Opportunity Cost, Step By Step

Opportunity cost is an oft-misunderstood economic concept that attempts to identify just what sacrifice is being made as a result of any choice or action.

A Definition --

The opportunity cost of a choice or action 'A' is the projected benefit of choice or action 'B', the highest ranked alternative choice or action which is precluded by 'A'. The precluded benefit of 'B' is in general a packaged combination of both desirable and undesirable effects, and only rarely reducible to a net number of some kind. Neither the choice nor the precluded projected benefit are necessarily a part of an objective reality, but are entirely subjective judgments made by the chooser or actor at the moment of choice or action.

A series of examples follow.

Example 1. A Simple Choice

I have an apple and an orange and offer you the chance to choose one of them for yourself.

If you choose the apple, your opportunity cost is whatever subjective benefit you would have expected to derive from the now precluded possession of the orange. Choosing the orange would simply result in an opportunity cost that is associated with the possession of the apple instead.

It is important to note that no matter how great or small the benefits of the actual choice, they have no effect on the opportunity cost, which is only associated with the precluded best alternative 'B'. Even if the apple comes with $10M and will bestow eternal life on its possessor, its opportunity cost still rests entirely with the orange. Utilities are subjective and can only be ranked in an order of preference. They cannot be added or subtracted.

Example 2. A Simple Exchange

This time I have the apple, but you have the orange and I offer you an exchange of my apple for your orange. Whether you choose to make the exchange or not, the possible end states are identical to ones above in example 1. Therefore, the opportunity costs of accepting or declining the apple are the same as above.

Example 3. A Simple Purchase

Once again I have the apple, but now I want $5 for it. Someone stole the orange overnight, so it no longer figures in the problem.

Most people would, in the normal course of events, say that the cost of something is what you pay for it. Somewhat surprisingly, this is exactly what the opportunity cost is in this problem.

If you choose to give me $5 for the apple, then the opportunity cost is the precluded benefit that you associate with the $5 that you have given up.

The difficulty here is that virtually no-one really understands money and the benefit that it provides. If I had said that I wanted a green piece of paper with the number five printed on it, it might be clearer that this example is no different than the others in that the opportunity cost is the perceived benefit, whatever it may be, of the item given up.

While money is a medium of exchange, and a common denominator for the pricing of economic goods and services, these are necessary, but not sufficient, conditions for money to have an economic value itself. Money only has an economic scarcity value because people demand to hold it, and a given unit of money can only, and must always, be owned by one person or entity at a time. As long as the total supply of money is finite, and constant at any instant in time, that total supply is also the sum of all the money that is owned by all the holders of money. When you hold money, you are competing with everyone else for the scarce supply of money. On the other hand, actual transactions made with money do not impinge on its scarcity, as every transaction is no more than a instantaneous transfer of ownership of the amount of money involved in the transaction from the buyer to the seller.

The benefit in holding money, and the opportunity cost of spending a quantity of it, is not merely that it can be almost universally exchanged for goods and services, but that it can so be used in an uncertain and unpredictable future, where the future supply of goods and their future subjective valuations can be taken into account at the time of exchange, and need not be known in advance. If the future were perfectly known in advance, then there would be no need to hold money, and a distinct disadvantage in doing so. If all of your future purchases were known, you could loan out your money at interest and schedule repayment at exactly the moment that the money was required. Alternately, you could negotiate for discounts on advance payments for goods and services.

Money is useful not only for actual purchases, but for providing for the uncertain future, as money held can beneficially deal with emergencies such as flat tires, and with opportunities such as two-for-one sales, for example.

This use of money in providing for the day to day future is the benefit that is given up when a quantity of it is spent, and is therefore the precluded opportunity cost of a purchase.

But the value and significance of the benefit of a given amount of money is by no means constant. Prices cannot measure value. Money is an economic good in its own right, and, as such, is subject to the law of diminishing marginal utility. For a given individual, at a given instant in time, the benefit precluded by giving up $5 is likely to be grossly different depending on the amount held in an individual's ready cash balance. Giving up $5 out of a cash balance of $6 is far more significant than if the cash balance was $200, or higher. Many economists make the mistake of assuming the value of $5 is the same, whether it is being subtracted from, or added to, a cash balance of $6. Common sense would tell us that that the effective provision for the short term future may be much more subjectively damaged by a reduction of a cash balance from $6 to $1 than it will be augmented by an increase from $6 to $11.

Returning to opportunity cost, knowing the number of dollars given up in a purchase is meaningless in determining the precluded benefit without a knowledge of the level of the individual's ready cash balance. Even with this additional knowledge, the subjective benefit still varies widely over both individuals and time. It can never be measured.

Returning to the specific problem, the opportunity cost of paying $5 for an apple is the marginal benefit of enhanced provision for the future by increasing the cash level by $5 back up to the original level.

Future posts may try to apply these facts to more complex and interesting problems.

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Why is it that I get this

Why is it that I get this uncomfortable feeling that there is some form of political baggage at the end of this?

If you want to explore opportunity cost, consider a more reasonable and simple example...

You have $5,000 to spend. You are torn between a new car and a fishing boat.

The opportunity cost of the car is the $5,000 plus the cost of going on fishing charters until you have saved enough to buy a boat as well.

The opportunity cost of the boat is the $5,000 plus the increased cost of maintenance on the old car, possibly increasing fuel costs (because it is wearing out), repaint job, ...

I have an apple and an

I have an apple and an orange and offer you the chance to choose one of them for yourself.

What if the choice is between an apple and an identical apple?

Good post, Don. Thanks.

Good post, Don. Thanks.

Scott, What if the choice is

Scott,

What if the choice is between an apple and an identical apple?

Then it would be a Buridan's ass case where the animal is tethered an equal distance from two identical bales of hay.

IIRC, the difficulty of making a primary choice results in a new choice of whether to make even a random selection between the bales or to starve to death. This choice is clear, at least to humans.

As far as opportunity cost goes, even a random selection must involve an identification of the individual apples. So if the left hand apple is chosen over the right hand apple, then the opportunity cost is the precluded benefit associated with the right hand apple.

Regards, Don

I second that. Solid

I second that. Solid explanation.

"On the other hand, actual

"On the other hand, actual transactions made with money do not impinge on its scarcity, as every transaction is no more than a instantaneous transfer of ownership of the amount of money involved in the transaction from the buyer to the seller."

It seems that someone who really believed this would think that the price of money (interest rates) is not effected by the number of transactions (velocity of money).

Jeff, It seems that someone

Jeff,

It seems that someone who really believed this would think that the price of money (interest rates) is not effected by the number of transactions (velocity of money).

Yes and no.

For the most part, Austrians have little or no patience for the idea that money circulates being an explanation for anything. This includes the idea of velocity.

Interest rates are not the price of money. Interest rates result from a combination of the time preference for present consumption over future consumption and the supply and demand for loanable funds.

In the absence of money, every good and service had an effective exchange rate with every other good and service. Money provides a common denominator for the prices of every good and service except for itself. The price of money is an array of exchange rates between a unit of money and every good and service that can be purchased with money.

While there will exist some degree of correlation between the number of transactions and the exchange value of the monetary unit, this is the result of the requirement to hold some money for at least a short time in advance of exchanging it for goods or services. It is the demand for holding money that results in money having a economic scarcity value.

Regards, Don

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Rápidas * Outra boa pergunta. * Starbucks (infelizmente, não a da nova Gallactica). * Oriente Médio liberal? * Portugueses com Escolha Pública e contra Austríacos? Sim. * O que os outros cientistas sociais acham disso, eu não sei. Mas economistas...