Core Concept 2: Opportunity Cost

by peter

1st September 2015

Opportunity Cost (OC) is the next best alternative foregone (given up) when a choice is made. When Milton Friedman said “there’s no such thing as a free lunch”, or Benjamin Franklin explained ‘time is money”, both were referring to the principle of OC –a principle that always holds for everyone, everywhere, in whatever choice they make. This eternal fact of economic life stems from the fundamental economic problem of scarcity.

“Remember that Time is Money. He that can earn ten shillings a day by his labour, and sits idle half of that day, though he spends but sixpence during his idleness, ought not to reckon that the only expense; he has really spent or rather thrown away five shillings besides.” Benjamin Franklin, Advice to a Young Tradesman (1746):

Scarcity

Economist Thomas Sowell put it like this: “The first lesson of economics is scarcity: there is never enough of anything to satisfy all those who want it.” We face the problem of scarcity every day whether we think about it or not. It might be nice to dream about a world without scarcity, but the sad reality is that the things we want are scarce because the resources that are needed to produce them are scarce

So OC expresses the basic relationship between scarcity and choice. Even if we are not asked to pay money for something, scarce resources are used up, for example, in production and there is an opportunity cost involved – what we could have produced. This applies to every consumption decision too: when I buy a pair of jeans, I could have bought two shirts for the same price (or a whole lot of other things). But notice it is the best alternative which we measure – not every alternative.

As Benjamin Franklin noted – time is scarce and has an OC. So we need to order our lives wisely, taking into account the OC of wasting time – or failing to take opportunities to get an education or enhance some skill.

Both Costs and Benefits

OC is the “cost” incurred by not enjoying the benefit that would be had by taking the second best choice available. So we need to consider:

Benefits (a monetary value)
Costs (a monetary value)

So to reason economically we need to focus on both the benefits and the costs of making that choice, and to make the comparison we need to place a monetary value on each.

An Example

I have £10,000 to invest – the legacy I received from my mother. The OC is the difference in return between a chosen investment and one that is necessarily not chosen instead. Say you invest in a share and it returns 2% over the year (it’s dividend). In placing your money in the share, you gave up the opportunity of another investment – say, a risk-free government bond yielding 3%. In this situation, your opportunity costs are 1% (3% – 2%). However, you may perceive that over the next three years the share will benefit from 10% growth, and the Government stock only 3% capital growth. In this case we need also to take into account the £1,000 capital appreciation of the share less the £300 of the stock. The benefits here of £700 (£1000 – £300) outweigh the cost (or lost amount) of the 1% lower yield per annum (£100 pa, or £300 over three years) compared with the choice I gave up of buying the government bond, when I bought the share.

Accountants measure things differently

Accountants measure only explicit costs or costs actually incurred, whereas economists measure both explicit and implicit costs, that is the opportunity costs of what might have happened had we chosen otherwise.

Explicit costs

Explicit costs are opportunity costs that involve direct monetary payments. The explicit opportunity cost of the factors of production not already owned by a producer is the price that the producer has to pay for them. For instance, if a firm spends £100 on electrical power consumed, its explicit opportunity cost is £100. This cash expenditure represents a lost opportunity to purchase something else with the £100.

Implicit costs

Implicit costs (also called implied or imputedc osts) are the opportunity costs not reflected in cash outflow but implied by the failure of the firm to allocate its existing (owned) resources, or factors of production to the best alternative use. For example: a manufacturer has previously purchased 1000 tons of steel and the machinery to produce a widget. The implicit part of the opportunity cost of producing the widget is the revenue lost by not selling the steel and not renting out the machinery instead of using them for production.

One example of OC is in the evaluation of “foreign” (to the UK) buyers and their allocation of cash assets in property or other types of investment vehicles. With the recent downturn (circa June- August 2015) of the Chinese stock market, more and more Chinese investors are turning to the United Kingdom as an alternative vessel for their investment money; the OC of leaving their money in the Chinese stock market or Chinese real estate market is too high relative to yields available in the UK property market (including expectations of capital gains here).

So Why is there “no free lunch”?

Nobel Laureate Milton Friedman was fond of saying, “There is no such thing as a free lunch.” Imagine that the friendly neighborhood pizza restaurant set up a table full of pizza boxes outside your school about lunchtime and put up a sign that said Free Pizza and Coke. Why wouldn’t that be a free lunch?

It didn’t cost you anything? Well, it may not have cost you in terms of money, but any situation which forces you to make a choice results in an opportunity cost.

Or consider this: you may spend several hours this evening tweeting and texting friends at no additional monetary cost to your phone plan. You may think of this as free, but there is a cost. What opportunity did you give up?

In his famous quote, Milton Friedman was reminding us that because of scarcity we must choose, and choice means that there is an opportunity cost. So the reason there is no free lunch is that your choice to eat free pizza means that you are giving up the opportunity to dine elsewhere, such as a local vegetarian cafe. Perhaps your evening spent tweeting and texting at home was an evening not spent with other friends at a football game.

So these three concepts – scarcity, choice, and opportunity cost – help form the foundation for economic reasoning. They are eternal principles – always true.

Introductory video http://study.com/academy/lesson/opportunity-cost-definition-real-world-examples.html

Video clips http://www.investopedia.com/terms/o/opportunitycost.asp

Further http://www.fte.org/teacher-resources/lesson-plans/edsulessons/lesson-1-opportunity-cost/