cash or from debit, credit, etc). But what about your time? We must consider time as another cost of the action.

How do we measure time? Simple: what else could we be doing with that time? Assume you also work as a server at the campus pub, where you get paid $15 an hour (including tips). This makes it easy to put a dollar amount on your time. For five hours of clubbing, you are forgoing the opportunity to earn $75 ($15 * 5). This is your implicit cost for clubbing, or the cost that has been incurred but does not result in a direct payment.

It is important to note that the implicit costs are the benefit of the next-best option. There are an infinite number of things we could be doing with our time, from watching a movie to studying economics, but for implicit costs we only consider the next best. If we took them all into account our costs would be infinite.

Consider the two options side by side, as shown below.

For clubbing, a willingness to Pay/Total Benefit of $100 minus explicit costs of $50 equals $50. For working, a willingness to Pay/Total Benefit of $75 minus explicit costs of $0 equals $75.
Opportunity Cost Comparison for Clubbing

This comparison shows us something interesting. Even though you are willing to pay $100 to go out clubbing, our “happiness” from working is greater. A rational consumer would chose to work. The $75 we could be earning from working is equal to our implicit costs of going out since, rather than going clubbing, we could be making money for the five hours. To truly consider costs we must always consider our opportunity costs, which include the implicit and explicit costs of an action.

The opportunity costs can be found be adding explicit costs for clubbing ($50) and total happiness for working ($75) for a total of $125 in opportunity cost.
Calculating Opportunity Costs

In this example, if you were to go clubbing opportunity costs are:

Explicit costs (cover, drinks, and ride home) : $50

Implicit costs (forgone income from five hours) : $75

Opportunity costs : $125

Should you go clubbing? You are only willing to pay $100, and your opportunity costs are $125, so no!

Does this mean you should never go out? Not at all. You just may be surprised that your willingness to pay may be well over $100.

Scarcity

This consideration of opportunity cost is rooted in an understanding that all resources are scarce. Both time and financial resources are scarce. Being a rational decision maker means considering the scarcity of all resources associated with an action. As decision makers, we have to make trade-offs on what we do with finite resources.

This leads us to a fairly simple conclusion. We should do something if the benefits outweigh the costs. The key insight is that the costs we are referring to are opportunity costs, which consider the next best alternative use of our resources.

Making Decisions

We have now looked at how to analyze two options, but how do we make the decision? We can lay the process out in three steps:

  1. Find your willingness to pay (or wage you would earn) from the option you are considering and the next-best alternative.
  2. Subtract the explicit costs from each option to find your “happiness” level.
  3. Choose the option that makes you “happier.”

If we want to change this into the process for a binary decision (yes-or-no decision):

  1. Add up all the benefits of an action.
  2. Subtract all costs explicit and implicit.
  3. If benefits are greater than costs, this is the right choice.

It is important to note that not all decisions are binary.

Sunk Costs

Just as it is important to understand the costs that should be considered in decision making, it is important to understand what costs should not. Consider the two options you may have when you wake up: do you work out or sleep in? Have you ever convinced yourself to get out of bed by reminding yourself that you paid $60 for your monthly gym membership? Well, you fell victim to a common logical fallacy.

A sunk cost is a cost that, no matter what, is unrecoverable. As such it should have no impact on future decision making. This may sound strange, but consider your two options using the analysis learned above for making decisions.

For work-out, a willingness to Pay/Total Benefit of $20 minus explicit costs of $0 equals $20. For sleeping in, a willingness to Pay/Total Benefit of $30 minus explicit costs of $0 equals $30.
Opportunity Cost Comparison for Working Out

Following our steps, we find the maximum willingness to pay for each option, subtract the explicit costs, and compare the happiness from each. It does not matter that we spend $60 on a gym membership because no matter what we do we can’t get that money back. With this willingness to pay reflected in the table, the better option is to sleep in, with an opportunity cost of $20.

Notice that the $60 is not included as an explicit cost because it is not an additional cost we have to incur as a result of working out. Since we have already paid the $60, it is no longer something we consider.

Sunk Costs & Business

Sunk costs aren’t exclusive to gym memberships, in fact, the sunk cost fallacy is common in big business and government. Ever heard someone explain, “we’ve invested too much in this project to back out now?” Even if you have not, it sounds fairly logical; unfortunately it is not.

Consider a mining company that has invested $5 million in the infrastructure of a mine. After new information is revealed, they learn of another, richer mine site that they can mine for $4 million, with projected revenues of $8 million. The current mine site will cost $1 million to extract the remaining resources ($4 million projected revenue). What should the company do?

While there are $5 million in sunk costs to continue mining the old site, there are no sunk costs in the new site.
Decision-Making Matrix Showing Sunk Costs

As shown, the total profits from the new site are higher, so despite the fact they have invested $5 million in the old site, they should abandon it and mine the new one.

The conclusion: sunk costs are irrelevant for decision making.

Licenses and Attributions

1.3 Opportunity Cost and the Market from Microeconomics: Markets, Methods & Models by Douglas Curtis and Ian Irvine is available under a Creative Commons Attribution-NonCommercial-ShareAlike 3.0 Unported license. UMGC has modified this work and it is available under the original license.

Opportunity Cost from Beginning Economic Analysis is available under a Creative Commons Attribution-NonCommercial-ShareAlike 3.0 Unported license without attribution as requested by the site's original creator or licensee. UMGC has modified this work and it is available under the original license.

1.2 Opportunity Costs & Sunk Costs from Principles of Microeconomics by Emma Hutchinson is available under a Creative Commons Attribution 4.0 International license. © 2017, University of Victoria. UMGC has modified this work and it is available under the original license. Download this book for free at http://open.bccampus.ca.

1.2 Opportunity Costs & Sunk Costs from Principles of Microeconomics by Emma Hutchinson is available under a Creative Commons Attribution 4.0 International license. © 2017, University of Victoria. UMGC has modified this work and it is available under the original license. Download this book for free at http://open.bccampus.ca